I thought in today’s article I would tackle a tougher question when it comes to equity compensation. I will tell you right now this is a hard question to answer, but it is one worth tackling. The question comes down to what happens if an employer offers you a lower salary but stock options, or vice-versa. You know, higher salary but no stock options.
Before we dive into this, I again want to mention a few key things. First, I cater to clients who work for older, publicly traded companies. When I am talking about stock options, I am referring to Non-Qualified Stock Options. I don’t handle ISO’s, which is more typical with private companies hoping to go public at some point. Some of the concepts I am talking about today apply regardless of public vs private status, so it may still be worth your time. Also, I will be talking about other types of equity compensation, like Restricted Stock, so it won’t just be stock options. With that, let’s get to it.
I wanted to discuss this topic as equity compensation in general is becoming a more popular request as part of the overall compensation package for employees. And this is not just with private companies. In general, more employees, or potential employees to be specific, are asking for equity compensation as part of their pay package. And I do not see this going away.
The question then becomes a trade-off. Are you willing to take a lower salary if that can be made up via equity compensation, specifically stock options? Or, should you go ahead and take the money now and forget the stock options?
Unfortunately, there is no simple mathematical formula to bust out to help you answer this question. At least that I know of. I’m sure there are plenty of people out there who have created their own spreadsheets to do a personal analysis, but I am not aware of any universally accepted formula to break this down. Of course, now that I say this I will find one. Oh well.
I am going to break this down into two main sections. The first, and simpler one, is if you choose to just take the higher salary. I bet you already guessed the second one. It is taking the lower salary but with some stock options in there.
Let’s start with the higher salary option since it is easier. The big benefit here is you have immediate cash in hand. Totally get it. There are lots of reasons to go this route. Maybe you have bills, like student loans to pay for. Or it may be the other end of the spectrum and you have kids going to college soon. Or it could be you have other plans with those immediate funds, like nice family vacations every year or an outside investment you want to participate in. Or it could be as simple as you know this way you will not be out anything.
That final reason is key. With stock options there is no risk for you to accept them. This is because unless they go up in value during a specific time-period they are worthless to you. I won’t go into deep detail, but will quickly explain. Let’s say an employer awards you some Non-Qualified Stock Options at a price of $50 with a 10-year exercise window. Unfortunately, the stock does nothing over the next 10 years and the share price actually drops to $48 a share. There is no reason for you to exercise these options and buy the shares as you would be paying $50 for a share worth $48 on the open market. However, if the stock had a great run during the 10-year period and it now worth $500 a share, you would be a fool not to exercise them. Again, you would pay $50 for a share worth $500 on the open market.
This whole explanation is that if the stock options do not go up in value you at least have the cash in hand from a higher salary to make you feel better.
To summarize, I guess the big benefits of taking the higher salary come down to immediate cash needs and/or a desire to make sure you are not out anything. This is a personal decision and falls along the lines of conversations I have with people who say they need to take Social Security as early as possible because they want to get back some of what they’ve paid in over the years and/or they are worried it will go under.
How about we turn our attention to option two. Lower salary but more in equity compensation. Once again, some background here.
Now, I do not want you to freak out here, but employers aren’t offering more equity compensation out of the goodness of their hearts. Weird, right. No, there are benefits to them as a corporation to offer these. They include reasons like it helps to preserve cash. Lower salaries means they have less cash going out in payroll and more there for them to work with. Also, stock options and all forms of equity compensation require employees to stick around longer than if you just received cash. Non-Qualified Stock Options have a 10-year window to exercise. Most Restricted Stock and RSUs have vesting periods of at least 3-5 years. I have never seen any data to back up this assumption, but I wouldn’t be surprised if paying out more in equity compensation is cheaper than constantly dealing with employee turnover.
A few other reasons employers are okay with more equity compensation include it helps to attract better candidates. I think we have all seen the headlines about hiring issues now. I can’t imagine offering equity compensation is a deterrent for most applicants. The final reason, and some may say the most important one, is equity compensation encourages employees to work toward that goal of increasing the company’s stock price. Higher stock price helps the company and every employee who has company stock, whether it is stock options, Restricted Stock, RSUs or even Employee Stock Purchase Plan positions.
I mentioned before a simple example of how there is no risk with stock options. If it does not go up in value you are out nothing. Well, I guess except maybe the time you spent hoping it would increase. That brings me to my first point with stock options – time.
If a main reason you are taking a job is because of stock options, you are almost saying you plan to be there at least 10 years. Technically you only have to commit as long as the vesting period, but I am trying to keep this simple. Most options have a 10-year window with them so I am going with a 10-year commitment. My point here is if you are job hopper then maybe it is in your best interest to forgo the options and go with the higher salary.
And this time commitment consideration applies if you have RSUs or Restricted Stock too. While these vesting periods are shorter than the 10-year options window, they usually are a handful of years too. Again, I am just trying to get across that if you take a lower salary and opt for more stock option and equity compensation benefits, plan on being there at least a handful of years. If you cannot commit for a few years, take the higher salary.
How about we get into the final reasons to consider when you are looking at the lower salary and equity compensation decision. This really comes down to faith that the company’s stock price will go up in value while you are there. I am going to break this into two sections.
First is with RSUs and Restricted Stock. I have mentioned this in other episodes, but I like these forms of equity compensation as they always have value. Stock options only have value to you if they go up in price. Even if RSUs and Restricted Stock go down in price they still have some value. Unless it goes to zero, which means bigger problems for the company. So, you at least get something out of RSUs and Restricted Stock.
With stock options, and again I am referring to Non-Qualified Stock Options, the share price will have had to go up during your options window for there to be value for you. So, if you go the route of equity compensation you are placing your faith and hard work with the hope the stock will increase in price over time. This is a risk. Not an insurmountable one, but is a risk to be aware of.
One final comment related to this decision. If you are leaning toward the equity compensation option, which makes perfect sense to me, be sure to do your best to have an appropriate and competitive starting salary. Don’t give up big chunks of immediate pay if you can help it. There is no reason you can’t get a little bit of both – good salary and stock options. Oh, and I would even suggest all of this applies if you are negotiating a new salary, whether it is for your current position or a new one at your same employer. No reason not to ask. Of course, I work for myself, so what do I know😉
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.