Why Do Millennials Love Equity Compensation and How Can Entrepreneurs Use It?
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MARK RIEPE: In November of 2021, a record 4.5 million Americans—or about 3% of workers—quit their jobs.1 This was part of a trend that's been playing out for months—a so-called Great Resignation that's been making news and leaving economists and companies to wonder if it's a short-term anomaly or a new normal that could outlast the pandemic.
And while it's not affecting all job sectors equally, it's caused some employers to rethink their compensation and benefit packages, both to entice current workers to stay and tempt job seekers to join their company.
I'm Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
In this first episode of our new season, we are going to look at equity compensation. It's called compensation for a reason, because it's an ongoing monetary reward for working at the company.
It's different from benefits like health care, tuition reimbursement, vacation days, sick days, or perks associated with the working environment (for example, free ice cream, massages, or nap rooms). Equity compensation is designed to give the employee a direct financial stake in the success of the company akin to what an owner might receive. Equity compensation is growing in popularity because employees understand that these forms of ownership can provide enormous upside under the right conditions.
But just because something's a good thing, doesn't mean that it comes without baggage in the form of psychological decision-making biases.
One of these is overconfidence, or our tendency to overestimate our abilities. On this podcast we usually talk about overconfidence in terms of investing, where we think we're better at investing than we are. This is driven by our misperception at how well we can predict what might happen to a company whose stock we own. It's why we always recommend that investors diversify.
When it comes to the stock of a company that we're familiar with (like our own employer) our tendency towards overconfidence can go into overdrive. The familiarity bias causes us to stick with investments we're familiar with because we think we have so much more information about it that we know what's going to happen to the company. Don't get me wrong, familiarity with your investments makes a lot of sense, but when it comes to predicting the future prospects of the firm, it's a lot more fallible that you think.
I think you can see where this is going. You work for a company that offers stock to its employees. You're obviously familiar with the company and have confidence in it. You have to ask the question: Is the stock as good as you believe it is? Maybe. But maybe not.
Now, I'm not saying that if a company awards you a grant, you should turn it down. What I am saying is that as these grants accumulate over time, you need to think about them in the context of your overall portfolio and not automatically assume they will generate outsized returns—even if they have in the past.
You need to evaluate it like you do any other investment you own. Think about both the upside and the downside and don't let any single company dominate your portfolio.
This is especially important with equity in your employer.
If the company doesn't do well, that may affect your employment, the other forms of compensation you receive form the company (for example, salary and cash bonuses), and your investment portfolio.
The bottom line is that there will come a time when it makes sense to sell some of your equity compensation, and you should be thinking about the conditions under which that makes sense.
Nevertheless, I think this trend towards more equity compensation for more employees is a good one, and it's nice to see younger employees so attuned to the potential benefits.
I'm going to explore this topic some more with my guest, Amy Reback. Amy is the head of Stock Plan Services at Charles Schwab, responsible for business acquisition and development, corporate client onboarding and service, plan administration, and platform development.
Amy's been at Schwab for 18 years, and she actually started at Schwab as a financial consultant working in our branches, so she's got a keen sense as to the needs of individual investors. That expertise has served her well in a variety of positions prior to and including her current role.
MARK RIEPE: Amy, great to have you here again. Thanks for joining us for the first episode of Season 10.
AMY REBACK: Thanks for having me, Mark. It's great to be back.
MARK: You know, the last time you were here, we covered a lot of ground, mostly related to employee stock options. And one topic I wanted to discuss today, though, is small-business owners and entrepreneurs. The pandemic has hit them especially hard, and we know they're contending with labor shortages brought on by the so-called Great Resignation. What have you seen from your perspective, what have you been seeing from entrepreneurs and how they use equity compensation? Has it changed in some way in the last couple of years?
AMY: Yeah, it has. We're seeing a couple of different trends. The biggest one that we're seeing from entrepreneurs … and I'll clarify up front that in this context, the term "entrepreneur" really refers almost exclusively to leaders of smaller, private companies who can be a little more nimble and creative in their compensation strategies. So the trend that we're seeing then, overall, from the smaller, private companies led by these entrepreneurs who are young, and fresh, and exciting, and they can be more creative is they're issuing more performance-based awards versus options. And that's going to lead to the question, I bet, what's the difference between employee stock option grants and performance shares?
So I'm going to make it really easy, and I'll stick to the biggest difference here. In most scenarios, employee stock options, or we just refer to them as options, they have one target to reach, and it's usually a stock price. And that value is almost always related to the underlying stock of the company, whether it's public or private.
