Do Stock Options Work as an Employee Incentive?

Stock options as performance incentives have been on a roller coaster ride for decades.

They were the quintessential get-rich-quick enticement used by tech startups during the dot-com boom in the late 1990s, but their star later dimmed amid allegations of abuse by unethical companies. So it’s hard for employers to know whether they are still a good, well, option.

Many executive compensation consultants say stock options are still a valuable tool—as long as employers know how and when to use them. If anything, stock options may be undervalued as a performance incentive tool, particularly as part of a long-term package.

Employees are economically motivated to exercise the option if the current stock price is above the strike price. The typical exercise period, also called the option term, is 10 years from the grant date, which theoretically allows enough time for the stock price to recover from a down market. In the U.S., option vesting is almost always based on years of service, although it is occasionally based on performance.

There are two types of stock options:

Incentive stock options. Taxation for these options can be deferred until the acquired stock is sold, and it occurs at more-favorable capital gain rates.

However, incentive stock options are subject to a variety of additional regulations and restrictions. For one thing, they can be awarded only to employees and are not available to board members or independent contractors. They also have a $100,000-per-employee limit on the value of stock that can vest in a given calendar year. Finally, recipients are required to hold option-generated stock for at least one year after the exercise date and for two years after the grant date in order to obtain favorable tax treatment.

If a company’s stock price never reaches the strike price when the shares vest and during the remainder of the exercise period, both non-qualified and incentive stock options are valueless and expire “underwater.” For that reason, some companies have curtailed awards of options during periods when stock growth has lagged.

Conversely, in industries with high growth rates, such as certain tech fields, options can be a lucrative incentive. However, if the intent is to attract employees and motivate loyalty by giving them a stake in the company, the conditional nature of the options could make them less effective than some other long-term incentives that involve the award of actual stock. There is also the possibility that, if the stocks do pay off handsomely, employees may become independently wealthy and leave the company.

There are a number of reasons for this. Many people came to associate stock options with fraud and abuse in the mid-2000s, after they were liberally used by Enron and other companies. A lack of growth further diminished their appeal.

Even at larger companies, stock options typically make up less of senior leaders’ total compensation than they used to. According to the 2014 CEO Pay Strategies Reportby consultancy Equilar, 17.5 percent of the value of an average Standard & Poor 500 CEO’s 2013 pay package consisted of stock options, down from 23 percent in 2009.

High-growth industry sectors, such as biotech and technology, are more likely to offer options. “For double-digit growth industries, stock options are phenomenal long-term wealth builders,” Seitz says.

They tend to be more common in public companies that can more easily establish stock value, notes Steve Parrish, national advanced solutions director at Principal Financial Group in Des Moines, Iowa. Starbucks and Southwest Airlines are two examples.

The largest number of stock options are awarded to individuals who can affect the fortune of the company, and at larger companies in particular, Parrish says.

They are also common among startups. “My client base is primarily privately held companies that are startups looking forward to a liquidity event like an initial public offering [IPO] or the sale of the company to a larger company,” says Alison Wright, a partner in the San Francisco office of law firm Hanson Bridgett LLC. Pretty much across the board, startups offer stock options to employees, even at companies loaded with cash, because the offering reflects the company’s potential, she says: “Employees get in early, get options at a low price, and then there is a liquidity event that dramatically raises the value of the company stock, which is where employees expect to make the big bucks.”

Consider the November 2013 IPO of social media giant Twitter. Twitter executive Ali Rowghani exercised 300,000 stock options at 84 cents each and sold the shares for $33.76 per share, resulting in a $9.9 million profit.

Many companies tend to offer restricted stock to entry-level employees; a mixture of 50 percent time-vested restricted stock and 50 percent performance-based shares to more-senior-level employees; and a mixture of stock options, performance-based shares and time-vested restricted shares to the most-senior executives.

“Most tech companies, especially in the San Francisco Bay Area and Silicon Valley, grant options to everyone, even though the CEOs get more of them,” Wright says. “That can foster teamwork and creativity in a startup company. On the other hand, in some industries and in some geographic locations, it is likely that lower-paid employees would rather have extra cash, which is easier to understand and to spend.”

The timing of stock option awards varies. “There is no right or wrong when it comes to methodology, and many times it is unique to the culture and ethos of each company,” says Carrie Kovac, West Coast regional vice president at E-Trade Financial Corporate Services, an equity compensation plan manager. Most companies award stock options annually as part of total target compensation, and many tech companies give them throughout the year. To compete for talent, some employers offer stock options at the time of hire. “Performance is often also a factor in the award frequency and grant size,” Kovac says.