Stock-based compensation has become an increasingly large component of employee pay, especially for executives at public companies. This impacts how these companies allocate capital in several ways. According to William Thorndike in "The Outsiders," innovative capital allocation is a key driver of long-term value creation. Effective leaders make rational choices for capital deployment based on ROI. Stock-based pay must align with these objectives.

Some key principles from Thorndike's outsider CEOs are maintaining capital discipline, prudent diversification, and returning excess cash to shareholders. However, stock-based compensation can motivate behaviors that stray from these ideals if not structured properly. For example, executives may pursue empire building acquisitions to increase the stock price near their option exercise date, even if acquisition ROI is questionable. And stock-based pay reduces shareholder return in favor of employee return.

While this describes potential issues with stock pay for mature public companies, the implications are different for younger, growth-oriented startups. For these companies, cash is precious. These younger businesses need to invest heavily in R&D, sales and marketing, and scaling operations to fuel rapid growth. Here, stock-based compensation allows them to compensate employees while conserving cash for crucial investments in the business.

Additionally, younger companies lack access to debt financing that mature companies can tap into. So they must rely more heavily on equity-based funding rounds that dilute founder/investor ownership. Issuing options and stock grants to employees fits this equity-based model of raising growth capital.

Stock compensation also incentivizes employees at these startups to think like owners, aligning their incentives with shareholder interests in long-term value creation. This is especially important at mission-driven startups needing all-hands-on-deck commitment to growth. Employees share in the upside of success. Of course, even for startups stock pay must be thoughtfully designed and governed through proper vesting schedules and share issuance discipline. Dilution still reduces existing shareholder value.

But the cash-conserving nature of stock-based pay makes it a powerful tool for capital-constrained young companies needing to direct cash to critical investments in innovation and growth. Handled strategically, it can accelerate startup success while thoughtfully incentivizing employees. For the right companies, it hits a sweet spot in the capital allocation toolkit.

Source of inspiration: https://www.morganstanley.com/im/publication/insights/articles/article_stockbasedcompensation.pdf