For performance-based shares, on the other hand, they usually have very specific financial targets or metrics or a combination of financial success factors for a company attached to them, and they can be paid out in a number of different ways, not just the company stock. And the payout choices for performance awards in the private space is really where we're seeing the innovative trends. So "How would you like that served? You've reached your goal. Do you want restricted stock shares? Do you want cash? Do you want crypto?" There's a lot of creative choices we're seeing for performance awards, and that's what really sets them apart.
MARK: And I guess that makes a lot of sense because we know that there's a war for talent going on and employees really like flexibility. This is just another form of that, right?
AMY: Exactly. Exactly.
MARK: In 2021, many companies went public, and many employees, of course, benefited from that. For those who might be interested in working at a startup and thinking that, you know, that company is going to be the next big thing, what advice do you have if they're offered some form of equity compensation?
AMY: Well, the first thing I'd say is ask what's guaranteed and what isn't. What are you really being offered? When will they vest? Do they actually become yours? And what's the timeline? How long would they be restricted after they vest? Are there performance or retention requirements attached to them? You know, maybe most importantly for a true startup, does the company have a path to exit the private market? Liquidity, in particular, can be an issue with private share awards. So understanding the actual value they represent to you and what you have to do to get that value is very important.
MARK: I guess, in a lot of ways, it's no different from you're going to work for a company and they tell you they have health benefits, right?
MARK: I mean, that's good, but you really need to understand the details, right?
AMY: Right, what's in the package?
MARK: Let's go back to the employer for a second. For someone who already owns a small business, and, you know, let's say it has fewer than a hundred employees. What are some of the ways to offer those employees equity or ownership?
AMY: That's a really great question, Mark. So, first, let's agree that ownership matters. If anybody's ever rented a car, or if you own a car, you know that when you rent one, you're probably less concerned about the state of that car than if it's yours. So employees are human—it's just human nature to care more about something that you have a beneficial interest in.
For small-business owners, which are usually private companies, they have pretty straightforward capital structures, a great way to transition to employee ownership is to offer an employee stock ownership plan. Different than an option plan, but an ownership plan. And that provides a path for employees of a small business to own shares of that company's capital stock.
For employers that have about a hundred employees, that's usually a way for either founders or senior executives to start divesting their shares, make them available for other employees to purchase. It gives them a step towards retirement, and it also allows those up-and-coming employees to buy shares. There's some tax advantages built in there that are different than options. I won't get into that. But it does create a beneficial interest for retention. It's less expensive for the firm than creating a more complicated capital structure, where new shares are issued as part of a compensation package, and there's a treasury, and all of that. So it creates a buy-in from the employees, but it's not a function of their compensation plan, like a traditional restricted stock program or equity compensation.
MARK: Millennials, I think, are now the biggest percentage of the workforce, and they're really at an age where they're starting to own their own businesses. Do you see any differences with respect to how the compensation structure they're using for their businesses and how they compare to prior generations?
AMY: I do. So millennials, in particular, have just an inherent understanding that to attract and retain talent, they're going to have to offer equity to their employees. It's table stakes. And I think back in Season 3, the first time I was on the show, we talked about, you know, generational expectations. And I think the term that I always use is my dad said, "Go get yourself a pension." And then by the time he was retiring, he said, "Make sure you get a really good 401(k)." And, generationally, those things are table stakes for companies now, you have to offer retirement of some kind.
But what we're seeing more and more demand for is equity—they want ownership. And millennials understand that because they understand and have been raised to have choice. So firms that are led by millennials, they're really understanding that they're going to have to offer equity, and they're going to be more interested in allowing them to just use it how they see fit. It's table stakes. They're not really going to monitor how they use it. Whereas more traditional firms led by traditional executives from older generations, they tend to have more goals for their equity plan. They want their employees to use it a certain way, and they change the eligible audience more often based on how those participants use it. It's not right or wrong, it's just a different approach. Millennials are going to care more about offering it as table stakes. It is just what you have to do to be in the game, and they're going to allow their employees to decide how to use it on their own terms.
MARK: So let's say you're an entrepreneur, and you're thinking about your employees who are, you know, as we mentioned, increasingly millennials. What's the psychology of that? What do you need to … I guess, what do you need to really get about your employees for that to really work for both parties?
