The idea of giving stock-based compensation is to turn employees into partners. In theory, giving employees stock will make them part-owners of a business and drive them to think and act like a business owner.
However, the reality is that the way SBC programmes of many companies are designed today actually does not motivate employees to think or act like business owners.
In today’s world, SBC is predominantly given in the form of RSUs or options that vest over three to four years. This means that employees are given a fixed number of shares/options every month over a three to four year period. Although this turns employees into shareholders, it may not adequately motivate them to think like owners of a business.
The reason is that employees can sell the stock as soon as they receive them. Many employees are also not inclined to hold the stock for a long period of time, instead opting to sell the stock when the prices go up. Employees may also consider their contribution to the company as too small to make any difference to the stock price.
As such, this form of SBC does not make employees think like shareholders at all. In fact, I would argue that cash-based compensation would be a better motivator for employees.
Complete lock up
One way that companies try to get around this is to have a lock-up period. In this way, employees are not allowed to sell the shares they receive for a number of years. The lock up period can range from months to years.
But, I think that this is still not enough. Employees need to think like perpetual shareholders where returns are driven by cash flows and ultimately dividends paid to shareholders.
As such, my radical proposal is for SBC to have perpetual lock ups. This means that employees who receive SBC are never allowed to sell unless they are forced to sell via a buyout.
By having perpetual lock ups, employees become true long-term shareholders whose returns are tied to how much cash flow a company is able to return to shareholders.
In this way, employees really think hard about how to maximise cash flow to the company so that the company can pay them a growing stream of dividends in the future instead of just fretting over stock prices. Stock prices are also not entirely in the control of a company as stock prices can also fluctuate based on sentiment and interest rates. Cash flow on the other hand is entirely influenced by management decisions and employee actions.
Although perpetual lock ups may not seem enticing to employees at first, if the company is able to grow and pay dividends in the future, the employee is entitled to a new stream of regular and growing cash income.
Possible push backs
I know there are many possible push backs to this proposal.
For one, some employees may not want to wait so long to receive dividends as an early stage company may take years, if not decades, to start paying dividends. Such a long lock up will not be attractive to employees who want to get rich quick. But that’s the reality of being a long-term shareholder of a business. True business owners are not here to flip the business to someone else but to reap the growing cash flows that the business builds over time. These are patient business builders and that is exactly what we want from employees.
Another pushback would be that it would encourage management to pay dividends instead of investing in other higher return investments. Although this is possible, management who have received shares and are long-term thinkers should be willing to forego some cash dividends today to earn a much larger stream of future cash dividends. Ultimately, a perpetual lock up should drive management to maximise dividend cash flow to themselves over the entire life cycle of the business and not just maximise dividend payment for the near term.
Final words
A perpetual lock-up sounds like a radical idea but it may make employees really think like long-term business partners.
The current model for stock-based compensation via vesting periods and short lock-ups just do not have the same effect in my view. Employees end up focusing on how to drive short term price movements or they just aren’t motivated at all to think like a business owner. In this case, cash incentives and the current form of SBC is not much different.
The only true way to make employees act and think like long-term shareholders is to make them one. And perpetual lock ups probably are the best way to do this.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.