Before the days of on-site masseuses and complimentary dry cleaning services, companies resulted to a more traditional form of employee motivation: the employee stock option plan. Not surprisingly, employee stock options are still one of the most effective and widely used retention tools for companies large and small. As it turns out, people are still motivated by money.
The concept behind employee stock options is simple: if you work hard and stick around, you will be rewarded with a piece of the upside that you helped to create. The company also benefits by conserving cash during early years and creating a culture in which all participants are aligned and invested – literally – towards a common goal. There is little doubt that equity compensation has been the invisible force guiding ivy league grads away from their former Fortune 500 destinations and into the world of startups.
However, there are issues with employee stock option plans that make them an imperfect tool for motivation and retention. Most notably, there is the problem of liquidity.
When an employee is working with a company that has grown substantially in value, the stock options that the employee received may come to represent a substantial majority of their personal net worth. On the one hand, it is great that the employee has developed some considerable wealth. However, if the company is still private (as many companies have been staying private for longer), that employee will have a difficult time accessing the wealth that they have been working tirelessly to create.
Not only does this limit the employee’s ability to use the wealth for important milestones like buying a home or paying for a child’s college tuition, but it also introduces substantial concentration risk into their portfolio. This is bad for the company as well; is it difficult to imagine an employee becoming paralyzed by over analysis, knowing that the outcome of their work related decisions could result in a substantial swing in their own personal net worth as well?
Whereas the employee used to feel a sense of partnership with the company, the employee may now feel a sense of captivity. The very tool that initially motivated the employee has now become a point of contention between the company and the employee. In other words, the horse must eventually be allowed to catch the carrot.
The good news is that companies are realizing that IPOs and acquisitions are not inevitable nor are they always ideal. Surprising as it may seem, some startups are staying private for longer because they are actually profitable. Or because their value proposition is so unique that they can raise venture capital effortlessly. Or because they are allowing themselves time to catch up with their own growth.
In any of these cases, it is likely that there will be market demand for those shares before there is a traditional liquidity event.
Now, it is understandable that companies do not always jump at the chance to spend cash reserves on sponsored share repurchases. However, by working with outside investors to allow the purchase of employee held shares, the company would accomplish two goals: first and most importantly, the company would alleviate the conflict between itself and its liquidity starved employees; secondly, by partnering with outside investors to sponsor the repurchase, the company would be able to dictate the terms of the deal and manage the cap table outcomes.
Some companies may argue that once the shares have been liquidated they lose their power as a motivational tool. The surprising thing is that many employees are not looking to liquidate their entire position. They are looking to diversify their wealth, not completely divest themselves of any interest in the company’s ownership. Yet in the case where a company is concerned about this outcome, they will still be advantaged by working with an outside investor group, where they would be able to dictate the terms of the repurchase and limit the percentage of shares that each employee is authorized to tender.
The main takeaway is that employees and companies are in conflict about how to solve the employee stock option problem. Employees demand liquidity while companies demand cap table management. The solution, as usual, falls somewhere in the middle. When both sides become ready to compromise, employee stock options will really motivate employees.