AMY: So I think one of the things that is really changing in the mindset today from millennials and entrepreneurs is they really understand and look at attracting employees no differently than attracting consumers. So incentive packages or offering equity is just a product, and it has to compete on the shelf with all the other choices that consumers, or in this case, employees have. Remember, back in our day, Mark, the diet soda wars of the 80s? And the first one was horrible, and it had like 25 calories, and then the next one had 10, and then 5, and then 1, and then 0. And it's all about, what's going to capture the interest of the audience and what can you do to one up the one next door?
So millennials, if you think about it, they were raised by baby boomers. And the baby boomers spent their early years protesting, marching in the street for a cause of some kind, and what they were really expressing was the desire to be heard. That was different than the generation before. And when they stopped marching, they put their signs down, they started raising families. What do you think they told their kids? Do you think they said, "Be quiet. You get what you get"? No, they said, "Your opinion matters. Speak up. You should have choices, and if you don't get them, you should create it. Your opinion and your ideas are going to be interesting to everyone and you will get a trophy for them." So good for them. Like it's super hard for a card-carrying member of Gen X, like me, to deal with in the workplace. But good for them—they are involved, and they like to speak up about it. They expect choice.
And over the last 15 to 20 years, that's been a huge change in the culture of our workforce overall. But it does explain why choice matters to them. And millennial entrepreneurs, the business leaders behind those startups, and just even employees who are demanding those types of table stakes, incentive packages, they know that offering choice for ownership via equity allows the recipient or the employee to feel their value is represented in a really unique way. And that's what's going to attract and retain employees at a better rate than the shop next door.
MARK: So what does that look like in practice? Maybe give me some examples of the sort of creativity you were just describing.
AMY: So some of the most creative things I've seen are just a laundry list of choices for how the employee might want to receive their shares or their award. And I mentioned a few of these earlier—cash, stock, crypto. But there's others such as, let's say, you might want the ability to defer your awards as if they were compensation, similar to like an executive deferred compensation that's common for top executives. That's going to put it into a qualified account, defers their tax liability until they withdraw them. It's almost like having another retirement account. Another one I've seen recently is the ability to choose to double-down, basically, on your award. They select an option well in advance and agree to some type of milestone. For example, they might get twice the shares if the stock price, or EPS, or, you know, predetermined metric hits a certain level. I've seen requests to have a predetermined formula for stock grants to be transitioned into an amount of time or extra time paid off, for a percentage to be donated to a specific nonprofit organization pre-tax, and I've even seen an inquiry about allowing employees to choose to have a percentage of their shares transferred over to an org that will use those funds to reduce their carbon footprint.
So the menu of choices and change is never ending, and we're seeing more and more created of that. Again, you know, the vast majority of these really creative requests we're encountering are usually associated with smaller, private firms. Most of those aren't contemplated for public companies or broad-based equity compensation plans.
MARK: Amy, as we're recording this, unfortunately, the coronavirus is still with us. But this trend toward, you know, people working from home and maybe more generally the workforce being quite mobile, I don't think that's going away. What are some of the things, when it comes to employee equity, that people should be thinking about with a more mobile or more dispersed workforce?
AMY: Great question. Couple of different trends, and it's relatively simple, or we can boil it down to things that are relatively simple. Most restricted stock grants, and, you know, have a few options for performance award. Again, this is different for large publicly traded companies. But we're in a 10-year-plus bull market. So we're not seeing as many performance awards or options for large companies. We're seeing performance awards at a higher rate for smaller, private companies. But for public companies, one of the trends that we're seeing is fewer options or performance awards, because we're at the high of this, you know, market and in order to get value out of those awards, you have to hit a higher and higher target. And if you're trying to incent your employees to stay, or retain them longer, or attract new ones, that has to be tangible. And with sky-high stock prices, it becomes less tangible for them or less realistic to achieve those goals.
The second trend that we're seeing, this mobile, global, work-from-anywhere transition, a much higher demand for help and guidance. You know, if you're going to decide to work from somewhere else, change your residence, you know, move to Scotland and decide to work from a really quaint farmhouse for a year, you're going to get a surprising and relatively unwelcome surprise in your tax bill at the end of the year. Even if you stay within the U.S., you could owe significantly more in your annual tax bill. So, fundamentally, it's not new, but there's been a lot of changes in the way that it can be tracked, and companies are paying more and more attention to it. I heard from one of the Equity Unpacked episodes that we did, we had a mobility specialist, and she said that there are undergraduate degrees now in corporate mobility where people are specializing in helping create platforms and processes to track where employees are, because there's big implications for the employers, as well, from a corporate tax perspective.
So lots of tax tracking that is involved here, but also from a corporate tax fulfillment requirement, as well, it can get pretty complicated.
