Employees and advisers of startups (and cyber-utopianists and venture capitalists) often talk as if employee stock options are a good thing, but they’re evil. They’ve changed my mind about this in the last few years, so they’ll go into it in more detail than they should probably have time to write up now, but the short version is: ESOs are bad for employees and bad for companies too.

What is a stock option?

An employee stock option is a contract from your employer to give you shares of the company’s stock at a set price by a specific date. If the price goes up, you can buy the shares lower and sell them for more money. You don’t have to buy them if it goes down, and no money changes hands.

What makes options lucrative is leverage: on paper, you can make much more money than you could in real life. For example, say your company setup Malaysia grants you an option to buy its stock at $10/share within five years, and the store soon rises to $30/share. If you exercise your option then and buy 100 shares, you can sell them immediately for $3,000, giving you a profit of $2,900. What’s especially good about this deal is that it cost you nothing: in return for a right you’d never use if it didn’t make money, you got $2,900 in cash ($3,000 minus transaction costs).

Employee stock options are one of the critical motivations for employees.

Employee stock options are one of the critical motivations for employees. If you think about how they were initially designed, they had a slightly sinister motive: to attract people who would work hard and be loyal, who would be willing to put all of their risks at a single place. The structure of the whole system was designed so that these types of people would naturally do well financially.

But under normal conditions, the incentives are not quite as clear-cut as that. Many people who would have been perfectly happy with a basic salary will go for the bonus with a more significant percentage. And others, particularly younger employees with less experience, will be very willing to accept bonuses even without an explicit promise from management that they will eventually pay off.

The result is that employee stock options appear to have become a primary source of motivation for a surprising range of workers. People who wouldn’t have cared about money before may now see it as an important goal in its own right. They may even start modifying their behaviour based on their performance relative to what they could expect in their next raise. So much so that they can end up doing less work than they would otherwise want to do, simply because they don’t need the money.