In recent decades, and particularly in the IT field, stock options have become increasingly popular as a method of compensation.
But should you accept stock options in lieu of salary?
A good question came in on this topic, in which the writer is debating accepting a lower salary in the hope that stock options will more than make up the difference:
“I’m in the process of considering a new career opportunity with a well-known privately held startup rumored to go public in the next year/year-and-a-half. Part of the compensation package will include equity, or stock options. Based on preliminary conversation, the salary they may offer would be slightly lower than the going rate for this position (say 10-15% less), to be compensated by an equity offer (stock options or restricted stock). My question is, how to negotiate a ‘number’ of these options to compensate for a lower salary over the next couple of years. Is there a formula for that?
Also, from the company’s point of view would the value of equity offered be tied directly to the perceived difference between the salary offered and the prevailing market rate or is it typically much more since if the company does well, I may be able to sell my shares at a profit. If the company doesn’t do well, my options might not be worth much, or anything at all, hence a risk. Please advise or reference sources to provide guidance.”
Let’s start by saying that there is no mathematical equation to help in determining the balance between salary and stock options.
More significant is the risk/reward relationship involved with stock options: The options could make you rich – but they can also become worthless.
But before we get into that, let’s talk a bit about the basics of stock options.
What are stock options?
Sometimes referred to as employee stock options, or simply ESO’s, they are granted by an employer, enabling the employee the right (but not the obligation) to purchase a certain number of shares at a specific price and at a specific point in time in the future. They’re most commonly offered to managers and officer-level positions.
Options usually have expiration dates. If the options are not exercised by those dates, the options will expire and become worthless. There is also a vesting period, after which the employee will have full ownership over the options. Vesting might occur over, say, five years. Vesting is a strategy that employers use to keep employees with the company for longer periods of time.
The market value of the stock at the time the options become vested determine the value of the options. And naturally that can never be known at the time the options are granted.
After two years with the company, the employee is vested in another 200 shares. But the value of the company’s stock has fallen to $40 per share. The options have no value unless the stock climbs to over $50. If the options expire before that price is reached, they will become worthless.
Why an employer would want to offer stock options
There are several reasons why employers offer stock options:
- To preserve cash – options don’t require out-of-pocket cash, like salaries do
- As an incentive to attract new employees
- As a performance incentive for existing employees (a higher stock price results in higher option payouts)
- To keep employees with the company longer (the main reason behind periodic vesting)
Trading salary for stock options
The writer of the opening question describes the employer he’s considering as a “well-known privately held startup rumored to go public in the next year/year-and-a-half.” There are two red flags in that assessment: startup and rumored.
What makes those two words so dangerous? “Startup” implies that the employer is a new or fairly new company. And “rumored” means that whether or not the company will actually go public is still subject to some speculation. Meanwhile, the fact that the event is not expected to take place for at least another year, means that the stock doesn’t even exist right now.
Due to market factors alone, there is always the risk of options becoming worthless, even with a well-established blue-chip company. All that needs to happen is for the market price of the stock to fall below the exercise price of the option.
The situation is much more problematic with a startup company.
There’s no way to know what the market reaction will be to the stock once it goes public. Though we hear of initial public offerings rocketing out of the starting gate and making the holders rich, stock prices fall at least is frequently.
That means that it is entirely possible that the salary the employee will give up in favor of stock options will never materialize. The employee will be betting that the future of this upstart will be very positive, and the company’s stock will be well received by the market. But if circumstances don’t break in that direction, he could not only be at risk on his job, but also on his projected investment in the company’s stock.
That’s double jeopardy, and likely too much risk with any job.
The better strategy with stock options
Stock options are an excellent benefit – if there is no cost to the employee in the form of reduced salary or benefits. In that situation, the employee will win if the stock price rises above the exercise price once the options are vested. And if the value of the stock never reaches the exercise price, the employee loses nothing.
The best strategy for this employee is to negotiate a market level salary. That will eliminate the risk of the many variables connected with the options, such as if the company will actually go public, how well received the stock will be when it does, the exercise price level of the options, and what the vesting schedule might be.
These are all variables that cannot be adequately factored into the decision at this point. Go with the market-level salary, and negotiate for the stock options as a secondary consideration.
This post originally appeared on Business Insider.