ASK A FINANCIAL PLANNER: Is it worth taking a salary cut to get stock options at a hot startup?
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Certified financial planner Jeff Rose answers:
I'm in the process of considering a new career opportunity with a well-known privately held startup rumored to go public in the next year/year and a half.
Part of the compensation package will include equity, or stock options. Based on preliminary conversation, the salary they may offer would be slightly lower than the going rate for this position (say 10 to 15% less), to be compensated by an equity offer (stock options or restricted stock).
My question is, how do I negotiate a 'number' of these options to compensate for a lower salary over the next couple of years? Is there a formula for that?
Also, from the company's point of view, would the value of equity offered be tied directly to the perceived difference between the salary offered and the prevailing market rate?
In recent decades, and particularly in the IT field, stock options have become increasingly popular as a method of compensation. But should you accept stock options in lieu of salary?
Let's start by saying that there is no mathematical equation to help in determining the balance between salary and stock options. More significant is the risk/reward relationship involved with stock options: The options could make you rich — but they can also become worthless.
But before we get into that, let's talk a bit about the basics of stock options.
What are stock options?
Sometimes referred to as employee stock options, or simply ESO's, they are granted by an employer, enabling the employee the right (but not the obligation) to purchase a certain number of shares at a specific price and at a specific point in time in the future. They're most commonly offered to managers and officer-level positions.
Options usually have expiration dates. If the options are not exercised by those dates, the options will expire and become worthless. There is also a vesting period, after which the employee will have full ownership over the options. Vesting might occur over, say, five years. Vesting is a strategy that employers use to keep employees with the company for longer periods of time.
The market value of the stock at the time the options become vested determine the value of the options. And naturally that can never be known at the time the options are granted.
For example, an employer might grant an employee the option to purchase 1,000 shares of stock at $50 per share, which is referred to as the strike price, or exercise price. After one year, the employee is vested in 200 shares, and the share price has climbed to $75. The employee exercises the options, and earns an immediate $5,000 profit — 200 shares at a gain of $25 per share.
After two years with the company, the employee is vested in another 200 shares. But the value of the company's stock has fallen to $40 per share. The options have no value unless the stock climbs to over $50. If the options expire before that price is reached, they will become worthless.
Why an employer would want to offer stock options
There are several reasons why employers offer stock options:
- To preserve cash — options don't require out-of-pocket cash, like salaries do
- As an incentive to attract new employees
- As a performance incentive for existing employees (a higher stock price results in higher option payouts)
- To keep employees with the company longer (the main reason behind periodic vesting)
Trading salary for stock options
The person asking the question describes the employer he or she's considering as a "well-known privately held startup rumored to go public in the next year/year-and-a-half." There are two red flags in that assessment: startup and rumored.
What makes those two words so dangerous? "Startup" implies that the employer is a new or fairly new company. And "rumored" means that whether or not the company will actually go public is still subject to some speculation. Meanwhile, the fact that the event is not expected to take place for at least another year means that the stock doesn't even exist right now. The options therefore represent a complete unknown.
Due to market factors alone, there is always the risk of options becoming worthless, even with a well-established blue-chip company. All that needs to happen is for the market price of the stock to fall below the exercise price of the option.
The situation is of course much more problematic with a startup company. There's no way to know what the market reaction will be to the stock once it goes public. Though we hear of initial public offerings rocketing out of the starting gate and making the holders rich, stock prices fall at least as frequently.
That means that it's entirely possible that the salary the employee will give up in favor of stock options will never materialize. The employee will be betting that the future of this upstart will be very positive and the company's stock will be well received by the market. But if circumstances don't break in that direction, he could not only be at risk on his job but also on his projected investment in the company's stock.
Adds Russ Thornton, certified financial planner and founder of Wealth Care for Women:
"Concentration risk = concentration risk, whether it's a high-growth startup or a blue chip stock. If this person is going to receive a paycheck from this company, his income is already going to be largely dependent on the fortunes of the company.
"It would dangerous to further tie his financial dependence on this company by relying on equity compensation. Just because it's well-known and 'rumored' to go public, doesn't mean that it will happen — there's no guarantee the company will even exist 18 months from now. Unless this person is just looking to build their résumé, I'd be cautious."
The better strategy with stock options
Stock options are an excellent benefit — if there is no cost to the employee in the form of reduced salary or benefits. In that situation, the employee will win if the stock price rises above the exercise price once the options are vested. And if the value of the stock never reaches the exercise price, the employee loses nothing. But that's not the situation with this startup employer.
“Get the cash compensation to a level you're comfortable with and then let the options be icing on the cake," says Taylor Schulte, a San Diego-based certified financial planner."I would suggest consulting with an expert just to help you better understand the nuances of the options you are being offered."
The best strategy for this employee is to negotiate a market-level salary. That will eliminate the risk of the many variables connected with the options, such as if the company will actually go public, how well-received the stock will be when it does, the exercise price level of the options, and what the vesting schedule might be.
These are all variables that cannot be adequately factored into the decision at this point. Go with the market-level salary, and negotiate for the stock options as a secondary consideration.
This post is part of a continuing series that answers all of your questions related to personal finance. Have your own question? Email yourmoney[at]businessinsider[dot]com.
Jeff Rose is a certified financial planner professional, and CEO and founder of Alliance Wealth Management LLC, an investment advisory firm. Jeff is an Iraqi combat veteran having served in the Army National Guard for nine years, including a 17 month deployment to Iraq in 2005. He is the founder of GoodFinancialCents.com, author of "Soldier of Finance," and editor of LifeInsurancebyJeff.com.
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