Granting Options to Employees

Granting Options to Employees

Introduction

In recent years, option rewarding has become an important component in compensation packages. Many companies establish their positions among other high tech companies from the point of view of employee recruitment by structuring generous and promising packages for their employees. Due to the high demand for employees in recent years, many companies offer to remunerate employees who bring new employees to the company, and in many cases this incentive too takes the form of options.

Currently, a significant proportion of employees in almost every high tech company holds options, and almost every company has a stock option plan for the company's employees and consultants, typically in the range of 20–30% of shareholders' equity. This form of compensation increases the alignment of interests between the employee and the company and creates a long-term bond between the employee and the company, the length of which depends on the number and vesting periods of the options. In addition, the allotment of options enables the company to save precious cash that is needed for the company's current operations.

On the downside, the effect which a decline in the price of the shares has on the morale of the employees and their loyalty to the company could be mentioned (see below for further discussion of this issue), and the dilution to other shareholders' holdings.

Stock Options Defined

A stock option enables employees to purchase shares of a given class in consideration for a pre-determined amount referred to as the exercise price. The employees profit from a rise in the price of the shares, since the exercise price is pre-determined, but they have not yet paid for the shares. Obviously, options already have an economic value when they are allotted, since they award employees the right to buy shares for a fixed exercise price, but they are not committed to such payment unless they choose to exercise them. The right to exercise options is tied to a contract and the vesting period changes from one company to another. However, a customary option vesting period is four years, with 25% of the options vesting at the end of the first year and approximately one quarter of the options of each subsequent year vesting at the end of every quarter thereafter. Many employment contracts provide for accelerated vesting if the company is bought out by another company. Once the options have vested, employees may exercise them over a period of several years, in accordance with the terms of the option.

Example: An employee is allotted 100,000 options for an exercise price of $1 per share. The vesting period of the options is four years. Two years later, the company goes public and the stock price is $20 per share. At that time, the employee can exercise one half of the options and sell them on the stock exchange (subject to the lock-up provisions of the prospectus and the securities regulations of the exchange in which the shares are listed). Let us assume that the employee exercises and sells all of his or her 50,000 vested options. He or she pays the company $50,000 and receives $1 million when selling the stocks (before commissions and taxes).

In many cases, the company or a trustee on its behalf performs these actions on behalf of the employees and transfers the money to them after withholding the required amount of tax. The terms of the options and the use of trustees have a significant impact on the tax consequences, as discussed in a later section of this chapter.

Advantages and Disadvantages in the Granting of Options

The granting of stock options in a company enables the employees to become part of the group of owners of the company. It is an exceptional instrument which creates loyalty and identification with the company's goals (as an owner), encourages employees to stay with the company for a long period of time (in accordance with the vesting period of the options), motivates excellence (with the aim of helping to enhance the company's profits), and all with a low cash flow. From the company's point of view, the advantages of granting options rather than shares lie mainly in the fact that unexercised options entail no voting rights or a right to dividends, and in the fact that if the employee resigns before the end of the vesting period, he or she typically forfeits his or her right to this benefit. A distribution of shares creates a reduction of capital that requires special legal and accounting treatment, whereas when options are distributed and the employee does not want to receive (or exercise) them, they expire and "disappear."

On the other hand, there are also problems in granting stock options to employees. For instance, a decline in the value of the options due to daily market fluctuations may lower the employees' motivation. In addition, the decision of who will be compensated may cause problems with non-compensated employees (including good middle management). In practice, almost all companies now grant options to all employees in managerial positions, and it is not uncommon to see companies in which all employees, junior and senior, receive options. In addition, some restrictions are imposed by the securities laws on the distribution of securities to employees, and the distribution of options or other securities to employees involves a registration procedure or the receipt of a special exemption. Furthermore, the investors in the company might object to the dilution in their holdings in the company that is associated with the exercise of these options.

Various studies have recently cast doubt on the effectiveness of compensation in the form of shares and options, as is offered today. From the employee's point of view, the allotment of options provides a chance to profit, but the employee and the company perceive differently the risk involved in holding options instead of cash. In practice, if we compare an actual valuation of employee stock options, with an estimate of the value of the options as perceived by employees, it appears that employees perceive the value of options to be approximately one-half that perceived by neutral valuation. The researchers Murphy and Hall, for instance, describe the allotment of options in public companies as an expensive and inefficient way of compensating employees. One of their reasons corre sponds to the principle described in Chapter 9 which discusses valuations: Most of the managers' capital (both financial and human) is concentrated in the company they manage. Therefore, the portfolio of such managers is not well-diversified and, when evaluating the options allotted to them, they use a higher discount rate. Consequently, as a substitute for other compensation, they will require a larger number of options and shares than that called for by an evaluation made by the other investors in the company (by using models for the evaluation of options, discussed later in the section on stock option plans).

