How do management stock options work

Although fairly common in small companies—especially those in Silicon Valley—option repricing is relatively rare for senior managers of large companies, despite some well-publicized exceptions. Again, however, the criticism does not stand up to close examination. For a method of compensation to motivate managers to focus on the long term, it needs to be tied to a performance measure that looks forward rather than backward. The traditional measure—accounting profits—fails that test. It measures the past, not the future. Stock price, however, is a forward-looking measure.

What App Users Care About When Sharing Personal Data: Permissions

Forecasts can never be completely accurate, of course. But because investors have their own money on the line, they face enormous pressure to read the future correctly. That makes the stock market the best predictor of performance we have. But what about the executive who has a great long-term strategy that is not yet fully appreciated by the market? Or, even worse, what about the executive who can fool the market by pumping up earnings in the short run while hiding fundamental problems?

5 Basics I Wish Everyone Knew About Employee Stock Options – Daniel Zajac, CFP®

Investors may be the best forecasters we have, but they are not omniscient. Option grants provide an effective means for addressing these risks: slow vesting. That delay serves to reward managers who take actions with longer-term payoffs while exacting a harsh penalty on those who fail to address basic business problems. Stock options are, in short, the ultimate forward-looking incentive plan—they measure future cash flows, and, through the use of vesting, they measure them in the future as well as in the present.

If a company wants to encourage a more farsighted perspective, it should not abandon option grants—it should simply extend their vesting periods. Their directors and executives assume that the important thing is just to have a plan in place; the details are trivial. As a result, they let their HR departments or compensation consultants decide on the form of the plan, and they rarely examine the available alternatives. While option plans can take many forms, I find it useful to divide them into three types. The first two—what I call fixed value plans and fixed number plans—extend over several years.

The third—megagrants—consists of onetime lump sum distributions. The three types of plans provide very different incentives and entail very different risks. With fixed value plans, executives receive options of a predetermined value every year over the life of the plan. Fixed value plans are popular today. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by compensation consultants that document how much comparable executives are paid and in what form.

But fixed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay and performance. Executives end up receiving fewer options in years of strong performance and high stock values and more options in years of weak performance and low stock values. The stock price has doubled; the number of options John receives has been cut in half. He ends up, in other words, being given a much larger piece of the company that he appears to be leading toward ruin. For that reason, fixed value plans provide the weakest incentives of the three types of programs.

I call them low-octane plans. Whereas fixed value plans stipulate an annual value for the options granted, fixed number plans stipulate the number of options the executive will receive over the plan period. Under a fixed number plan, John would receive 28, at-the-money options in each of the three years, regardless of what happened to the stock price. Here, obviously, there is a much stronger link between pay and performance. Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases the value of future option grants.

Likewise, a decrease in stock price reduces the value of future option grants. Since fixed number plans do not insulate future pay from stock price changes, they create more powerful incentives than fixed value plans.

I call them medium-octane plans, and, in most circumstances, I recommend them over their fixed value counterparts. Now for the high-octane model: the lump-sum megagrant. While not as common as the multiyear plans, megagrants are widely used among private companies and post-IPO high-tech companies, particularly in Silicon Valley. Megagrants are the most highly leveraged type of grant because they not only fix the number of options in advance, they also fix the exercise price. Shifts in stock price have a dramatic effect on this large holding.

Every few years since , Eisner has received a megagrant of several million shares. Since the idea behind options is to gain leverage and since megagrants offer the most leverage, you might conclude that all companies should abandon multi-year plans and just give high-octane megagrants.

When viewed in those terms, megagrants have a big problem. Look at what happened to John in our third scenario. After two years, his megagrant was so far under water that he had little hope of making much money on it, and it thus provided little incentive for boosting the stock value.

What to Expect Upon Exercise

And he was not receiving any new at-the-money options to make up for the worthless ones—as he would have if he were in a multiyear plan. It would provide him with a strong motivation to quit, join a new company, and get some new at-the-money options. Ironically, the companies that most often use megagrants—high-tech start-ups—are precisely those most likely to endure such a worst-case scenario. Their stock prices are highly volatile, so extreme shifts in the value of their options are commonplace. And since their people are in high demand, they are very likely to head for greener pastures when their megagrants go bust.

Indeed, Silicon Valley is full of megagrant companies that have experienced human resources crises in response to stock price declines. Such companies must choose between two bad alternatives: they can reprice their options, which undermines the integrity of all future option plans and upsets shareholders, or they can refrain from repricing and watch their demoralized employees head out the door.

Silicon Valley companies could avoid many such situations by using multiyear plans. The answer lies in their heritage. Before going public, start-ups find the use of megagrants highly attractive. Accounting and tax rules allow them to issue options at significantly discounted exercise prices. The risk profile of these pre-IPO grants is actually closer to that of shares of stock than to the risk profile of what we commonly think of as options.

When they go public, the companies continue to use megagrants out of habit and without much consideration of the alternatives. This can be a way to recognize the profit on your option grant and receive cash, but you will no longer hold the stock, potentially forgoing future growth. Our financial planners and tax experts can help you explore alternatives for exercising your stock options and help you plan for your future.

How do stock options work?

Reach out to our team to get started. As a hematopathologist, Steven Kussick focuses on blood-related cancers such as lymphoma. The Treasury Department and the IRS announced that the federal tax filing deadline for individuals has been extended to May 17, Employers can reduce risk and streamline the operations of their retirement plan by sweeping small k accounts of former employees.

Please remember that past performance may not be indicative of future results. Moreover, you should not assume that any discussion or information contained on this blog serves as the receipt of, or as a substitute for, personalized investment advice from Brighton Jones LLC.

Brighton Jones LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.

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The other piece of your vesting schedule to keep in mind is the total length of the vesting schedule. This outlines how often, and for how long, your shares will vest. In this example, after you reach your cliff, your remaining shares will continue to vest for three years—two shares each month.

If you leave the company, your shares will stop vesting immediately and you can only buy shares that have vested as of that date. And you only maintain this right for a set window of time, called a post-termination exercise PTE period. Historically, many companies made this period three months. However, some companies offer more generous PTE periods now.

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At Carta, for example, you have as long as you worked at the company to buy your shares. These are the four things that every startup employee should think about when they receive their offer letter and join a new company. In our next section, we cover how to think about what your options are actually worth.



Read Equity Part 2. Read Equity Part 3.