Evaluating Stock Options as Attraction, Retention, and Incentive Alignment Tools

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In my second year as a CEO, it became clear to me that our business could benefit from formalizing and codifying our company’s core values. Though I was originally fearful that they might quickly devolve into tired, clichéd, and mostly hollow platitudes, I eventually came to appreciate that if they were formulated, rewarded, and communicated correctly, core values could become a powerful set of guiding principles for our company, that would help us define our culture, purpose, and who we truly were both as individuals and as a group.

Though each of our values were important, the value to which we referred most frequently was thinking and acting like an owner (we playfully titled this “We Take out the Trash”). To ensure that this value had substance behind it, I decided to make select employees (specifically, the members of my management team) actual owners of the company by way of issuing them stock options. After all, what better way to have people act like owners than to actually make them one?

After many years of using company stock options as attraction, retention, and incentive alignment tools, I’ve come to appreciate their merits, risks, and possible alternatives. I intend to share these lessons with you today.

More specifically though, below I will argue that while options do have their time and place, there are often much simpler and less expensive alternatives that arguably have a greater impact on attraction, retention, and incentive alignment.

But before we get into any of that, let’s briefly define what options are.

The Basics: Definition and Major Economic Terms

A stock option is essentially a legal agreement that allows its holder to purchase shares in a company at a pre-determined price (known as the “strike price”) at some point in the future. At the time of that purchase (otherwise known as “exercising” the option), the holder benefits from the difference between the strike price and the current fair market value of the shares in question. For example, if you have the option to purchase shares in a company at $10, but the current fair market value of those shares is $30, then the holder can buy the shares at $10, immediately sell them at $30, and pocket the $20 difference.

Though stock options can feature a wide variety of legal and financial terms, those presented below tend to be particularly common. As you consider issuing your own stock options, note that each of the terms below represents a possible lever for you to pull to create the specific type of incentive that you’re hoping to create.

(1) Vesting: Vesting essentially refers to how or when an option becomes “exercisable” for its holder. For example, if you grant somebody options for 120 shares on January 1^st, and have them vest evenly throughout the course of a year, then the recipient will receive (and can exercise, if they so choose) 10 shares/month for 12 months. Vesting doesn’t have to follow such a simple and linear schedule however, and indeed provides the issuer of the options with plenty of creative possibilities to encourage specific behaviors. For example:

• Options can vest based on the passage of time (monthly, quarterly, or annually). Structures like these are often used when employee retention is the primary goal
• Options can also vest based on agreed upon financial or operating results (for example, hitting a certain revenue target by a certain date). Structures like these are often used when incentive alignment or rewarding great performance is the primary goal

(2) Cliffs: A “cliff” simply refers to when the vesting period actually begins. Using our simple example above, if there was no cliff, then the options would begin vesting immediately upon their issuance on January 1^st. However, if that vesting period was subject to a 6-month cliff, then the vesting period would begin on July 1^st (6 months after their initial issuance). Cliffs tend to be particularly useful when granting options to newly hired employees. This is so because if an employee quits or is terminated prior to the cliff date, then they are not entitled to exercise any of their shares, as they haven’t yet begun to vest (in our example, the 6-month cliff period will be used to determine whether the newly hired employee is indeed worthy of becoming a shareholder in the company). Conversely, cliffs tend to be less common when issuing options to long-tenured employees.

(3) The Strike Price: Perhaps the most fundamental term in any option contract is the strike price. That is, at what price the holder can exercise their options. Broadly speaking, there are three very different approaches to the strike price that you can choose to employ:

• “In the Money” Options: An option that is “in the money” is one where the strike price is less than the current fair market value of the company’s shares (note that a strike price can set be as low as $0.01). In instances like these, the option acts as more of a “reward” for work already done (akin to a simple share grant in many ways) as opposed to an incentive to create incremental value over and above the company’s current worth. Note however that an in-the-money option may create material tax consequences for the holder, as they have clearly received something of value, which often represents a taxable transaction. In addition, these options often have more meaningful dilution implications for existing shareholders (both described in further detail below)

• “At the Money” Options (Fair Market Value Strike Price): More commonly, the strike price will be set at the current value of the shares at the time of issuance. For example, if the company is worth $10/share today, then the options issued today will also have a strike price of $10/share. In instances like these, the options have no economic value today, and only have value to the extent that the company’s valuation increases in the future. For this reason, fair market value strike prices tend to be less of a reward-for-work-already-done, and more of an incentive-for-work-still-yet-to-come. They also tend to have fewer tax consequences for the recipient, as the options granted to them don’t yet have any economic value, and therefore often don’t represent a taxable transaction at issuance.

