How to Retain Employees at Start-Ups: Stock Options

As valuations of young technology companies tumble in the private and public markets, more companies are likely to follow the lead of social media giant Twitter. To keep its employees from running out the door, the San Francisco–headquartered microblogging service recently handed out more holdings of its stock.

Although additional stock compensation obviously represents an expense for companies — one many often leave out of pro forma earnings — it’s not necessarily a problem. That’s because without high-performing employees, say analysts, start-ups are destined for a quick demise.

“If a company does well, the stock expense won’t matter, and if they don’t get and keep employees, they can’t do well,” says Jitendra Waral, senior research analyst for consumer electronics and the Internet at Bloomberg Intelligence in San Francisco. What matters most is how successfully a company executes its business plan — not whether it has to increase employee compensation to do so.

As for Twitter, whose stock price has dropped some 68 percent in the past year, it’s not the only young tech company to see its valuation plummet. CB Insights, a venture capital research firm in New York, cites 60 private companies that executed a down round of funding or a down exit since the beginning of last year. The list includes San Francisco’s technology wearables company Jawbone and New York–based deal-a-day web site Gilt Groupe.

As valuations have slipped, so has financing. Global venture capital funding plunged 30 percent during the fourth quarter of 2015, to $27.2 billion from $38.7 billion the previous quarter, according to Venture Pulse/CB Insights. A total of 1,742 deals were executed in the fourth quarter, the lowest since the first quarter of 2013.

That tale of woe can make it difficult for young tech companies to attract and retain employees. “If there’s a decrease in valuations, employees for those companies are seeing lower returns for taking the risk of working for a small company,” says Yossi Feinberg, professor of economics at the Stanford Graduate School of Business.

As long as there’s a belief that the venture capital market will rebound soon, start-ups don’t have to worry too much about finding and keeping workers, he says. It’s when people are worried about a sustained fall that they’re reluctant to work for start-ups. “We’re near that now,” Feinberg says.

In times such as this, when valuations of young tech companies are falling but those of many large ones aren’t, stalwarts such as Alphabet, Facebook, Oracle Corp. and Cisco Systems have an advantage in attracting engineering and other talent, Feinberg says. “The bottom line is that people move toward safety when there are questions about high-risk ventures.”

The fear of a slowdown makes people reluctant to leave safe jobs for start-ups. Of course, some successful younger companies can continue to retain talent as well. Airbnb and Uber Technologies, both headquartered in San Francisco, are still hiring, notes Scott Devitt, managing director of Internet equity research for financial services company Stifel in New York.

For companies like Twitter that aren’t doing very well, there’s little choice but to offer more equity compensation — either shares themselves or options with lower exercise prices — to retain and attract workers, analysts say. Compensation is what it’s about for attracting engineers, and given the cash-poor status of many start-ups, equity is the only means for them to boost pay packages.

“Companies in a crisis can’t afford to have workers exit and can’t afford cash, so they have to give away stock,” says Aswath Damodaran, professor of finance at New York University’s Stern School of Business. Twitter has enough cash that it is doling out retention bonuses in addition to the shares.

Still, it’s not all bleak for the start-ups. When valuations drop, workers realize their stakes in the companies are worth less. “But I don’t think people extrapolate the math that much,” Feinberg says. “Usually, it’s big bets the talent is making, looking for a ten-times or 20-times return.” So, as long as the company is performing well, employees may be willing to give it the benefit of the doubt.

It’s all about the company’s prospects, not just valuations, Feinberg says. “If I’m at Theranos, I’m probably looking elsewhere,” he says, referring to the troubled medical testing company. “But if it was Uber having a down round, that doesn’t mean I’m looking for a different place.”

For companies that boost their stock compensation, the story is somewhat similar: The ones that succeed with their business operations won’t suffer for it, say analysts. Google repriced 7.6 million stock options for more than 15,000 workers in 2009 to keep workers from jumping ship during the 2008–’09 financial crisis.

“Additional equity grants aren’t a predictor of the future in and of themselves,” Stifel’s Devitt says. “It’s the business in the end that matters.” Regardless of whether they increase equity compensation, “companies that should sustain will sustain.”