A new rule is forcing business owners to think twice about stock options.
Nothing sweetens the pot like stock options. Not only do they entice top talent, they also allow business owners to conserve cash needed to grow. What's more, options have always been cheap: They don't cost the company a dime until they are exercised -- usually when a company is sold or goes public.
But stock options are about to get pricier -- thanks to a new regulation passed by the Financial Accounting Standards Board in December that aims to standardize accounting standards at both public and private companies. Under the rule, private companies must list outstanding options as an expense item on their books rather than merely tacking them onto financial statements as a footnote, starting this December.
For many business owners, that's going to mean skyrocketing accounting bills. Bill Coleman, founder and CEO of Cassatt, a software company in San Jose, Calif., figures it will cost him as much as $100,000 a year. That's because expensing options is a complex task that will require his accountant to estimate Cassatt's stock price over a 10-year period. Even worse, Cassatt will have to generate more revenue to absorb the added costs, which could delay Coleman's ability to take the company public. "We may have to go an extra year or two before we have enough sales," he says.
Fortunately, options are not the only way to dole out equity. Here are four strategies to consider.
With restricted stock, employees receive shares in your company but can sell or transfer them only after they have vested. Say you grant an executive 1,000 restricted shares, each worth $1. The executive immediately takes ownership of the shares, and as a result has an instant stake in your business. But since the stock is restricted, it can't be sold or traded until the end of a vesting period, usually three or four years. If the stock price doubles to $2 per share by then, the employee winds up with $2,000 worth of stock. If the price drops to, say, 50 cents per share, the stake is worth $500. Upside: Restricted stock is more of a sure thing than options, so employees are likely to be happy with fewer shares, which will decrease the effect on your company's profits. Downside Like options, restricted stock must be expensed throughout the vesting period. And since it's guaranteed, it may be a less powerful incentive than options.
If restricted stock doesn't seem like enough of an incentive, try doling out stock-appreciation rights. Say you offer that same executive appreciation rights on 1,000 shares of your company's stock, again valued at $1. The executive benefits only if the value of the stock increases during a specified period. If the stock price jumps to $2, the employee gets $1,000 -- the equivalent of the increase in the stock's value -- in the form of either cash or shares. If the value of the stock stays the same or decreases, the executive gets nothing. Upside: Stock-appreciation rights must also be expensed during the vesting period. But appreciation rights usually yield less than options, which will decrease the effect on your company's bottom line. Downside Since employees pay cash to exercise options, they often go unclaimed. But stock-appreciation rights are guaranteed, as long as your company's criteria are met.
As the name implies, these shares don't yield equity. Instead, they mimic the performance of stock during a set time period. Say you grant your executive 1,000 phantom shares worth $1 each. If the shares meet a specified price of, say, $2 by the end of a specified period, the employee receives the equivalent of the increase in value of the shares, or $1,000 -- which is paid out in a cash bonus rather than stock. Upside: Like stock options, phantom stock must be expensed throughout its vesting period. But, from an administrative standpoint, it's easier to dole out because it involves only cash. Phantom stock also gives employees a vested interest in boosting your company's value without cutting into your ownership stake. Downside You'll need to have plenty of cash on hand when it's time to pay up.
Options, With a Twist
Coleman, for his part, will continue to issue stock options despite the new FASB rule. Luring top employees with options did, after all, help him turn his first start-up, BEA Systems, into a billion-dollar company. If you intend to do the same, consider adjusting the assumptions that generate your stock's estimated value by, say, reducing the vesting period, since options with shorter lives are worth less and have less of an effect on the bottom line, advises Judith Thorp, head of the compensation and benefits practice at New York City-based consulting firm KPMG. Or ask your accountant to plug in a lower volatility score -- the metric used to gauge the frequency and severity of price swings -- when valuing your company's stock. But keep in mind that any fancy financial footwork will have to pass muster with your auditor. Given the heightened regulatory environment these days, that might not be easy.