Stock options are widely used as employee compensation tools in two big areas: public companies and private technology startups. In this article, we discuss a bit of their use in technology startups, especially in Silicon Valley. For the purposes of this article, we'll only discuss the use of stock options for employee compensation, as opposed to trading in markets and investments.

What are stock options?

Stock options are securities that give their holder (employees) the right to buy stocks of their employer companies at a certain price, called the strike price, and at a certain moment in the future.

Usually, stock options are issued to employees under a vesting schedule. Vesting schedules in effect make the options become exercisable (i.e., they allow the holder to actually buy the shares) in installments at future dates. So let's say an employee gets options that give her the right to buy 1000 stocks of her employer. If she's in a 1-year cliff, 4-year vesting schedule, which is the most common arrangement in Silicon Valley, she'll be able to buy 250 stocks at the turn of the 13th month, and then 1000/36 stocks at every subsequent month-end.

Stock options also have strike prices. Using the example above, our employee has 1000 stocks to buy. Let's say at the end of her cliff, she gives notice to the company that she intends to buy her first 250 stocks. Her options will necessarily have a strike price, which is the price she'll pay for each of her 250 stocks. So if the strike price is U$ 1.00, she'll have to write a check of U$ 250.00 to her company in order to buy the shares (shares = stocks).

The employee makes money by exercising the stock options - buying stocks - at a price that is lower than the price they sell the stocks in the future.

How are stock options used?

In Silicon Valley, the most common use of stock options is when they are issued to employees when they're hired at a new employer. Cash-poor, early-stage startups look to minimize the amount of cash compensation committed to employees.

But employees are not dumb, and demand market compensation, which is usually a number derived from what the employee could be paid at a big company like Google or Facebook. So in order to still be able to recruit these employees with lower cash salaries, companies supplement compensation packages with the issuance of equity stock options for the difference.

For companies, stock options have other advantages other than the fact that they don't deduce from their cash balances. Power is also stacked on their side. That's because as we've seen stock options are issued on a vesting schedule, and therefore if the employee's fired she'll lose the options that have still not vested.

According to Andy Rachleff, founder of Wealthfront, some of the benefits of stock options are that they "align the risk and reward of employees betting on an unproven company, reward long-term value creation and thinking by employees, and encourage employees to think about the company’s holistic success."

Evergreen and merit issuances

Stock options are not only issued to employees when they're hired. Some companies also issue them on a merit basis, frequently alongside salary raises and bonuses. These new stock option grants are done as a way to reward employees that show the right behaviors and produce the best results, often after the end of a performance review. Again according to Rachleff, "...these grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year."

Other companies issue stock options in a more egalitarian manner to most employees. Rachleff calls these "evergreen grants" and says that evergreen grants, "... which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter." In Rachleff's view, these grants aim at retaining employees and should be done on a yearly basis so that employees never have a big vesting cliff on their horizon.

In these cases, the main goal of stock options is the retention of employees, who are more likely to stay with the company if they have shares still invested. The goal of these evergreen grants is to keep a relevant balance of shares to be vested in the coming years of employment.

What do stock options really reward

We think ongoing stock option issuances - all those grants made after the initial one - don't really reward past performance, as most companies advertise, but really the potential of future performance.

As we've seen, options are issued on a vesting schedule, which makes their exercise be conditioned to continued employment with the company. Therefore, even if they are issued to those who've shown better results or behaviors in the past, they can only be exercised by those who continue to deliver in the future.

If an employee has produced amazing results in the past but isn't expected to keep producing those results in the future (it happens quite frequently), she'll likely not be issued as many stock options as another high potential employee.

Therefore, we believe stock options are really issued to the employees that offer the highest "present value" to the company, and that "present value" is usually assessed by managers' individual guts.

How to correctly assess potential

As we've seen, stock options issued to employees after their initial grant are really rewarding the potential for future performance. We've also seen that "potential" is assessed by gut, and not even acknowledged inside companies as valid criteria for grants.

Is there a better way to evaluate potential?

We believe a great way to think about potential is using Korn Ferry's Learning Agility framework. According to the company, potential can be defined by an employee's capacity to keep on delivering great performance in the future at more and more complex positions.

If the employee can be promoted to jobs that carry more responsibility and complexity and still deliver amazing results and behaviors, she'll have shown potential.

But how can we predict potential?

One way is to analyze past performance. If an employee has a track record of nailing ever higher complexity jobs, she'll likely be able to keep doing it in the future, therefore showing "learning agility." That's the ability to quickly learn new skills to deliver on greater responsibilities. Another way is to use questionnaires built to assess potential, like those sold by companies like Korn Ferry.

In any way, we think acknowledging that there's a "potential" axis on which employees are reviewed and upon which stock options are granted is already a great first step in order to increase their effectiveness within companies.