In the past, stock-based compensation was more common with fledging startups that had to find ways to preserve the little cash they had.
But today, stock-based compensation is used by almost every major company in the world. Even big firms with lots of cash continue to use stock-based compensation. One reason is because employees want to get paid in stock.
How it works
To understand why this is, we need to look at the mechanics of how stock-based compensation works.
In a typical compensation package, an employee may be offered an annual contract with, say, 33% of the compensation coming in the form of restricted stock units and the rest in cash. This means that an employee who is on a $100,000 annual package will get $33,000 worth of shares per year.
But here’s the catch. This $33,000 worth of shares is based on the share price at the time of signing the employment contract. If the share price rises, the amount that the employee receives each year will be more than $33,000.
For instance, many Nvidia employees who were hired before the massive run up in its stock price the last few years are now receiving shares every quarter that are worth so much than when they joined the company.
Here’s how the math works. Let’s say you were hired by Nvidia five years ago. Back then, its shares were trading at a split-adjusted price of US$6.10 each. You were given a US$200,000 annual package for five years that consists of US$134,000 in cash and US$66,000 in stock . Using the stock price of US$6.10, the US$66,000 in stock-based compensation means you will receive 10,819 shares each year. The number of shares that you receive each year is fixed, even if the stock price goes up or down. Fast forward to today, and that 10,819 shares that you receive each year is now worth US$1.1 million.
Typically, stock grants only last for a few years before they expire and new grants will be made at the current stock price. This is why some employees may want to leave the company after the stock price has run up a lot and they have collected all their shares from the initial grant.
Stock-based compensation lets an employee enjoy the potential upside from a company’s stock without having to put down their own capital to buy shares. For instance, you, the Nvidia employee who was hired five years ago, essentially “bought” US$330,000 (US$66,000 multiplied by 5) worth of Nvidia shares five years ago. That’s a huge bet for most people, but stock-based compensation allows an employee to enjoy the returns of this bet without actually having to buy shares.
Potential downsides
However, there are potential downsides for an employee who takes a pay package that has a significant component in stock-based compensation.
For public-listed companies, employees can sell the shares when they vest. But for private companies, the shares are illiquid and employees may not have an easy way to convert the shares to cash. In addition, employees who work for a small startup and get shares in the startup have a high risk that the startup fails and the company’s shares ends up worthless.
I know of friends who are stuck with shares in companies they previously worked for. These companies may be struggling or have no clear path to an IPO or to be acquired, leading my friends to be stuck with shares of the companies without any real means to cash out.
The risk for employees of public-listed companies who receive stock-based compensation is that the share price falls. This is the case for many US-listed technology companies after 2021, with many of their stock prices still down by 50% or more from their 2021 peak.
Imagine if you joined Okta in April 2021 and received a 4-year pay package of US$200,000 consisting of US$134,000 in cash and US$66,000 in shares. Back then the shares were trading at around US$244 each, so you would receive 270 shares per year. Today, 270 Okta shares are worth US$27,049 – a materially smaller sum compared to the grant value of US$66,000. You would have been better off taking US$200,000 in all-cash compensation.
Bottom line
All things considered, despite some drawbacks, stock-based compensation is still an attractive proposition for an employee as it allows them to make a huge “bet” at the grant date stock price of a company without laying out any capital at all.
If the stock surges like Nvidia’s, then the employee could be set for life. However, if the stock fails, employees still get the cash portion of the annual pay package.
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 have a vested interest in Okta. Holdings are subject to change at any time.