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Why Your Company Doesn’t Need Employee Stock Options

November 7, 2011 by Kevin Custer

Something many companies struggle with, particularly as they transition between growth stages, is how to structure compensation in a way that attracts top talent at all levels. Though figuring out salary and bonuses can be difficult, it’s usually the long-term incentives that take the longest to figure out.

Long-term incentives, which align personal outcomes with the desired long-term outcomes of key stakeholders and include stock options, are seldom successfully used to change short-term behavior of any staff – that’s what bonuses are for. Long-term incentives are usually only effective with senior management or executive team members that are actually responsible for developing and implementing long-term strategies, and help to align the interests of the senior staff with other key stakeholders.  That’s why we recommend against giving stock options to most staff, outside of the executive team. But with the executive team, long-term incentives are used to drive decisions, rather than behavior – in other words, these incentives make it so executives have “skin in the game” and are personally affected by the decisions they make for the company (i.e. more capital/dilution, acquiring another company, launching a new market.) So how do you structure those long-term incentives to be as effective as possible in driving decisions that will benefit all key stakeholders?

Here are some general numbers. For most companies in the growth stage ($3 million to $20 million in revenue). I would expect to see a CEO have between 5% and 7% of a significant deal, with the balance of the executive team (about 5 people), to be another 5% to 8%, for a total of 15%.  These incentives can range from options to a bonus. One simple structure for a bonus we’ve used? If the company sells at X price by X date, then $X is taken off the top of a company’s sale price to be divided among the employee pool. So for example, let’s say in your company’s sale, you need to deliver $50 million to your shareholders. If you set the sale price at $57.5 million and take 15% off the top for incentives, you can set aside enough to give the staff a $15,000 bonus (80 people = $1.2 million) and divide the remaining $6.3 among the executive team.  Of course, if more time or capital is needed to complete the sale, you can either lower the incentive pool or raise the target price. Over-performance means a bigger incentive pool, and under-performance shrinks the pool.

Ultimately, the keys to a good long-term incentive compensation program that will drive desirable decision by your executive team are clarity and simplicity.  For the most part, you can reward most of your employees with bonuses and salary – there’s no need to extend stock options and other long-term incentives beyond the executive team.

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