Avoid Using Stock Options For Compensation
Compensation, recognition, reward and retention are exceedingly complex and vary from person to person and situation to situation. There are few hard and fast rules in this area of management, other than those that exist to ensure lawful behavior, but there are some reasonable guidelines that apply to the vast majority of circumstances. Not using stock options for compensation is one of these.
In almost every small enterprise, there comes a time when it seems like the smart thing to do is to grant employees stock options in lieu of cash compensation or an increase in cash compensation. There are plenty of reasons why this seems like a wise move at the time. Chief among these, of course, are that it reduces the cash drain on the company and the employee will likely appreciate the upside potential of the stock and may see it as even a more substantial reward than cash. While these reasons are valid and are likely to be true, they both ignore one important factor – the actual goals of cash compensation.
Their are two primary goals of cash compensation. The first applies only once –at the time that an employee is hired. Here the goal of cash compensation is, as part of a complete package of salary, benefits, signing bonuses and, often, stock or options, to recognize the market value of an individual and entice them to join a company. The second goal is ongoing and involves changes in cash compensation. The goal of making such a change is to recognize the employee’s contributions over the previous period (often, between reviews of the employee’s performance).
After a person is hired, increases to compensation are the primary form of short-term, tangible feedback that a manager has available to him/her. Of course, there are other forms of feedback as well, including private and public recognition, time off, special projects and the like (note: I don’t include spot bonuses in this list, because they are very difficult to apply broadly, although spot cash bonuses work the same way as increases in cash compensation with a somewhat shorter term effect). None of these are tangible, though, and all lack the well-recognized social perception of the value of getting a pay raise or feeling that one is getting paid what they feel they are worth.
For most people, increases (or lack of an increase) to compensation have an immediate impact on that person. They get a strong indication of their progress as well as their overall level of success. The vast majority of people also clearly understand and appreciate the implicit recognition that comes with cash that they can spend immediately. The additional income will usually be used to improve their quality of life and will most often go toward simple things like dinners out, a gift for the employee’s spouse, a vacation, mortgage payments, new car or something similar.
Of course, like everything in life, we get used to the elements of our environment that are relative constants. In this way, the perceived value of any cash compensation change diminishes over time. People simply get accustomed to their new standard of living. For most, though, this takes quite a long time and the value a manager gets from the implicit pat on the back that comes from a pay raise lasts for a long while. The driver here is that since an increased standard of living is realized on a day-to-day basis, the employee reflects on the compensation change and on its source frequently.
So, cash compensation is all about recognition. Initially of the employee’s potential value to the organization and later, of the quality and value of the work they have performed over a given period. Additionally, changes in compensation are sticky, they are remembered by the employee frequently and for a reasonable period of time.
A stock or option grant has a different goal and a substantially different effect on people. Any grant of equity (from here on out I’m just going to refer to stock or options as equity) will immediately be perceived as positive feedback by the employee and a strong indicator of the value he/she adds to the organization; in this sense, even stronger than cash increases. No brainer, right? The difference comes about in how quickly this feeling fades. In my experience, an equity grant is forgotten much faster than any cash compensation increase. Since it doesn’t impact the employee on a day-to-day basis, the grant may quickly elicit a what-have-you-done-for-me-lately feeling in the employee. After all, the equity grant doesn’t help put braces on your kids’ teeth today even though it may completely cover the dental reconstruction later. Additional cash is felt on every trip to a restaurant and during the planning of every vacation. Equity becomes a distant memory quickly.
Does this mean that equity doesn’t elicit behaviors that you want from your employees? Not at all. The behaviors that it creates, though, are just different and shouldn’t be confused with those that come about from cash compensation changes.
By its very nature, equity is about the long term. Granting an employee equity in the company creates a bond between the employee and the company that ties the success of the two together (although not mutually). If the company is successful, the employee is successful. As such, equity does not have the strong day-to-day positive impact that cash compensation has. It does, however, effect how the employee acts over a longer period of time. Because of this, equity is ideally applied as a tool to recruit, reward and retain employees.
The recruiting part is obvious – it’s, most likely, the primary part of the package you offer to someone to choose to join your enterprise instead of another. It’s value is, of course, the shared excitement of making a boat-load of money if the company is successful and the employee helps it achieve that success.
Retention is the epitome of the value of equity. Inevitably, there are going to be tough periods and times when good employees are going to be actively recruited by others. During these times, good people will always have the option of reducing their efforts or, perhaps, even leaving the company. While other factors such as good management or the mindset of co-workers have a strong influence on the behavior of any employee, there’s nothing quite like owning a chunk of the company to keep an employee focused on the end-goal.
Reward is the area that comes closest to the recognition provided by changes in cash compensation. Reward and recognition are very similar. In my terminology, the difference is that reward is feedback that pertains to an event, or set of events. Recognition is feedback that applies to a period of time. Usually an extended period, in fact. Cash is a good reward mechanism, but equity is even better. Tying great actions together with increased ownership in the enterprise is a perfect application of equity’s long-term, implicit feedback. You can’t expect great things from an individual every day, but when they do happen, greater ownership in the company is the right tool for the manager to encourage that behavior over an extended period.
The bottom line is that a manager wants to recognize the day-to-day efforts of an employee with the tool that is most frequently reflected on by that employee. In almost all cases, that’s going to be his/her salary and the most recent changes to that salary. Extraordinary achievements, on the other hand, are best rewarded with equity. Its’ longer-term positive feedback potential is more indicative of the lower frequency of such successes and will encourage the employee to repeat those successes over the long term.
As with rewards, retention only works over the long haul. That’s why it’s almost impossible to continue to retain employees with cash. Here again, equity is the perfect tool because when pondering his/her future with the company, the employee’s ownership is a huge long-term stabilizing factor that will help prevent the employee from jumping ship when he/she is being actively recruited or the employee or company are facing issues.
Recognize people with cash and recruit, reward and retain people with equity.
Brad Feld has an interesting take on this topic from the entrepreneur’s point of view. Check out his post titled, Giving Up Salary for Equity After VC Funding. Having been burned before after being talked into trading salary for equity, I whole-heartedly support Brad’s conclusions.
I realize that this will likely provoke a debate on the semantics I use. I’m sure that there are many similar terms that apply. Hopefully, the ideas come through with the words I’ve chosen.