An alternative method for achieving the same targets—bonding the employee with the company for a long period of time and aligning the interests of the company and the employee—is a distribution of restricted shares within the framework of the employee's compensation package. These are shares that, like options, cannot be sold until after a certain vesting period, and enable employees to purchase a certain number of shares in each period for a price lower than the current market price. Since shares are less volatile than options, employees perceive them as being less risky and they are consequently cheaper to the company as a means of remuneration, although their economic nature is similar to that of options.

Stock Option Plans

The importance of the correct structuring of the stock option plan within the overall setup of employee and manager compensation cannot be overrated. An increasing number of companies add various components at the time of planning the options in order to best realize the organization's objectives. It is important to note that almost any element of compensation reached by structuring options may also be constructed by a combination of a salary and bonuses. When comparing compensation plans, one must examine all of their components and the relationships between them, as is presented later in the section on methods of employee compensation. As a simple illustration, a cash bonus that cannot be redeemed for a fixed period of time, but is based on changes in the price of the share, is similar in nature to options. This type of compensation is indeed nicknamed as "phantom stock."

  • Approval of stock option plans— In most cases, options are distributed pursuant to a stock option plan (although they may also be distributed without any such plan). A general stock option plan is usually approved by the Board of Directors, and the managers are authorized to decide on an allotment of the options to the employees. In certain cases, the CEO retains the authority to set specific terms such as the vesting period of the options and the exercise price.

  • Exercise price The options are usually allotted with a fixed exercise price which is identical or below the price of the share at the time of allotment of the employment contact signing. When there are various classes of shares, options may be awarded with an exercise price that is lower than the price of the shares in the last investment round, since employees are usually awarded options to buy shares that are inferior to investors' shares from the points of view of distribution at the time of the company's dissolution and their voting power. Therefore, it is logical that their price will be lower than the price of new shares allotted to investors. However, in various companies, particularly publicly traded ones, the exercise price of options is updated according to an appropriate stock index. The goal is to create an incentive to outperform similar companies in the field. The choice of shares used as a benchmark for the update is problematic, and it is usually made by the company's compensation committee, with the aid of outside advisors. In certain plans, the exercise price is updated with the rise in the price of the share, while others set a fixed exercise price. It is important to remember that options plans whose exercise price is constantly being updated could annoy the managers and increase the likelihood of their departure during long periods of underperformance, as the benchmark is rarely updated downward.

  • The number of options— It is usually customary to allot a fixed number of options for each period of service. Alternatively, options can be allotted concurrently with the signing of the initial contract, yet be vested only after predefined periods of service. In practice, if the price of the share rises, the employee profits not only from the rise in the price of the options that were allotted and have been vested, but also from the value of any options not yet vested.

    Another customary plan is to award options annually at a certain pre-fixed value. For instance, every quarter over a period of four years, a manager will be issued options worth $100,000, with the value being determined every quarter separately. Thus, if the value of the company rises during that time, the number of allotted options will decrease. Such compensation naturally gives rise to the problem that as long as he or she is still receiving options, a manager who can influence the company's market value could have interests that are inconsistent with the best interests of the company. On the other hand, such plans allow the company to limit the cost of the managers they recruit. In addition, this method enables companies to periodically adjust the value of the options they award in accordance with what is customary in the market at that time.

  • Employee departure— An employee who leaves the company is usually entitled only to the options vested up to the time of his or her departure from the company, although he or she might be entitled to exercise the vested options for a few months after the departure. Stock option plans often provide for a forfeiture of rights in the case of a criminal offense, or, alternatively, for a right to additional options even after termination of the employment relationship.

  • Restrictions on the exercise of options— When a company is publicly traded, various regulations may apply to option holders with respect to the exercise of the options. Such regulations may result from legislation in the country in which the shares are listed or the company is registered, or from various managerial decisions designed to restrict the legal exposure of the company and its managers. For instance, many companies prohibit their employees from exercising options and selling shares at any time other than shortly after the publication of the company's statements, in order to prevent any allegations of insider trading by officers.

