The lack of understanding of stock options is not unique to the employee. Stock options, preferred shares with their protective provisions, valuation, cap tables, and incentives in general are broadly misunderstood by leadership of these companies as well – including sometimes executive leadership.
I know of a COO at a venture-backed company that would recruit team members partially using the allure of “stock options”. The company was growing fast and the idea of stock options in a fast-growing company was exciting to prospective team members. The problem was that neither the COO nor the new recruits understood the math behind them. If the COO had understood the math he would have found some other way to motivate his team members rather than setting them up for disappointment. The small grants done at fair market value relatively close to an upcoming liquidity event were akin to offering them “magic beans” only capable of growing a baby carrot or two.
In the above instance and many others, I would argue that stock options are not the right vehicle for incentivizing employees. There were not enough options in the pool for any meaningful grant to these employees – no matter how hard they negotiated up front. Significant appreciation at that point in time (near a liquidity event) was improbable. Many studies have been done on how to motivate performance, but I’m confident that none have concluded that offering iron pyrite is the way to go. I know my company is in the business of pricing stock options but the fact is that sometimes they aren’t the right means of compensation.
I don’t claim to be the master of proper compensation packages. But it’s my view that stock options make the most sense when they represent meaningful grants to team members who are sacrificing to build material value in a business. They are required to be granted at fair market value. As such they are theoretically worthless at the time of grant. But a meaningful grant to someone who can make a material impact on increasing the value of the underlying stock makes a ton of sense to me. Inconsequential grants to people in positions with less opportunity to drive value seems like a waste. I’m not saying those people shouldn’t be compensated at market rates for their contribution. I’m simply saying that compensation package should include bonuses or incentives that are more concrete and directly tied to what they can control within their roles.
To be clear I am not advocating the decreased use of stock options. I’m advocating the transparent and intelligent use of them where they can have the most impact. I’m advocating that those granting the options in the first place should absolutely understand the math behind them and be able to explain that math to the recipient. The funny thing is that as of today, I believe too many executives granting the options would struggle with that math and if they did understand it they might be placing those chips more carefully and impactfully.