Why would someone argue that stock options are a better form of compensation?

Question

I'm reading How Google Works by Jonathan Rosenberg & Eric Schmidt. In the Talent - Hiring is the most important thing you do chapter, the authors briefly pause the management topics to give career advice (specially directed to young people).

When talking about compensation, the authors argue that, early in your career, the most important thing is to pick the right industry where you will get paid well in the future, than to pick companies now based on compensation. The reason that they give is that, in the future, your compensation will have much more equity and early in your career stock options are limited compared to the future.

While I agree that the advice in itself is sound, I cannot completely understand the reason. For me, the advice makes sense because your compensation in the future is going to be far bigger than today, but in my opinion the fact that you will be receiving more equity/stock then is actually a con. What I (perhaps incorrectly) inferred from their argument is that its more advantageous to have a big part of your compensation being equity/stock than actual salary. I don't see the sense in this, for me given that compensation is X I would pick everything in salary and no stock if this was an option. In the particular case of Google, Tesla & other companies, there is no dividend, so I cannot expect my income to grow steadily for receiving these options.

My best guess is that a company will not be willing to give the same compensation if no stock is offered, but in that case I don't see much point in the reason for the advice. The only way I see this making sense is in a case similar to those of Jonathan and Eric, who became wealthy due to the massive valorisation of Google stock. But if I started working for Google today, I wouldn't have reasons to expect the same growth (and Google doesn't pay dividends). So what am I missing here?

Answer 1

Firstly, you need to distinguish between stock and stock options. Just giving out stock has no special benefits. But stock options have big benefits for the company:

• "buy now pay later": they cost almost nothing until the options vest, which is usually some years after they are delivered to the employee.

• incentive payment: you generally lose unvested options if you quit the company, so they act as a staff retention scheme. The final value of the options is dependent on how well the company does, so the success of the employee is linked to the success of the company.

• stock doesn't cost cash, so the bootstrap funds required by the company are smaller. Instead the staff are

• can cheat staff out of options payments: there have been plenty of acquisitions in which the options are valued at zero

For the employee:

• if the company is successful, the value can be huge. Far higher than the company could have afforded to pay you month-to-month.

• access to early-stage shares which aren't on the public market (you can have stock options long before any IPO)

• favourable tax treatment. This has mostly been taken away, but there are still "R&D incentive" schemes in lots of places where you can acquire the options without paying income tax and/or capital gains tax

The downside risk is that you are being paid in lottery tickets. There's no guarantee that the options will be worth anything.

(An additional category is RSUs: restricted stock units. Again there's a vesting schedule, and this acts as a staff retention scheme)

Answer 2

They are not arguing that stock options are better than cash.

"The reason that they give is that, in the future, your compensation will have much more equity and early in your career stock options are limited compared to the future."

I see nothing in that statement that claims stock options are a good thing relative to cash. It is a statement of fact that you should plan your career around, not a statement of a certain type of comp being superior. The reality is once you hit a certain level you will rarely find opportunities to make more than $2-5mm per year in cash unless you actually own and control the company and can make distributions to yourself or reap the rewards of a company sale. If there's a board that oversees compensation, they will limit the amount of cash compensation in order to prevent people from jumping ship and retiring. Stock options theoretically orient someone to care about the company's future and typically vest over multiple years. It's structured in a way to keep key employees invested in the company. For example (here), Google's CEO total comp in 2019 was $280mm, of which $276mm was stock options. He only received a similar amount of cash in 2020, presumably because targets were not hit to receive the stock options.

So you are right that companies will never offer $280mm in cash, and the only way to get there is through stock options. The reason they are giving that advice is because the long-term prospects of the industry you are in and the company itself will ultimately determine the value of the stock options, so it's important to avoid an industry like oil that's in terminal decline, where stock options have very little upside 30 years from now. Personally, I find this advice to be useless. There are better, more important considerations for starting a career than the future worth of stock options. The industry you are in can be changed without a lot of fuss, especially at the executive level.

On the actual question of whether stock options are better than cash, that's a personal question. How much do you believe in the company? How much do you value the tax deferral stock options provide? Are you ok with the lack of diversification? Generally, people will prefer in equivalent amount in cash since you could just use the cash to buy company stock or call options if you wanted to, but there's still an immediate tax impact here that giving stock options would avoid.

Answer 3

If you are compensated with stock, then dividends are often taxed at a lower rate than salary income, but otherwise you are hoping that the value of the stock will increase over time.

And if you are compensated with options, you are not entitled to dividends as you don't own the stock itself, but again you would be hoping that when the options vest you could use them to purchase stock at a reduced price relative to the current market price - and then we're back to my first point above.

This would not be appealing to everyone, indeed. For example (and I suspect especially early in a career) the value of "cash now" is much greater than "cash later" if you're living paycheck-to-paycheck or needing to get a relatively large mortgage requiring proof of income.

(For the employer, of course, the value of stock or options is that they don't have to pay as much cash out at payroll!)

Answer 4

Employee stock options give workers an opportunity to own a slice of the company. They allow them to purchase stock at a set price within a specified time frame, typically for less than the current market price. If a company goes public, the benefit can be life changing for early-stage employees and executives.