Valuation of Options

Employee stock options are similar in nature to call options. They award the right to buy an asset (in this case, the share), for a predetermined term (determined either as a fixed amount or calculated by using a formula). As mentioned above, options are often granted at an exercise price that is similar to the price of the share at the time the option is awarded. The transfer of the options to others is almost always restricted, they cannot be sold to third parties, and they must be exercised within certain time frames, usually less than ten years from the date of the grant. They are usually subject to a long vesting period, and in most cases are not protected against dilution resulting from the allotment of shares to different investors. A detailed discussion of the pricing of options lies beyond the scope of this book, but this subsection will review the fundamental principles of option valuation.

The customary model for option valuation is the Binomial Model, of which the Black and Scholes model is one version. This model, which was originally developed to price traded stock options that were not allotted by the company, provides in principle a good yardstick for valuating options, and its formula may be adjusted to account for the various terms of the options. In the case of employee stock options, the value of the options is substantially lower than that produced by the model without adjustments, due to the multitude of limitations imposed on them, mostly related to limitations on their transferability. According to various estimates, their value is on average less than one-half that produced by the Black-Scholes model.

The model prices the value of options on the basis of the following elements: the price of the share at the time of allotment, the risk-free interest rate at that time, the life span of the option (namely, the period in which the options may be exercised), the share's volatility (in the case of a closely held company, the data of similar listed companies are used after adjusting for the lower liquidity of the shares) and the dividend yield of the shares.

Paradoxically, the higher the share's volatility, the higher the value of the option. The reason for this is that the option holder will exercise it only if the price of the share is higher than the exercise price. Consequently, a higher volatility that may translate into a higher price per share (or a lower price per share, although this eventuality is irrelevant to the exercise of the option) increases the range of profits to the option holder. Obviously, this is not to say that the value of the option is not affected by a decline in the price of the share—the value of options drops faster than the price of the share when the latter declines.

In order to get a general idea of the value of options, let us look, for example, at an option that is exercisable over a period of ten years, with an exercise price identical to the price of the share at the time of awarding of the option. The annual share volatility is assumed to be 30% (which is more than the average volatility of large American companies, but is similar to a typical volatility of shares of established high tech companies) and no dividend yield. In such a case, the value of the option would be approximately 55% of the current value of the share.

The dividend yield has a dramatic impact on option holders since they are usually not compensated for dividend distributions, which signify the transfer of financial resources from the company to its other shareholders. Startups usually do not pay dividends, and therefore the significance of dividend payments is lower.

Responses to a Fall in Stock Values

As mentioned above, options became a material component of many compensation packages. Consequently, when stock prices fell, particularly in the second half of the year 2000 and during 2001, the value of such options declined dramatically. A plunge in stock prices has a severe effect on employee morale and on their loyalty to the company, since there is no point in waiting for an option to vest and become exercisable if the exercise price is higher than the market price of the share. In the past, companies in such situations have repriced the exercise price of the options, for instance, by issuing additional options with lower exercise prices to revive the motivational power of the options. This was done by the computer company Apple, the software company Netscape, and the electronic bank E-Trade. However, since the repricing of options infuriates investors in public companies, only a small portion of companies whose shares collapse indeed reprice their options. Repricing may cause severe accounting problems. The current rules require that if the exercise price of an option is amended downward, any upward change in the price of the share after the repricing be recorded as an expense in the financial statements. This has resulted in a smaller occurrence of repricing in the latest crisis compared to the scope of the phenomenon in the past. An alternative is for the company to cancel the exiting options and issue new options after more than six months, based on the prevailing market price at that point. Reporting rules do not customarily require the recording of the repricing value as an expense, since, in the interim, employees are exposed to potential changes in market prices.

Accounting Aspects of the Distribution of Options

The following discussion of financial reporting will be made according to U.S. Generally Accepted Accounting Principles (GAAP). In principle, under the current rules, if the price of exercise of the option is at least equal to the price of the shares at the time of awarding the options, then the cost of the options need not be recorded as an expense in the financial statements. A passionate and lengthy discussion has been conducted in recent years between high tech companies and the authorities with respect to a modification of the financial reporting rules governing the allotment of shares and options to employees. On the one hand, such compensation is clearly a substitute to a cash payment and is therefore justifiably recordable as an expense. On the other hand, the valuation of options is complicated and subject to various assumptions with respect to the company's operating data (such as the share's volatility) and the effect of various circumstances on the value of the option (such as restrictions on the transferability of options to third parties, restrictions on the exercise of options, and their inferior position compared to ordinary shares with respect to dividend distributions and voting rights).