• “Out of the Money” Options: “Out of the Money” options feature a strike price that is greater than the current share price of the company. As a result, these tend to be more common in instances where the recipients are rewarded only for creating very meaningful economic value for the company.

(4) Acceleration: Some options feature an acceleration clause, which says that the vesting schedule gets “accelerated” (i.e. all options immediately vest) upon a “change of control” event, typically a sale or majority recapitalization of the company. This is a common clause in instances where a liquidity event represents an explicit goal for the company, and there is a willingness on the part of management to allow employees to benefit from achieving that goal.

As with each of the terms profiled here, issuers can tweak the acceleration clause to incent specific types of behaviors or outcomes. For example, acceleration clauses can be written to only come into effect at certain enterprise values: If value of the company at the time of the change of control event is greater than a certain number, all shares can immediately vest. If not, then the options in question aren’t subject to the acceleration clause, and the holder can only exercise those options that have vested already.

(5) Option Forfeiture: One of the trickier clauses in most option contracts contemplates what happens to the options should the employee leave the company (whether they quit, get terminated without cause, or get terminated with cause). More specifically, the option contract will have to stipulate what happens to both vested and unvested options should the employee leave the company. Again, how you structure this specific clause may have an impact on what types of incentives you’re looking to create: If retention is your primary goal, then you may choose to have a relatively punitive forfeiture policy, which would create an economic disincentive for the holder to ever leave the company. If however you’ve issued options to long-tenured employees as a sort of reward-for-work-already-done, then you may choose to utilize a more employee-friendly forfeiture policy, which often sees the holder keep their vested options, even if they were to leave the company.

(6) Fair Market Value Buyback: Some option contracts feature a “fair market value buyback” clause, which would allow the company to repurchase the shares from the recipient at a fair market value. In small, illiquid, private companies however, fair market value is often very difficult to determine in any instance other than upon a liquidity event, so this clause often needs to stipulate how fair market value will be determined, usually with the help of a neutral, third-party valuation firm.

Benefits of Stock Options

Though I think that there are often simpler, cheaper, and more effective alternatives than options, I don’t think that they’re without value entirely. Indeed, options can play a meaningful role in your overall attraction, retention, and incentive alignment strategy. Below is a list of some of their primary benefits:

• Options do indeed allow key employees to benefit financially from a liquidity event, which is fitting given that those same employees often helped to create the value being crystallized by the transaction in the first place. In addition to this, remember that members of your senior leadership team are likely to play key roles in the transaction process itself (responding to questions, furnishing due diligence requests, and so on), so it usually doesn’t hurt to provide them with an incentive to do the best job possible throughout the course of that process.

• More qualitatively (but not to be overlooked), is the symbolic or optical importance of making a key employee an owner of the company. Even if the financial rewards associated with options are difficult to value and may reside many years into the future, simply being granted options is often a very meaningful gesture, especially for employees who have never participated in something similar in the past. Related to this, options may also indeed play a role in incenting “owner-like” behaviors by their holders: If you’re an owner of the company, you may be more likely to book your next hotel at the Red Roof Inn instead of the Four Seasons.

• In certain industries (early-stage technology and software immediately come to mind), options have grown into a prerequisite of sorts, often required to attract new, in-demand employees. The importance of being able to issue options to new employees is particularly important for smaller, resource-constrained companies who may not be able to pay market salaries.

• Depending on the wording of the forfeiture clause described above, I think it’s reasonable to suggest that options do indeed play a role in retaining key employees, especially if a) the value of the options is reasonably well understood by the recipient, b) a liquidity event is a realistic possibility, and c) the dollar amount involved is material.

• Options can sometimes act as an important attraction mechanism for external Board members who may not have had the chance to be an original investor in the company

Challenges & Drawbacks of Options

Without negating any of the very real benefits discussed above, my experience is that the value of options as attraction, retention, and incentive alignment tools is higher at an intellectual level than at a practical level. This is so for several reasons, including:

• Options are relatively complicated financial instruments, and they tend to elicit as much confusion as they do excitement on the part of their recipients

• Related to this, options are very hard to value, especially in small, privately held companies where there is no liquid market for the shares and no opportunity for price discovery. How valuable is an at-the-money option to purchase 20,000 shares in a small marketing consultancy at some point in the future? What happens if we never sell the company? How do I know that the strike price chosen is indeed representative of the current value of the company? These are all very reasonable questions for any option recipient to ask.

