We all know that equity compensation is the driver behind the astronomic growth in executive compensation. We all know that it is also the reason that tech lords make millions before the tenth year of their careers. It is the reason that the average home in San Francisco and San Jose is more than $1 Million. We all know that these things are true because we have all read or heard the stories. What if these stories were only partially true? What is equity compensation REALLY worth? How do you know how much to give? How do your employees know how much they are getting? What truly drives, impacts, reduces and magnifies this value? In this post, I will discuss the key “tions” of equity. Valuations, taxation, restrictions, dilution, perceptions and competition (the list is longer, but this is a blog article, not a thesis.) These tions are the shapers of equity value that are seldom discussed. In a future post, we will also discuss survey values, modeled values, realized/realizable values and risk-adjusted values.
Valuations are a tricky thing. As a private company you want them to be low until the moment you don’t. 409A values set the prices of stock options and other appreciation-only tools. Having a low (but defensible) valuation allows you to provide great value to early employees at the same basic dilution as if the value was higher. How much value are you providing? That is another tricky bit. Does your company have the potential to be worth $1Billion? More? Less? Are you the type of company that has a realistic chance of an IPO or are you planning on an acquisition? Your potential value is the main limitation on the value of any individual award. Is your value already very high? Is there a potential it will drop? Traded publicly? Are your fundamentals great? How about market outlook on your industry? Have you had a scandal, a missed EPS target or a slow down in some key metric? What about each of the companies in the peer group used for your executive and broad-based survey data? All of these elements change value, few of these elements are considered when determining how much to grant or how much equity is worth when it vests or is exercised.
Taxation is big. It’s very big. While different forms of equity offer different tax planning opportunities, all forms of equity are taxed sooner or later. The media tends to report pre-tax information. Employees tend to expect pre-tax values. In the US, taxes can eat between 35% and 50% of gains. In other countries, these levels would seem like a blessing. Awards like RSUs have an automatic tax event at vest. This does not always align with actual dollars being delivered. Companies must also remit payment very quickly. Cash poor companies may find this onerous. Other companies may simply be late or do it wrong. Of course, all pay is taxed, but most of it is taxed in regularl times and annoying little amounts, instead of an off-cycle gigantic amount. Many companies provide little or no access to tax planning and employees are left to figure this out on their own. Any value and goodwill created by a program may be greatly diminished.
Restrictions come in many forms. They include the lack of liquidity in private companies and a wide array of vesting and performance criteria. There can also be limitations on sharing information that may help in future planning. Blackout periods and post-IPO lockups may stop value extraction when the prices are best. Remaining employed is another struggle for some. Every restriction reduces value in reality or perception, often both.
Dilution comes in many forms and all of them impact value. Perhaps it's the dilution round of investing. Possibly it's the dilution of other employees’ equity compensation shares being transacted. Or maybe it is a restructuring of the company or the acquisition of another. While dilution was once solely the domain of concern for founders and outside investors, it has become a concern to early employees at many start-ups.
Perception is negatively impacted by all of these “tions” in combination with generally poor communications. In the world of equity compensation, perception truly is reality until the award is transacted. The perceived value of equity is driven as much by confidence as it is by current and past stock price. When the market sours the real value of equity compensation is often only temporarily impacted at many companies. But, research has shown us that people feel the loss of money (even money not yet realized or even earned) more than they do gains of the same amount. Without current intrinsic value it is often not just unmotivational, it usually is demotivational.
All the while, your competition continues to grant equity or change their programs. Their low stock price creates potential that you may not currently have. Their high stock prices drive transactions that frustrate your employees. Their massive drop in stock price provide opportunity for you to attack, at the same time creating opportunity for them to raid anyone sitting on a lethargic equity value. Both of you provide data to the same survey providers and the values you provide have little or no context and provide only snapshots of true values.
What is equity compensation really worth? It is worth anywhere from nothing to everything, depending on facts and circumstances. But even the best equity grants must be tempered by valuations, taxation, restrictions, dilution, perceptions and competition. Avoid the “tions” and risk your equity program driving your executives elsewhere and your tech lords revolting. There is, of course, truth in the outsized legends about equity compensation values, but even those legendary values had to navigate everything above. With great power comes great responsibility (to educate and communicate).
Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several inustry respurces including the recent Performance-Based Equity Compensation. He has co-authored “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.