Companies that choose not to report options as an expense are still required to report the value of the options while specifying the assumptions underlying such valuation. In addition, it should be noted that even if the company does not record the cost of the options as an expense in its statements, the per-share profit data under full dilution is still affected by the number of allotted options.

Issuance of Options Shortly before an IPO

As mentioned above, when a company is not publicly traded, options are often issued for classes of shares that are inferior to those of institutional investors from the points of view of voting rights, dividend distributions, and rights upon dissolution. Since the value of these shares is lower, there is usually no requirement that an expense be recorded for the difference between the exercise price of the options and the per-share price to investors in the most recent investment round. In addition, when the options are allotted long enough before an IPO, generally one year earlier, there is little chance that the difference between the price of the share in such an investment round and the exercise price will require the recording of an expense and result in a tax liability for the employees, i.e., that it be denied the preferred tax status of approved ISOs (Incentive Stock Options). As a rule, companies exercise more caution in awarding options as they near the date of an IPO. The "rule of thumb" is an allotment discount range of up to 25% of the IPO price for options allotted in the quarter immediately preceding the IPO, and approximately 75% when they are allotted at least three quarters before the IPO.

The Amount of Capital Held by Employees and Other Officers

An examination of private startups in the United States reveals that companies which raised more than $5 million usually allotted between 15% and 30% of the company's shares to the senior management team and to the employees. In many cases, the allotment to employees is even pre-arranged by creating a "pool" for employees in the investment agreement with institutional investors. Obviously, the structure of compensation and ownership-allocation is highly diverse and corresponds to the contribution made in the startup's early phases. On average, though, CEOs hold 10– 30% if they are also entrepreneurs, and 5% on average if they are hired CEOs in companies that raised more than $5 million; hired COOs (Chief Operating Officers) receive holdings of 1–5%, depending on the company's stage of development and capital-raising; hired CTOs (Chief Technology Officers) generally hold 1–3%; a VP (Vice President) of Marketing would hold 1–2%; a VP of Sales would usually hold a little less than that; and a VP of Business Development would hold shares and options in the range of 1–3%.

A survey of public Internet companies conducted in 2000 by Mercer Consulting revealed that the total equity held by the CFOs of such companies was a little over 1% shortly before an IPO, of which approximately two-thirds took the form of options. COOs (entrepreneurs or otherwise) held approximately 1.5% of the equity, and Sales and Marketing VPs received slightly smaller allotments.

It is important to reiterate that the timing of employee recruitment is a crucial factor in determining the percentage of shares they will be allotted. For instance, a CTO joining the company after the first round of investment may get 3–5%, but less than 1% if he or she joins the company shortly before an IPO. Therefore, when comparing different companies and employees, it is essential that the employees' seniority in the company, and not necessarily their positions, be taken into account. It is also important to understand that the percentage allotted to an employee is directly related to the employee's reputation and the degree of confidence which the company and its financial backers place in him or her, and not necessarily to the company's current value. These are less objective factors which cannot be known to the employee with certainty.

In most cases, a small percentage is allotted to the members of the Board of Directors (who are often, in any case, the representatives of the investors), and additional options are allotted to various service providers of the company, such as selected advisors and important suppliers.

An examination of the number of employees who receive options upon joining the company reveals that close to 100% of VPs and directors receive them, and more than 60% of employees receive shares or options, a percentage that rises with the employee's rank. In addition, most companies make additional allotments of shares and options besides the allotments made to employees upon joining the company. Approximately 80% of officers and 50% of employees receive additional options on an ongoing basis after joining the company.

In addition to the ongoing allotment of options, which is usually associated with bonus plans, many companies have plans that allow employees to buy shares with a discount of up to approximately 15% off the price of the share. The amount of the shares depends on the employee's salary. Such plans, known as ESPPs (Employee Stock Purchase Plans), receive preferred tax treatment as described in a later section in this chapter.

Options and Shares in Spin-offs

In spin-offs, many companies come across the issue of options and shares that were allotted to employees of the parent company who are now working for the spun-off division. In addition, employees who remain with the parent company may demand shares in the spun-off division, like the employees who work for such a division. This demand is based on the argument that a material component of the value of their options was taken away from them since, as opposed to other shareholders, employees who hold options in the parent company do not always receive a direct share in the divisions. In most cases, employees who assisted in establishing the division will receive a stake in the spun-off unit, even if they do not become employed by it. Employees who move to the new division will naturally gain a share in it, which is supposed to compensate them also for a potential loss of pension, equity, and other rights in the parent company.