Stock options are one of the most used and least understood tools in the compensation toolbox. Recently, a new optionee asked if I could explain stock options in a manner that even his dog could understand. I have included my answer below.
"Come here Rover, I have got something to explain to you. Stock Options ....STOP scratching yourself and listen....Stock Options are an offer from the company that allows you to buy company stock at a later date. The cool thing...STOP sniffing my pant leg....The cool thing is that the company will let you buy that stock at today's price. If the stock price goes up then you get a great deal. If it goes down, then you get nothing (or close to it). A couple of key details....COME back here and stop rubbing noses with that cute poodle...If you quit your job any options that haven't vested will probably go back to the company. In fact, ...GEEZ stop pulling at your leash!... the shares you do exercise may also be bought back by the company (I would have to read the plan and agreement to know for sure.)
...What did you ask boy? How do you value them?... A private company is required by IRC 409A to have a reasonable valuation performed on the company at, or near, the time of grant and again at least annually or whenever the value may have materially changed. A public company generally uses the day’s closing or average price. ....OK, just hang on and I will get you a treat....The 2000 options you received may have a starting value of a few dollars or a few thousand dollars. It depends on the number of shares outstanding and the total value of the company. The final value will depend on the success of the company, the change in stock price, and your ability to keep your options etc. ...I'm not sure what’s in the treats, probably beef and bones or something like that...They could be worth nothing or they could be worth millions! The key is working to raise the value of the company as a whole.
I hope this helped a little. Now roll-over and let me rub your tummy.
As I re-read my response I realized that although the dog may now understand the basic concept of a stock option, they would not be able to understand the true risks and benefits of such a complex tool. Stock options, like many forms of equity, have inherent upsides and downsides. We tend to focus on the positives when we choose to use them and emphasize the negatives when we use something else. We seldom provide a fully colored, 3-dimentional picture of how these instruments work in a world of volatile stock prices, complex income and tax ramifications and various financial planning strategies.
When we choose to use complex compensation instruments during a period of unpredictable markets, we must also provide far more training and resources to our employees. Similar examples can be made for many types of equity instruments and nearly every form of performance-based pay. We short-change our employees and our companies by not ensuring that our employees truly understand the what, why and how of every compensation program we offer.
Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation” and “Beyond Stock Options.” Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter @Performensation and @SayOnPay
Great article!
Posted by: Windsor lewis | 11/30/2011 at 12:44 PM
Thanks Windsor!
Posted by: Dan Walter | 11/30/2011 at 02:08 PM
I find that using the concept of a rain check works pretty well....
Posted by: Rodney Hulsey | 11/30/2011 at 03:35 PM
Hi Rodney,
The rain check concept is interesting, but risky in a volatile market. Most people understand that a rain check entitles them to something in the future. Stock Options often result in no value to the individual.
Posted by: Dan Walter | 11/30/2011 at 04:06 PM
Another simple explanation for people unfamiliar with various comp components. NOW, when are you going to write one specifically on CEO comp??? :-)
Posted by: Jacque Vilet | 11/30/2011 at 05:13 PM
Thanks Jacque!
I hope to provide a similar type of post in December, covering Executive Compensation / Say on Pay.
Posted by: Dan Walter | 11/30/2011 at 05:46 PM
Clever article! It makes the point that employee stock options can't really be "dumbed-down" so companies need to provide ongoing education and assistance to help employees make timely and profitable decisions. Visit http://blog.stockopter.com for a variety of resources on this topic.
Posted by: Bill Dillhoefer | 11/30/2011 at 07:32 PM
Hi Bill,
I agree that education cannot stop at an explanation. Research shows that participants must receive continuing education both in how the plan rules and processes work and in how to achieve value from their equity compensation.
Like most things in life, the learning must be ongoing, consistent, broad and deep.
Posted by: Dan Walter | 11/30/2011 at 08:34 PM