Stock Options and Cash Compensation
Negotiating salary is about quantifying risk. Compensation strategies that are aggressive with equity and stock options often teams more upside, but with the upside comes more risk.
Before accepting a job offer, be sure you’re striking the right balance. This framework can help you understand what you’re stepping into and whether you’re getting the best deal for your situation.
Let’s start with some basics.
Stock options align interests and provide long-term incentives through several mechanisms. Firstly, they foster an ownership mentality by granting employees the right to purchase company shares at a predetermined price, cultivating a sense of ownership and commitment. Secondly, they directly tie employee rewards to company performance, as employees benefit from the company’s growth, aligning their interests with shareholders. Lastly, stock options are particularly attractive in startup environments, where the potential upside as the company grows and potentially goes public is significant, offering employees a chance to reap substantial rewards as the company succeeds.
Cash compensation offers stability and flexibility through immediate financial rewards, enabling employees to cover expenses without concern for market fluctuations. It also plays a crucial role in meeting immediate financial needs, promptly addressing expenses like debt repayment or living expenses. This form of compensation provides employees with a reliable source of income, ensuring their financial security and peace of mind in the short term.
Stock options vs. cash compensation: What are the trade-offs?
- Immediate vs. Long-Term Rewards: Cash compensation offers immediate financial rewards, providing stability and liquidity. In contrast, stock options typically require a longer-term commitment, which may take years to vest and realize their full value.
- Financial Stability vs. Potential Upside: Cash compensation provides financial stability, ensuring employees can cover expenses and plan for the future with certainty. Stock options, however, offer the potential for significant upside if the company’s stock price increases. Still, they also come with the risk of value fluctuation and potential loss if the stock price decreases.
- Alignment with Company Performance: Stock options align employees’ interests with the company’s performance since their value increases with the company’s success. Cash compensation, while providing immediate financial rewards, may not offer the same level of alignment with the company’s long-term goals.
- Liquidity: Cash compensation is immediately accessible and can be used for any purpose, while stock options lack liquidity until they are exercised and converted into cash or sold.
- Retention and Motivation: Stock options can be powerful tools for retaining and motivating employees, especially in startups with the potential for significant stock value appreciation. However, cash compensation may be more effective in meeting immediate financial needs and attracting talent, particularly in industries with high competition.
- Tax Implications: Cash compensation is subject to immediate taxation. In contrast, the taxation of stock options varies depending on factors such as when they are exercised and whether they are qualified or non-qualified options.
5 steps to balancing stock options and cash compensation
#1 Lay out your full financial picture, including stock options
Start with the basics: what you’re earning today and what’s in your portfolio.
If you’re excited about an opportunity with a huge upside in the form of stock options, but it decreases your current salary by 40%, you’ll want to get very critical so that you can understand whether you can manage a lower salary and have a healthy cash-flow that supports your lifestyle and long-term financial plan.
#2 Organize your short- and long-term personal goals
Some factors to consider are whether you’re comfortable delaying retirement if your equity compensation doesn’t work out. If so, risking more equity and upside might be a good option. However, suppose you have obligations such as student loans, education funding for your children, or a large mortgage. In that case, prioritizing the security that you can meet them is an important factor to weigh. In cases like those, higher cash compensation has more value.
You’ll also want to consider how much you want to grind. Are you OK working weekends or do you need to take spring break off and spend time with your family?
It’s important to not get too distracted by big numbers – especially hypothetical ones – and ensure you are assigning value to your time. If obligations are met, your cash flow is where you need it, and you are enjoying your work and your life, there is real, meaningful value there that can’t necessarily be made up by an IPO.
It’s really a concept of living a richer life. Is your life richer because you’re not working weekends, or is your life richer because you have an extra $500,000 at the end of five years? There is no right answer in general, but there is a right answer for you.
#3 Forget about the immediate numbers for a minute
How much money you’ll make next year or over the next 3-5 years isn’t everything. It’s also important to look at how the job impacts your future prospects. For example, understanding what you need to get out of the job, what it means for your career, and whether you’re excited about it.
I worked with a client at Brighton Jones who took a role as an executive of a private company that was trying to go public. The ultimate financial upside wasn’t huge, certainly not what the original projections suggested. However, the credibility they earned as an executive who helped take a company public opened some major doors.
The accomplishment was a huge resume boost, which showed in the next opportunity’s value. Sometimes a job opportunity has value for your career that can factor alongside the monetary value you take home.
#4 Negotiate a total package, not just your stock options
Depending on the type of equity compensation in the offer, you’ll need to consider various tax implications. For example, your cash compensation may be taxed differently than your stock compensation if you have Incentive Stock Options.
When you negotiate a total package, include a combination of cash and equity, and then go a step further. Here’s where other executive benefits like deferred compensation plans, supplemental executive retirement plans, and more factor in.
Don’t lose sight of the “normal” benefits. Some companies offer very generous 401(k) benefits, for example. Say you have two offers: Company A contributes $18,000 more than Company B. That means you’ll need Company B’s offer to be about $25,000 higher pre-tax per year just to break even.
#5 Make your call
Cash-poor start-ups used stock as a lottery ticket-type mechanism to woo high-paid white-collar workers to their businesses. The practice is now widely adopted by nearly every publicly traded company, tech or not, according to a recent Financial Times report.
Before you swing for the fences, evaluate your foundation, existing portfolio, and long-term goals. Stock options can be attractive, especially for workers in their 30s and 40s with plenty of earning years left.
At the end of the day, it’s offer-specific. If you’re weighing multiple job offers and compensation structures, your Personal CFO can help you make the best decision for your personal tax situation and your big picture.