Stock options helped create the tech boom of the '90s, but some large corporations like Microsoft are starting to drop them.
While this strategy makes sense for large corporations where options can distort accounting and corrupt executive decision-making, entrepreneurs may be better off sticking to the status quo.
"If stock options make people work hard, make good decisions and generate cash flow, why would an entrepreneur walk away from them?" asks David F. Larcker, professor of accounting at the Wharton School in Philadelphia. Options attract top talent and spur productivity. But small businesses need to confront the prospect of new regulations that will force companies to count options as a business expense and weigh options' ability to boost earnings against balance sheet costs. "If options made sense before expensing, they'll make sense after expensing," Larcker says.
To many economists, options still come out ahead for entrepreneurs when compared to the alternatives. Fortune 500 companies planning to abandon options, for example, are choosing restricted stock instead. But this method is a poor choice for small businesses, say many observers, because it rewards longevity more than performance. Indexed and premium-priced options, two variations on the standard stock option, represent better, if somewhat flawed, choices.
Indexed options return financial gain when the company stock rises above a chosen index. In one example, an option held when the stock climbed 10 percent and the Russell 1000 grew 20 percent would have no value since the company had underperformed. If the index had fallen 20 percent but the stock climbed 40 percent, the option would be worth the difference. Premium-priced options come with an exercise price set higher than the market price to spur management to work toward pushing share prices higher. The more the shares exceed the premium price, the more valuable the option.
Both methods seek to link options more closely to performance, but entrepreneurs should approach each with caution. "The more these options affect the ability for an executive to make a profit," says Dan Ryterbrand, managing director of Frederic W. Cook & Co. Inc., a New York City-based compensation consulting firm, "the less the perceived value."