Assessing and Adjusting Employee Stock Option Plans

Granting stock options to employees is an excellent way to align effort with results for the company and the employee. Not to be confused with employee stock ownership plans (ESOP), used to transition complete ownership of a company into the hands of the employees, an employee stock option plan, (ESO) can be an important and effective element of an organization’s ability to attract and retain top talent in their business. These long-term incentives enable an employee to participate in the financial success of the company at a future date when the company is either sold or enters the public market. They are also a reflection of a company’s overall mindset when it comes to how they want to approach building employee engagement, buy-in, and commitment at different stages of company growth. At the early stages of growth, leaders wrestle with many questions to inform their initial direction, including:

• Is an employee stock option plan right for our company?
• What behaviors and outcomes are we seeking to incentivize?
• Which type of plan would best fit our organization?
• Should all employees be eligible for the program?
• What is the right level of employee option grants?

When organizations arrive at the answers to these questions and choose to implement an employee stock option plan, there are many details to work through, from program setup and maintenance to extending and completing grants. The work, however, does not end there. As an organization grows and changes, its employee stock option plans may need to change as well. Below, we take an anonymized look at one organization’s evaluation of potential adjustments to their ESO several years after initial adoption.

Assessing the Need for ESO Changes

AB-Tech (ABT) is a high-tech manufacturer that has been in business for nearly 70 years. For some time, the company has been operating well under the value that was established years ago under the guidance of previous leadership teams. The value of options granted in earlier years had declined and stock options granted to employees in the past were no longer relevant to the generation of current business value. In the case of ABT, the issue was how to right size the percentage of ownership that would be appropriate for employees at this stage of the company’s life.

ABT’s CEO partnered with a vcfo incentive plan expert to assess the current state of the ESO and determine the right path for moving forward. The CEO also conferred with ABT’s board to explain why changes to the employee stock option plan were needed and how the ESO could be changed to ensure that it was scalable and incentivizing the right outcomes for the current environment. Key questions included:

• How would past stock option grants that may have expired or been exercised be handled for current employees?
• Should new grants be issued to existing employees to avoid situations where questions of equity may arise by providing new grants to recently hired employees?
• What adjustments are needed to align the ESO with the current value of the business?
• What potential vesting or changes to vesting are needed related to newly created and issued stock option grants?
• How would the relative business impacts of different employees and employee groups be considered?
• Should all employees participate in a newly created stock option plan?
• What equity grants should be provided to different levels or groups of employees?
• Would adjustments to the ESO properly incentivize sought-after talent needed to support ABT’s business strategy?
• What are the market benchmarks related to equity grants for acquiring and retaining top-level talent?
• What type of equity instruments (classes of shares) will be used for equity grants to employees?
• What is the method and process for determining value of the equity instruments to be used for equity grants to employees?

In evaluating these and related questions, the organization recognized the need to transition the ESO to a graduated plan. This would recalibrate the value of the options. A range of employee characteristics would need to be considered, including employee job levels and job families, as well as service time.

Implementing Changes to an ESO

With findings from the questions above in hand, vcfo worked with the ABT’s Board of Directors, the CEO, corporate counsel, and the leadership team to redesign the plan’s architecture. The group leveraged recommended tools and processes to guide decision-making and revised plan components. Key steps included:

• 1:1 dialogue with a range of ABT leaders and employees to understand current perceptions and sensitivities to potential plan changes
• Job leveling to create clearer job roles, classifications, and hierarchies for internal mobility and career paths
• Evaluating ESO survey data from reputable sources to ensure market competitiveness of ownership percentage by job level, relativity to their funding round and size of their employee option pool
• Evaluating a revised ESO in tandem with ABT’s compensation philosophy and broader employee pay plans

The 1:1 dialogue and related communications helped employees to understand why changes to the plan were warranted and how the company would continue to rely on and reward them for the work and effort they contributed to creating a profitable and successful organization. The organization was able to successfully introduce a revised ESO that integrated effectively within a new overall compensation structure.

A Powerful Incentive

Employee stock option plans can be a powerful and beneficial incentive both for employees and employers. These plans should not, however, be viewed as “launch and leave alone” initiatives. ESOs should be periodically evaluated to determine whether they are still delivering the right outcomes, incentivizing the right behaviors, and aligned with the state and strategy of the business.

Specific HR and finance experts can be especially helpful to leaders as they undertake ESO assessments and look at the performance and structure of their compensation and benefits plans, particularly when partnered with corporate counsel. Getting the terms of the ESO right results in engaged employees who feel valued by their employers and are invested in doing their part to grow the business.

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Is it time to evaluate your ESO and broader incentive plans? Request a free consultation from a vcfo expert who can help you put together the right plans for your business.