• Options are illiquid, and don’t have any inherent value unless and until there is some sort of liquidity event. As somebody once told me “I can’t buy groceries with options”

• With options, there is typically a very long time that elapses between behavior (like increasing revenue) and reward (like collecting proceeds from a liquidity event). As any introductory psychology textbook will tell you, incentives are most powerful when there is a very short period of time that elapses between behavior and reward. As a result, it’s reasonable to propose that options may not have the incentive power that most introductory finance textbooks might suggest. For this reason, options are often treated as “lottery tickets” of sorts among their recipients, that may have some upside in the future, but possess very uncertain (if any) value today.

• The size of any given option pool (that is, the number of options that a company is permitted to offer to its employees) is typically determined by the company’s Board of Directors, and has to appropriately weigh the pitfalls of dilution against the potential benefits specific to attraction and retention of key employees. Though any option pool tends to be better than no option pool, some option pools are so small that they never really get the opportunity to have their desired effects, especially if the plan is to distribute them across a number of different employees.

• Beyond some of the complexity already discussed above, remember than when options are exercised, the holders of those options become actual shareholders in the company. When there are several shareholders present, often there is a requirement for a shareholders agreement, itself a long, complex, and multi-variable legal agreement that governs the rights, responsibilities, and relationship between the company’s various shareholders. If you don’t currently have one in place, you may need to draft one, which can be a long, complicated, and expensive process.  

• Under the right circumstances, options can be taxed as a capital gain, which represents much more favorable treatment relative to something like a cash bonus, which would be taxed as ordinary income for the recipient. That said, most jurisdictions tend to have very specific rules around when option proceeds can be taxed as a capital gain, and when they can be taxed as ordinary income. For example, in Canada, employees must have exercised their options – and must have held them for at least two years – before they’re eligible for capital gains treatment. If options remain unexercised, or if they were exercised less than two years ago, then they lose their tax advantage.

• Closely related to the tax point mentioned above: When employees exercise options, they have an obligation to actually write a check to the company for the value of those options (equal to the strike price per share x the number of shares owned). In many instances, this could represent tens or hundreds of thousands of dollars of cash that most employees simply don’t have on hand. Of course, employees could choose to exercise their options only upon a liquidity event (which tends to be a “cashless” transaction, as their buy-in simply gets netted out from their transaction proceeds), but such a scenario would see them lose their capital gains tax treatment, as they have not been exercised and held for at least two years.

Other Alternatives for Attraction, Retention, and Incentive Alignment

Depending upon the incentives that you’re hoping to create, there are several other options that CEOs can utilize to achieve their attraction, retention, and incentive alignment goals. I present some of these alternatives below, but won’t comment on their tax and dilution implications for the sake of brevity:

• Profit sharing programs, where employees are entitled to X% of a company’s annual profit (or Y% or a company’s annual profit over-and-above a certain target number)
• A simple cash-based “closing bonus” (that could scale up with higher levels of enterprise value) paid to key employees upon a liquidity event
• Phantom equity: A slightly more formalized version of the closing bonus mentioned above is “phantom equity”, where employees receive hypothetical shares that track the value of the company’s actual equity. This isn’t real equity, but is instead a promise to pay out a future cash bonus based on the appreciation in the value of the company over a specified period of time.

My favorite method of all however also happens to be the simplest: A cash bonus paid to an employee once they achieve some sort of desired outcome. This could take the form of a “stay bonus” paid to a critical employee 6-12 months after acquiring their company (retention-focused), a bonus for beating a certain revenue or profit number (reward-focused), or a signing bonus for a new employee (attraction-focused). The reasons why I like this approach so much are almost the complete inverse of why I find options to be so imperfect. Cash bonuses:

• Are simple
• Are easy to value
• Are easy to understand
• Are liquid (you can indeed buy groceries with cash bonuses!)
• Feature a very short time period between action and reward (thus increasing their motivational qualities)
• Don’t require a shareholder’s agreement to be drafted
• Are flexible, given that they can change each year (or quarter, or month) depending on what’s most important to the company at the time
• Allow you to change course and correct mistakes more easily: If you preemptively offer options to certain employees during your first month as a new CEO, only to realize 12 months later that the person in question was never worthy of those options in the first place, you have very little recourse. With a cash bonus under similar circumstances however, you can simply elect not to offer a similar bonus in subsequent years
• If the employee in question leaves for any given reason, usually they simply forfeit their right to the bonus payment with no further legal or financial headaches

In Sum

Though stock options certainly have their time and place, my direct experience suggests that there are often much simpler and less expensive alternatives that arguably have a greater impact on attraction, retention, and incentive alignment. For the reasons articulated above, the next time that you consider offering options to your own key employees, ask whether it might be better to offer them a simple cash bonus instead.

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