In Part 1 of this three-part series on ESOPS, I expressed concern that the combination of economic uncertainty, cost-cutting measures, and unwarranted vilification of cash incentives might result in an upsurge in Employee Stock Option Plans (ESOPS). In that posting, I described my concern in terms of the following objections:
- The volatility of share price
- Minimal employee impact or control over this price
- The artificial illusion of extreme value fostered by granting large numbers of low-value shares
- Managers creating unrealistic expectation of the future value of options
- Excessive complexity and administrative expense
- The huge distraction (even obsession) caused by such programs
- The tendency for options to create more selfishness (and jealousy) than teamwork
But this is only the tip of the ice-berg. The effectiveness of any compensation program is directly related to how well employees understand it. Since stock options are among the most complex compensation vehicles around, a major communication and education effort is essential in order to avoid confusion and dissatisfaction. This is particularly important with options because unlike other forms of compensation, there is a long list of gotchas than can creep up to bite employees in the backside and shatter their expectations. Below is a list of some of these things:
Stock options are rarely owned by employees when they are granted. Instead, the employee "vests" or qualifies for their options over time based on some schedule. These schedules often require employees to wait 4 or 5 years before they actually own the options granted to them when they join the company.
Dilution occurs when investors put money into the company and receive stock in return. This has the immediate effect of reducing the value (not the number) of everyone else's shares.
When companies go public, it is not uncommon for them to declare a reverse split. This is an instantaneous reduction in the number of shares owned by all employees. One of my clients had been telling employees for months that their stock would be valued around $12 per share when it went public. They neglected, however, to mention that this was after a 10:1 reverse split (they argued that such information would demotivate the employees so they conveniently suppressed it). So while it is true that the stock did come out around $12 per share, every employee lost 90% of their shares, effectively making their stock worth $1.20 per share, not the $12 they were promised.
Some stock plans involve buy-out clauses that enable management to buy-back employee shares at any time at the fair market value that exists when the buy-back occurs. I once owned a 5% share in a Company that was rapidly increasing in value. When management saw that the company would be worth a fortune in a few years, they activated the buy-out clause, paying me a small amount for shares that three years later were worth a fortune.
Stock options are granted as common stock. But some companies also issue preferred stock (usually to investors) with considerably greater privileges and hence value. Since preferred stock gets paid out first, there are many instances where the holders of common stock (i.e., the employees) end up with nothing.
Stock options normally have expiration dates. It is possible for employees to wait 5 years for shares to fully vest then have them expire before they are worth anything.
Not surprisingly, with such complexity, uncertainty, confusion, and greed, stock options are ripe for litigation. This is a great boon to lawyers, but a source of enormous frustration, delays and ultimately disappointment for employees.
Before a company is publicly-traded, the value of stock options must be determined through an independent valuation. This amounts to a complex financial analysis followed by a judgment call on the part of a valuation professional. Such professionals value companies based on a number of different variables, but the most important one is profitability. Unfortunately, profitability can be easily manipulated by those with a controlling interest. I have one client whose company profit is severely impacted by the owner's lifestyle, much of which is charged to the business (corporate jet, country retreat, expensive meetings in exotic places). By the time all this is over, there isn't much profit and the value of the business is adversely impacted.
THE BOTTOM LINE
Whenever I am advising business owners about whether or not to create a stock option plan, I usually suggest they keep their equity and find other ways to motivate employees. Whenever I am advising employees about whether or not to accept a job involving a significant cut in pay in return for stock options, I usually suggest that they negotiate for more cash or look for another job. At the end of the day, stock options don't do the company or its employees any favors. Both are better off making effective use of incentives which are far better at driving results. They also pay employees in something they can count on, cash.
In the next entry of this three part series, I will take a look at the type of ESOP I really like, the Employee Stock Ownership Plan.