We recently published a paper on SSRN, Stock-Option Financing in Pre-IPO Companies, that examines a new industry in which specialty-finance companies provide capital to employees and executives to facilitate the exercise of stock options in pre-IPO companies.

Equity awards and stock-option grants are a central element of compensation programs in pre-IPO companies. According to the National Association of Stock Plan Professionals (NASPP), approximately three-quarters of private companies offer stock options as part of their compensation mix. In Silicon Valley, where many technology and healthcare startups are located, over 90 percent offer stock options. Stock options are not just awarded to the highest-level executives. Half of companies distribute stock options to over 80 percent of their employee base; a third distribute them to all employees.

Companies include stock options in the compensation mix for attraction, retention, and incentive purposes. Because of the leveraged nature of stock-option payouts, stock options attract highly skilled and risk-tolerant employees who are willing to sacrifice current salary for the potential of much larger future pay if the company is successful through their efforts. By paying a portion of the compensation in equity, companies in the early stage of development can reduce cash outlays. Stock options also serve as retention tools, by encouraging employees to remain with the company until granted awards are fully vested and full value realized upon completion of a liquidity event.

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