MARK: Well, and because of that, it wouldn't surprise me at all that if we're going to be having situations where the employees are maybe more confused than potentially they already are about stock options and equity compensation, in general. So how can employers be more proactive and get the help their employees need so that they can learn about the process, get it to them upfront, as opposed to waiting for them to ask?
AMY: Well, it's just an entire process of communication and education. And I mentioned earlier that a lot of the millennials and entrepreneurs are really approaching employees as if they are consumers. And that's, I think, a really great way to look at this. If you want people to pay attention to something, you have to give them an incentive to do it. What's in it for me? Why does somebody buy something, or pay attention to it, or choose to spend the capital of their time on it? So, really, marketing what your equity plan is, what it can do, what they need to know. Saying it over and over and over again in multiple channels is the most important thing.
The second thing I'd say is nearly every large employer with a traditionally structured equity compensation plan is going to work with a broker-dealer. If you're a public company, you have to. So if you're working with a broker-dealer like Charles Schwab to provide employee education on your equity plan, start with what they have to offer to employees and leverage every opportunity to provide that support to your employees. That's usually a multi-channel approach between the provider and the employer. But you also have to get, you know, really careful about the type of direct conversations that an employer in the equity group would have with your employees, because they're not licensed with FINRA or the SEC to give advice or guidance on security. So you really have to leverage the help and guidance and expertise that your broker-dealer brings to the table.
MARK: Amy, one last topic I want to cover, and that's about the regulatory environment. Since we last spoke, we've had a change in administration, and that sometimes can come associated with it new rules and regulations. I was thinking, you know, kind of off the top of my head, you know, obviously, there have been some tax rate changes since we last talked. What else has been going on that's important, especially around … I think there's been some talk about 10b5-1 plans? What are those and what should people be paying attention to?
AMY: Yeah, that's a good one. And I'll thank you in advance for breezing right past the tax topic. So that first proposal that you mentioned about 10b5-1 plans, that could really impose some pretty significant changes to when and how top execs or insiders at public companies can trade their shares. That's mostly related, as you mentioned, to these 10b5-1 trading plans and also the amount of time that the stock has to be owned before it can be sold by an executive that's deemed as an insider. So I'm not going to get into all of the details, but let's suffice it to say that those proposed changes are significant and are really pertaining to SEC guidelines that haven't been revised in 20 years.
MARK: Amy, we did an episode last season on SPACs, or Special Purpose Acquisition Companies. Are you seeing any issues with these so called blank-check companies or other innovative ways in which companies are going public beyond the traditional IPO route? How does that have an effect on equity compensation?
AMY: Yeah, so that's another interesting one. It's a change or just discussion, you know, there's no official proposal by the SEC. But the discussion has started about, you know, having different requirements or new requirements for private companies before they become public, from a financial disclosure perspective. So you mentioned these … I call it the alternative path to public. Any company that takes a different path from traditional IPO—the most often ones that we see are direct listings and SPACs, as you mentioned. But, you know, right now the amount of financial disclosure they have to provide going into those transactions, it's significantly higher for a traditional IPO.
So let's be clear: There are plenty of companies that have chosen these alternative paths to public, and they provide the same level of financial disclosure that would be required by a traditional IPO, but they've done so specifically to create transparency. And the point there is they are not required to do so. I'm not here to pass judgment on that, but the fact remains that these are different, and they're happening in unprecedented numbers. The IPO market, it's been booming—that's not a surprise. And if you look at all the different ways companies can go public over the last three years, it was in 2019, 232 new public companies, 480 in 2020, and 1,058 in 2021. That's a massive increase in the number of companies that are offering their securities in the public markets in a really short period of time. And when you look at the success rate of those companies, there's only 27% of those that went public in 2021 that are at or above their initial price, their offering price.
So, you know, if you're the SEC, the foundational function of the SEC is to ensure the investing public has the information they need to make informed decisions. Now, IPO buyers have to prove they have the financial means to make that investment in a company that has no trading history, but when only 27% of those opportunities that you have to invest turn out favorably for investors, it's going to catch the eye of a regulator who aims to ensure that the public has access to make those informed decisions.
So why do we care? How does this impact equity compensation, and why am I why am I droning on about it? Listen, the stats mean that 63% of share owner employees of private firms that went public in 2021 had a significant reduction in the value of their equity shares, even if they had at a really low, you know, initial price, their total net worth was impacted pretty significantly. So even if they don't have executive roles for these broader-based plans, it's a large population.
