Stock Options Good Option for Startups

Stock options are supposed to be one of the most direct ties between pay and performance. While critics cry foul at excessive compensation at some of the nation's largest corporations, the Business School's Richard Lambert has taken a close look at the value of stock options in entrepreneurial firms..
       Lambert, the Joseph McDonald Professor of Accounting, believes options are useful in startups because compensation, incentives, and financing are much more closely linked in startups than in larger firms.
      One important reason options work so well in small companies is that they save cash. Paying employees in stock options is the equivalent of paying them in cash and then requiring them to use part of their compensation to purchase equity in the company. This equity stake can provide powerful incentives, especially in smaller, entrepreneurial firms where even employees below the executive level have a significant impact on the value of the firm. In larger companies, the direct effect of each employee is diluted. Also, options do not show up as an expense on the income statement, hence the moniker "stealth compensation." This improves the firm's financial appearance compared to what it would be if cash bonuses were awarded.
      In startups, stock-based compensation can be used as a screening mechanism to attract the right people--those who are willing to forgo a safer financial package. They are likely to be bigger risk takers, to have more faith in their abilities and ideas, to be more motivated to work hard, and even to be more creative, says Lambert. Because options are worth less than the stock price at the time they are awarded, the company can grant more options for what it would cost to give actual stock. That magnifies the incentives, at least on the upside. If an employee's upside is unlimited while the downside is limited, he or she will be motivated to take risks, says Lambert. On the other hand, if a grant of stock or a bonus is given, employees will be more conservative in order to "protect their winnings," he says.

--By BARBARA BUELL