Managing Share Price Volatility
At many tech companies, equity is a significant part of employee compensation. One challenging situation that can happen when a company heavily weights equity compensation in their comp philosophy is the rebaselining of compensation expectations as equity values increase or decrease. Essentially, when share prices increase or decrease by a large amount, the actual value that employees receive in a given year can experience a high degree of volatility, causing mismatched expectations, confusion, or dissatisfaction with comp.
This concept is intuitive, but worth describing in some detail so that you can fully understand the implications of share price volatility on total compensation as a manager. These examples can be complex so we’ll be running through them with math and examples.
While the examples below consider a public company with liquid stock for simplicity’s sake, many of the same concepts are applicable to any company that compensates its employees with equity, particularly later-stage private companies whose stock is ideally only a few years from liquidity, and whose valuation is more closely tied to business performance and market trends.
When Share Prices Increase
When share prices increase, they can artificially increase the expectations that employees have for their compensation. If share prices later plateau, team members can feel disappointed that their new compensation is “lower” than it was during a period of high growth.
New Hire
Let’s take a hypothetical startup, Aviato, where a new hire receives $100,000 of equity over 4 years, as part of their new hire grant. This grant is the equivalent of 4,000 shares valued at $25 when they are hired.
Year 2
In year 2, the employee receives a refresh grant worth $25,000, consisting of 1,000 more shares vesting over 4 years. The stock’s valuation remains the same, at $25. They’re also still vesting their new hire grant:
Year 3
Like some lucky startups, the Aviato team works hard, builds a great product, and continues to sell it effectively. Success strikes – Aviato is looking like a real winner, and their share price increases rapidly. In year 3, the Aviato’s stock increases in value to $50 – a very significant gain. The employee again receives a refresh grant worth $25,000 vesting over 4 years, which works out to 125 shares per year.
At this point, the employee is doing great – when their grants are summed up, they’re vesting over twice as much equity in year 3 as they were in year 1!
Year 4
Year 4 brings more of the same. The stock goes even higher, to $60, and the employee is now making almost $90,000, over three times what they made in their first year at Aviato. This is a great turn of events – this employee’s equity compensation for the last 2 years has been meaningfully higher than when they were hired.
Year 5
But then year 5 rolls around. Aviato stock remains at $60. But the employee’s equity compensation has fallen significantly relative to the last few years – they thought that they were making $70-80,000 of equity per year, but now they’re back down to about $35,000. What’s going on?
There are two issues at play:
- First, the employee’s new hire grant has “rolled off” – they’re no longer vesting that significant 1,000 shares per year, which was indexed to a time when Aviato was a much smaller and less successful company.
- Additionally, the more recent grants that the employee received (starting in Year 3, when the stock started to really ramp up in value) were smaller purely on the basis of number of shares. This makes sense – the company’s valuation increased rapidly, but has remained relatively flat for the last 2 years. But the result is that the employee’s compensation now feels much lower relative to what it was in the 2 years prior.
The real confusion here is that the employee was never really being granted $68,750 or $88,740 per year: This is just what they made in years 3 or 4. They were still receiving a standard refresh grant of $25,000 per year all along, to make sure that they weren’t falling below market compensation. It just so happened that due to stock price appreciation, these grants became worth significantly more for a period of time. That’s excellent for the employee, but their compensation was never actually structurally set up to be (for example) 3x the market.
This discrepancy can lead to mismatched expectations as early as year 4 – at this point, the employee can see the expected direction of their future equity vesting, and can realize that next year’s compensation will likely be lower than their compensation in the year prior.
When Share Prices Decrease
Let’s take a similar scenario, but track what happens when Aviato share prices decrease significantly over time.
Year 1
Just as in our first example, we’ll begin with a $100,000 grant vesting over 4 years.