You know, if you're looking at a decline of somewhere between … I think the lightest one was −16%, and the worst was a decline in price of 88%, 213 of them had a stock price decline of 25% or more … if you look at that, those equity plans are not competing with the other incentive plans in the marketplace at that point. That means employees are going to leave. Speculation starts to follow those big departures. That creates more price volatility. And so, and so, and so on the cycle goes
So, when you think about it, equity comp in the private space has a ripple effect on the markets in the economy than most of us give credit for. So providing additional financial disclosures ahead of going public could avoid some of that.
MARK: Amy Reback is the head of Stock Plan Services here at Schwab and the host of her own podcast called Equity Unpacked. Thanks, again, Amy, for being here. This has been great.
AMY: Thanks so much for having me, Mark.
MARK: Millennials now make up the largest percentage of the U.S. labor force, about 35%.9 They also make up a large share of the self-employed and those starting new businesses. Between these shifting demographics and a pandemic that's upended normal routines, the way Americans work and look for work has changed dramatically. This goes beyond things like greater flexibility concerning work-from-home policies. Employee expectations around compensation may be changing as well.
Millennial-run firms may, as Amy noted, view equity as table stakes in a compensation package.
But they can differentiate themselves in how they structure their offers—and in the help and guidance they provide. Equity compensation can be difficult to understand when we're at our most rational. Throw in some hard-wired biases, and the value of investor education becomes even more apparent.
In the introduction to the episode, I talked about overconfidence as a decision-making bias that may cause certain employees to place too much value on equity comp. And while the tendency, on average, is toward greater use of it (and I think that's a good thing), some employees may be missing the boat because of another bias that entrepreneurs and employees should think about.
Present bias is our tendency to give too much weight to short-term gratification at the expense of future payoffs. This matters when it comes to equity compensation because the payoff from that form of compensation often takes years. Imagine you're an entrepreneur trying to recruit candidates. People who are prone to present bias will discount equity compensation and instead opt for companies who offer more immediate forms like a higher salary or a signing bonus in the form of cash.
For people the entrepreneur already employees, some of these employees who have present bias may not place a lot of value on the equity grants they receive and prefer cash.
As I've said before, the trend toward greater use of equity comp is a good thing for both employees and companies, but it does introduce more complexity for both parties.
Just like any investment, it's important to understand what you own and what you're getting and set your aside your emotions as much as possible so that you can evaluate the opportunity as clearly as you can.
A great way to get more educated on this topic is to take advantage of Amy Reback's podcast called Equity Unpacked. Amy talks candidly with guests from the stock-plan world to untangle how it all works so you can make more empowered decisions. Make sure you subscribe and give it a listen at Schwab.com/EquityUnpacked.
And if you have any questions about how your equity compensation fits into your portfolio and financial plan, you can always call Schwab at 877-279-4476. And if you'd like to learn more about the familiarity bias, check out our second episode of Season 6.
If you've enjoyed the show, please leave us a review on Apple Podcasts. And if you know someone who might like the show, please tell them about it and how they can also follow us for free in your favorite podcasting app.
You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
1 Fortune, The Great Resignation
Leonhardt, Megan, "The Great Resignation rages on as a record 4.5 million Americans quit," Fortune.com, January 4, 2022
5 Patagonia: Yvon Chouinard, How I Built This with Guy Raz, NPR, December 25, 2017
Patagonia: Yvon Chouinard : How I Built This with Guy Raz : NPR
6 Paljug, Katharine, "16 Cool Job Perks That Keep Employees Happy," businessnewsdaily.com, December 21, 2021
After you listen
- Learn more about including equity compensation in your financial plan.
- Listen to Amy Reback's podcast, Equity Unpacked.
- Follow Mark Riepe on Twitter: @MarkRiepe.
- Learn more about including equity compensation in your financial plan.
- Listen to Amy Reback's podcast, Equity Unpacked.
- Follow Mark Riepe on Twitter: @MarkRiepe.
- Learn more about including equity compensation in your financial plan.
- Listen to Amy Reback's podcast, Equity Unpacked.
- Follow Mark Riepe on Twitter: @MarkRiepe.
As many small and early-stage businesses are still coping with the effects of the pandemic, one way to attract high-quality employees and help keep payrolls manageable could be the use of equity compensation. Increasingly, millennials are demanding that new job offers include equity as part of any compensation package. What's behind this trend? When does it make sense?
In this episode, Mark talks with Amy Reback, head of Stock Plan Services at Schwab. They discuss what to look for in an equity compensation package, how employers can offer ownership in creative ways, and what changes to the regulatory landscape might affect equity compensation.
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