Heads I Win, Tails You Lose - Painless Risk Taking

The heated stock market for high-tech startups has spawned many newly rich through riskless stock options.

If you run a startup company in the U.S. with a tight budget, but you need competent employees to successfully launch your company, what can you offer to attract talents without ponying up high salaries?

Generous stock options, of course.

Stock options confer to employees the right (not an obligation) to buy a certain number of shares in a company at a fixed price pegged to the trading price at the time of the grant (i.e., the grant price or strike price). Options typically "vest" over five years, at the rate of 20% per year. Employees can "exercise" their grant only after it is vested. Vested options will expire after a specified period of time if they are not exercised.

Employees are willing to accept less than competitive salaries if they expect their options' appreciation will more than offset the lower salaries. When the market price of the company's stocks goes up, employees who exercise their options will pocket the difference between the exercise price and the grant price (minus income tax and brokerage fee). Thus, the risk of foregoing market salaries may be amply compensated by the stock appreciation.

On the other hand, if the market price falls below the grant price, employees have foregone competitive salaries without any offsetting compensation. It seems like the employer has successfully shifted the risk of running the company to the employees. But, if the employer does not make up for the loss, his talent employees will look for greener pastures elsewhere. And with them goes the hope of ever reviving the business. This threat is especially serious in knowledge-intensive high-tech startups where the only important assets are the highly skilled employees. So, many companies resort to repricing¹ their stock option grant to reflect the lowered stock price in an attempt to hold on to the talent pool. In effect, repricing stock options has taken any risk of foregone salaries away from employees.

In short, whether the company stock goes up or down, employees with stock options always come out on top.

Options emerged in the late '80s as a way to link top executives' pay and stock performance. Silicon Valley firms gave them to most employees to offset the low pay of a start-up or compensate for long hours. Now options are distributed throughout the corporate food chain and far beyond tech enclaves (see note2²) (Newsweek). The long vesting period was intended to reduce the high turnover rate of important employees. Increasingly, many companies are granting options that can be converted into stock relatively quickly in order to attract talents. If a competitor wants to hire someone badly enough, it will simply offer enough new options to make up for any money left behind. Few consultants still argue that options are a tool to retain executives in Silicon Valleys. High-tech companies lose as much as a fifth of their work force each year (New York Times).

The importance of stock options in the compensation package is due to a number of factors: a) an overheated stock market -- one where the performance of certain Internet highfliers seems to have little to do with fundamental performance -- is creating an employment environment that resembles a lottery³; b) an attempt on the part of old-line companies to match the pay packages of high-tech startups to reduce employee defection (Business Week 3/30/98 & WSJ 6/9/99); c) tax advantages⁴ enjoyed by companies in the form of deductions for the appreciation of options when they are exercised, but not as cost when the options are granted (WSJ 5/13/97)

Stock options have been attractive elements of employee compensation packages only because repricing has taken the risk out of the gamble. But, the gravy train has been brought to an end by an announcement of the Financial Accounting Standards Board (FASB). After December 15, 1998, companies must account for repriced options as an expense chargeable to earnings (Business Week 2/15/99).