Year 2
Just like in our first example, the employee receives a refresh grant worth $25,000 consisting of 1,000 more shares vesting over 4 years. The stock’s valuation remains the same, at $25. They’re also still vesting their new hire grant:
Year 3
But now, let’s imagine a dimmer scenario. It turns out that Aviato, a travel site, experiences a massive data breach and rapidly loses customers. The company’s stock plummets by a full 80%: From $25 to $5. This might seem like a crazy circumstance, but many public tech companies fell by this much or more in the tech bubble bursts of 2022 (post-Covid) and the early 2000s (the Dotcom Crash).
In this situation, the employee is now making half of what they previously were in terms of equity compensation.
Year 4
But in year 4, the Aviato share price has recovered somewhat – it’s still far below the $25/share highs, but also a full 10% higher than it was in year 3. As a result, the employee’s equity compensation is now closer to the desired rate ($25,000 per year), but still below what a new hire would get.
Year 5
In year 5, the share price continues to recover, all the way back up to $8, and the employee’s compensation is now slightly above a new hire grant.
This type of scenario, with a fall and gradual recovery of share valuations, can lead to two common issues:
- The first is that employees feel like they worked for “cheap” when the share price was lower – it’s a subtle point, but they arguably vested less stock at the time.
- The other is that it can cause salary compression or inversion, where less tenured employees earn more than equally experienced (or in some cases, more experienced) employees by virtue of when they started at the business.
Both of these situations can be challenging to manage. While the employee is still doing all right if they hold the stock through further appreciation, they still experienced the downsides of share price volatility.
Some Advice for Communicating About Volatility
As a manager, there are several ways that you can help your team understand share price volatility and manage it on your team.
The first point that must be emphasized is that working at any company with equity compensation will always involve a degree of unpredictability – companies and markets rise and fall, and employees should understand that stock compensation, like variable bonuses, are contingent upon business performance and natural market volatility. It isn’t uncommon for stock prices to fluctuate by tens of percentage points in a given year.
Additionally, volatility can go in either direction for employees. Team members may not “make back” compensation in years when share prices decline, but they also wouldn’t need to give back compensation if share prices soar.
Historically, in cases where share prices have fallen significantly, many companies will look to at least partially make up for the difference in the form of new equity grants or other compensation such as bonuses. This typically only occurs when a company’s valuation:
- Was stable at a higher point for a long time (enough time for many employees to receive shares at this price)
- Falls significantly
- Remains low for a protracted period of time, with little expectation of it recovering in the medium term
If share prices fall in this way, there are very different considerations if a company uses stock options or Restricted Stock Units (RSUs) to compensate employees.
If a company uses RSUs, it can be relatively straightforward to issue stock grants that help get employees to a better place. RSUs have guaranteed positive value (although that value is variable), so even with a suppressed share price they still have retentive value. RSUs always preserve future upside and have downside protection since very few companies actually go to $0.
If a company uses stock options, however, there can be additional challenges if employees’ options are “underwater”: when the price to exercise an option to purchase a share is higher than the value of the share itself. Underwater options can create a very challenging situation. If an employee was earning $25,000 per year in RSUs and that amount drops to $12,500, it’s unfortunate but often still workable. But if $25,000 goes to $0, that’s much more likely to cause a significant issue.
In the difficult situation of underwater options, employees need the stock to go up for their equity compensation to be worth anything and employee retention can suffer as a result. Under these circumstances, many companies have chosen to reissue stock options in order to provide a more retentive compensation package.
When share prices rise for a period of time, it can be valuable for companies to communicate the fact that employees’ compensation growth after accounting for share price appreciation is not necessarily the compensation that they should expect in future years. Clear communication around compensation cycles and broadcasting a clear compensation philosophy is key.
The area of share price volatility is also an area where differences between private and public companies can be especially pronounced. While the hypothetical company Aviato was public in our examples for simplicity's sake, private company valuations are much more subjective, and private companies don’t have the advantage of being revalued every day. This adds an additional layer of nuance and expectation management to any sort of equity compensation discussion.
Conclusion
Understanding the dynamics of how share price volatility can manifest in employee expectations is important for Total Rewards teams and managers. We hope that this post has given you a better sense for the intricacies of equity compensation in a volatile environment, and has provided some ideas on how to communicate about compensation with your team.
