Hopefully you’ve read the first blog of this series about stock options. This article will address stock options from an employer’s perspective.
Benefits of Using Stock Options
The biggest reason companies use stock options is to incentivize their key employees. Stock options can be a great way to tie the performance of management and employees to company performance, leading to increased focus, commitment, and longevity. While stock-based compensation is an important element in businesses small and large, start-ups see quick correlations since employees can witness the direct impact that their efforts have on the value of the company and as a result, on their shares.
Another major advantage is to attract top talent, especially management. Entrepreneurially minded individuals join start-ups for the growth potential instead of the salaries (which can be fairly meager in the early years)—manifesting itself in an equity stake in the company. Without stock-based compensation, it can be extremely difficult to attract top management talent. Consider a local example from a company we advised in Utah County. They were a young but budding start-up and very strapped for cash. At our suggestion, they got more aggressive with their incentives and began offering more in the way of stock options. Although this came at a cost (giving up equity), it had a positive overall impact since they were able to hire the management team they needed to grow the pie for everyone.
The last reason is that stock-based compensation can act as a serious talent retention tool. In our ever-evolving, Utah startup environment, the next big thing is right around the corner. Smart companies offer stock-based compensation. Smarter companies use a vesting schedule so that those options become the employee’s only after they hit tenure with the company—usually in tranches.
Selecting Employees for Options
First rule: select with caution. Once they’re an owner and on the cap table, their name will come up in every equity or financing discussion. There is a balance between giving up too much at a discount and using it wisely to incentivize employees. Most large, publicly traded firms offer stock options to most of their employees, and other non-tech, well-developed firms are doing the same. A common mistake is offering too many options too soon, leaving no room for additional options to future employees.
As an outsourced CFO, I have seen the good, the bad, and the ugly. Be careful in your analysis when considering stock options—and give us a call if you’d like to talk through it.