As a result, stock options have become an extremely lucrative portion of the total compensation for executives of publicly traded companies. Considering the enormous amount of wealth that has been created through stock options for executives, it should come as no surprise that private companies find themselves at a disadvantage in attracting, retaining, and motivating top executive talent, largely due to their limited ability to issue stock options. Now, however, a growing number of private companies are looking for -and finding - ways to compete for executive talent by offering their own version of equity-based or equity-like incentives.
This article presents case studies of two privately held, nationally known companies-a wholesaler of giftware and novelty items and a food ingredient manufacturer-to illustrate three key points:. How private companies can determine whether some form of equity-based compensation is right for their situation and, if so, in what form; and.
Not surprisingly, the experiences of these two very diverse companies highlight how differently this process can play out depending on the company's specific circumstances.
As a result, one company opted to develop a full equity-based incentive program for its executive team, while the other company came to a very different conclusion based on the same analysis. It chose not to offer equity to its executives, but instead developed and offered a plan that mirrors an equity-based plan without diluting company ownership. Following a successful turnaround, a nationally recognized wholesaler of giftware and novelty items, which has been family owned since its founding in , decided to provide some form of equity-based compensation package for the executive team that helped orchestrate that turnaround.
This was not surprising considering that since the turnaround in , the company's sales and gross margins have steadily increased, recently bringing the company back to profitability.
Although initial efforts to work through the downturn brought on by the economic recession of the early s were unsuccessful, the company, led by its core executive team, eventually downsized and refocused its products and marketing. As the company's fiscal health improved, recognizing the contributions and loyalty of several key members of the management team in operations, merchandising, and sales became of paramount importance.
How Do Employee Stock Options Work?
These individuals had remained with the company through its most tenuous period and helped effect the turnaround. With the turnaround complete, the CEO and the vice president of sales, the two owners of the company, wanted to reward these executives for their loyalty and hard work. Longer term, the owners wanted to ensure that the company would be able to retain these executives, while also having some way of sharing the expected future growth and profitability of the company with them.
Making the decision on whether to offer equity will depend greatly on a specific company's business circumstances. Yet, companies should not overlook some other important considerations when weighing the pros and cons of providing an equity stake in the business. The Owners' Point of view. In a family-owned business, for example, providing equity-based compensation raises a number of financial and emotional issues for the owners.
Over the life of the company, owners often make major personal and financial sacrifices to keep the company afloat and growing, in many cases going so far as to pledge personal assets to obtain financing.
Of course, the company's owners have also put up with the inevitable long hours, extensive travel, stress, and other commitments of running a business. Considering all this, it is not surprising that many owners are not completely comfortable "giving away" a piece of the business, even if it is to a deserving executive team. From a more practical perspective, equity ownership causes justifiable concerns about sharing detailed financial information with executives who are not part of the family or principal ownership.
The Executive Angle. Even executives receiving an equity stake do not do so without qualms. First of all, equity ownership often requires executives to use their own assets to purchase the equity. In fact, equity based incentives may not appeal to many executives who think that they have enough "at risk" without adding equity ownership in a privately held company with only a few owners. Executives are also likely to be concerned about how the equity should be valued, the future risks of ownership, and the potential for "selling" their equity in the future, i.
Because of all these issues, executives are likely to name cash, and lots of it, as their pref6rred form of compensation. Unfortunately, smaller private companies find that cash is usually tight, particularly if such companies fall into the lower range of market capitalization the common stock outstanding multiplied by the market price of the stock used to rank publicly held companies. Small companies usually manage cash flow tightly, especially if they are leveraged with high-yield debt. To work through these issues before offering equity-based compensation, it is important for executives and owners to educate themselves about various equity-based and equity-like incentives and how they work.
This way, both parties can end up with a plan that suits all their needs. A four-year vesting period means that it will take four years before you have the right to exercise all 20, options. This is where that one-year cliff comes in: This means that you will need to stay with the company for at least one year to receive any of your options. Once your options vest, you have the ability to exercise them. This means you can actually buy shares of company stock. Until you exercise, your options do not have any real value.
Monetize Your Private Company Stock Options
The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well or poorly the company does, this price will not change. You can also hold it and hope that the stock price will go up more.
Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options. There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them. Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it costs you to buy the shares.
Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest. You can find this in your contract. When and how you should exercise your stock options will depend on a number of factors. You would be better off buying on the market. But if the price is on the rise, you may want to wait on exercising your options. Once you exercise them, your money is sunk in those shares. Or a recent round of financing which gave them a valuation? Another way to ask this : how does my strike price compare to the purchase price of the VC or PE company's investment?
Sometimes its the same as their investment price, but it actually should be much lower, because the common stock your option covers is worth far less than the VC's preferred stock. What is the vesting schedule?
Non-Qualified Stock Options-Private Companies
Do the options vest on termination without Cause? What happens on Change in Control? Is there any performance hurdle to achieve change in control vesting? Often, there is a substantial financial hurdle before many of the options participate in the exit event. What percentage of the Company is represented by my option grant? Are there upcoming rounds of financing that will dilute you?
Other content in this Stream
Even if your offer includes a large portion of that pool, your offer has these vulnerabilities: i the next round of financing will dilute your interest, or ii the performance-hurdle before your option participates in a liquidity event exit event is so high, you won't ever achieve your promised percentage of ownership. Some of these things will be outside of your control.
But at least, you should know what will be happening next with the financing of the employer before you accept the offer. What is the exit strategy of the Company? Is the Company being prepped for a sale? In the case of a sale, will the buyer need to keep you in your role? Some jobs are more vulnerable to post-change in control termination than others.