Exercise Your Options

Offering stock options could help you nab the most desirable employees.
Magazine Contributor
6 min read

This story appears in the April 1998 issue of Entrepreneur. Subscribe »

When is a whole pie worth less than a piece? If your is that pie and you're holding all of it, you may be hindering the company's growth, making it worth less than it could be. That's because a huge trend today--in companies as diverse but as successful as and --is the distribution of slices of the business to employees. "There are plenty of strong reasons to give employees an equity stake," says David Lewin, a professor at the University of California, Los Angeles' Anderson Graduate School of . "Every employee should have some compensation at risk. They'll share in the downside and in the upside."

This thinking is big news for small companies. Until just a few years ago, only the senior-most executives in the majority of companies were offered equity stakes. What changed all that? Entrepreneurial businesses, mainly in high-tech industries, began making available to all levels of staff. Suddenly, stories of office managers worth several million dollars began to emerge--and that turned options into a very powerful human resources tool. The payoffs have been obvious, with many companies that are most generous in options awards--notably Microsoft--emerging as growth pace-setters.

Robert McGarvey writes on business, psychology and management topics for several national publications. To reach him online with your questions or ideas, e-mail rjmcgarvey@aol.com

Benefiting From Options

Just what can do for you? Plenty--in recruiting, employee retention and employee motivation. But first, you need to understand the basics; namely, options are not stocks but rather the right to purchase stocks at a specified price, usually at a date well into the future.

Why not just give stocks to employees? Stocks have a superficial simplicity in their favor, but look deeper, and the arguments are all in favor of options. For starters, options have minimal tax and accounting impacts, at least until the options are exercised. Tax implications of stock grants are far bigger, and the impact is immediate.

"There are so many ways awards of stocks can go wrong for you and your ," says Wilton Sogg, an attorney with Hahn Loeser & Parks in Cleveland.

Sogg points out there are many "what-ifs" to consider before awarding stocks: What if the employee quits? Gets fired? Becomes disabled? In any of these cases, you'd want a legally valid buy-back agreement prepared well in advance (ideally in tandem with handing over the stock certificates). But buy-backs can still go awry. What if you lack the cash when you need it? What if the employee's lawyer finds a loophole in your buy-back agreement? A disgruntled minority shareholder is always bad news; give out equity, and you may be preparing the way to give yourself exactly that. Says Sogg, "There are many better, smarter ways to give employees incentives."

At the head of that list of smarter ways is options. First off, options can come with many attached strings, a common one being that they can't be redeemed until a specific date. "Four years is a common vesting period," says Marlee Myers, an attorney and managing partner in the Pittsburgh office of law firm Morgan, Lewis & Bockius LLP. But a vesting period of anywhere from three to six years is normal, she adds.

Attaching a multiyear vesting period to options helps retain employees, says David Morse, a partner in the law firm of Whitman, Breed, Abbott & Morgan in New York City. "If the employee leaves before the options vest, they lose the options," Morse says. "They have to stick around to get the pay-out. That's a big plus because hiring and training new employees is so expensive."

Hiring better people is another key benefit for companies that use options wisely. "By offering equity, [companies] give employees a chance to make big profits later," says Myers. Many job candidates will jump at this deal. And that means a lean, cash-strapped business can often hire employees at lower pay. Not all job candidates will find this prospect appealing--but the high-energy self-starters you most covet likely will.

Once employees are on board, options can jump-start their commitment. A few stock grants won't mean an employee will suddenly share your appetite for 80-hour work weeks--but options will likely prompt the employee to invest discretionary energy and creativity into his or her job. "Options can definitely make employees more motivated," agrees Morse.

That said, don't take your employees' enthusiasm for options for granted. "You have to market the value of this program to them," says Morse. You need to spell out to employees that every stock option makes them a partial owner.

The Flip Side

Aren't there drawbacks to options? You bet. Plans can easily run afoul of securities and tax laws as well as accounting rules. "You can make a lot of big, expensive mistakes," says Myers. "Before setting up an options plan, get legal and accounting advice."

The bigger worry, though, is dilution of shareholder value. Hand out too many options that get converted into stock, and suddenly per-share earnings can tumble dramatically. "This becomes an issue when you're looking for bank financing or are wanting to do an initial public offering," says Morse. "The more options outstanding, the weaker your position."

Is that enough of a worry to put the brakes on an options program? Not judging by their mounting popularity. "More businesses are looking into doing this than ever before," says Morse.

"[In addition,] under the law, you can be very selective about when and to whom you give options," says Myers. Where might you put options to best use? Nowadays the three chief uses are in employee recruiting, where hefty options awards are dangled before job candidates; as bonuses for key employees who help the hit certain tangible targets (sales or profit goals, for instance); and, lastly, as across-the-board awards to all employees to help keep them motivated. What formula will work for you? There is no generic recipe. But good advice is to start small--award tiny parcels of options and watch for the results. Odds are, you'll see real improvements quickly, and you'll also discover the best way to use options in your company.

In most cases, too, employees become more valuable in tandem with their ownership stake. "The bottom line," says Morse, "is that options turn employees into owners--and owners do act differently."

Contact Sources

David Morse, c/o Whitman, Breed, Abbott & Morgan, fax: (212) 351-3131; (212) 351-3131

Marlee Myers, c/o Morgan, Lewis & Bockius LLP, 32nd Fl., Oxford Ctr., Pittsburgh, PA 15219, myer3310@ mlb.com

Wilton Sogg, c/o Hahn Loeser & Parks, 3300 BP America Bldg., Cleveland, OH 44114, (216) 621-0150.


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