Leveling The Playing Field: Paying Workers With Credit Lines Backed By Put-Hedged Restricted Stock
A modest proposal. Hear me out.
I’m not even sure this needs to be stated. Income inequality is massive. The difference keeps growing. But let’s look at why.
While politicians often rail on about income tax, the reality is that the super-rich generally became super-rich not through income, but through capital gains. Aka, via owning the stock of companies which grew dramatically over time. Their salaries were generally insignificant compared to their capital gains — indeed, some take only minimum wage salaries, to make a point.
Workers, by contrast, are generally paid in cash. While the company’s value growth may be exponential, a worker’s wages are fixed. This is by design, and generally suits both parties:
- Workers need cash; they can’t afford to sit around waiting for a company to grow.
- Owners generally have the financial assets to sit around waiting. They’d rather not dilute their ownership, and instead just pay workers a constant amount.
In the end, the owners take the lion’s share, and the workers take the crumbs. Sometimes workers are granted stock options (generally only vesting after a given length of time; if the worker is fired or laid off before then, they can lose their options), but even these are generally only a small portion of their total compensation, particularly for workers at the low end of the pay grade (which usually do not get any stock options at all). This is unfortunate, as stock options encourage an employee to strive more for the company’s success, as they directly benefit from it.
Simultaneously, a second problem plays out: control. Since the voting shares are predominantly in the hands of the upper tiers of the organization (and outside investors), they’re the ones who control the company — not employees. Voting shares elect the board, which makes policy decisions and exerts influence over the CEO through their ability to replace them. Shares can also be used to introduce and directly vote on specific corporate decisions.
As a general rule, a corporation will be run in a manner that seeks the best return for its stockholders. If you’re not a stockholder, it doesn’t have your interests in mind (at least directly).
How Exactly Do Wealthy People Get Cash?
As mentioned, workers generally support the status quo because they need cash. They can’t afford to just sit around and wait for stock to grow, then sell it years down the line. Even if you paid them in stock that was already vested, most would immediately cash it out to pay for their daily lives.
Yet it’s clear that wealthy people frequently do come up with massive sums of cash, despite taking little to no salary. How is it that, say, Elon Musk gets the funds to keep founding new companies, or Sergey Brin gets the funding to build himself a giant floating sky palace, or whatnot? Aren’t all their assets tied up in their companies?
The answer is, “Yes”. They just borrow against their stock.
So long as the amount they borrow is relatively low versus the value of their stock, or their borrowing is properly hedged, they face little risk from stock declines. They continue to own — and control — their stock, and have the money needed to spend on their various projects.
However… what if we could bring this to workers as well?
What I propose here may have been proposed by others previously — I cannot say that it is entirely original. But I propose the concept of paying workers with restricted stock options and using that to back a put-hedged credit line so that they can have immediate access to cash. Specifically:
- The restriction would be an inability to sell or transfer shares for varying periods of time; a worker might be paid in some stock that’s restricted for 1 month, 6 months, 2 years and 5 years, for example.
- The restricted stock options would not need to vest; they would be granted independent of how long the employee remains with the company.
- All shares would be voting shares, with immediate voting rights, even while the sale restrictions remain.
- Whatever percentage that the employee borrows against their stock, their credit line hedges the borrowing by buying put options, in an economically-optimal manner. This means that the larger a percentage of the stock that the worker wants to borrow from, the more “overhead” they have to pay to insure their credit line against stock price declines. But this decision is left entirely in their hands.
- Employee compensation is increased based on the expectation that some nominal percentage of their stock will be borrowed against at any point in time, in order to pay for the expected cost of the hedging.
- From the company’s perspective, this is offset by the fact that stock compensation is generally favourable to a company’s finances, and encourages greater worker productivity.
What is a put option? To oversimplify, a put option has no intrinsic value unless the value of the underlying asset (in this case, the employer’s stock) drops below a given value (its “strike price”), wherein the intrinsic value is $100 per $1 that the stock drops below that price. So, picture the following scenario:
- Jane is paid $5000 in shares of her employer, XYZ, whose stock is trading at $200/share (aka, 25 shares). We’ll pretend that they’re all restricted for 6 months. If she had been paid in cash, her salary would have been ~10% less, but it’s been boosted to compensate for her hedging costs.
- Jane wants to take $4000 out of her credit line to put in her bank account for that month. Her credit line now needs to hedge against a price decline to $160/share for 25 shares of stock, aka ¼ of a $160 PUT option. The actual hedging would happen in the background, collectively (e.g. you don’t actually trade in fractional options); Jane does not need to concern herself with it.
- A $160 PUT option for six months out on a relatively stable $200 stock might cost $1600 or so. So Jane is also charged 1/4th of that, or $400. But this is offset by the salary increase.
- If Jane had only taken, say, $2500 from her credit line, then her hedging costs might only be $150 or so.
Short-term stock would tend to be hedged first, as short-term PUT options are cheaper than long-term options. But again, this would all happen behind the scenes. As far as Jane is concerned, it’s just a credit line she can draw on at will to transfer to her bank account, with the knowledge that the larger the percentage of it she draws on, the higher her “fees” will be.
Now, what happens to Jane’s credit line as the stock changes in price?
- If the stock price drops, the amount left in her credit line will drop with it. That said, since her borrowing is hedged, it’ll never drop below zero.
- If the stock price rises, however, the amount left in her credit line (and her net worth) will grow — just like the company’s CEO.
- Since on average companies tend to grow (average annual S&P 500 growth over the past 10 years = 10%), on average Jane’s credit line can be expected to significantly appreciate in value.
- So for example, if Jane borrowed $4000 of her $5000 worth of stock (including hedging costs), and then her company’s stock value doubled due to some great news, Jane now has another $6000 left to borrow, not $1000.
- Even if her company underperforms the market, Jane will still keep getting new stock every pay day to borrow against; it’s just that any money remaining in her credit line will depreciate.
- It will be in Jane’s best interest to help the company grow, as she directly and immediately benefits from it.
- Since Jane will always have significant stock on-hand — particularly stock with long-term restriction periods — she and other workers will always have a significant say in all board decisions, including the ability to vote against any board members that she sees as anti-worker. But she’ll also need to think of the impact of decisions on the company’s bottom line, as it’s her bottom line as well.
I think such a system could completely reverse the current power imbalance present in today’s corporate system. A few caveats, however:
- All of the above applies directly to public corporations, but gets more complicated with private corporations, which do not have a constant market value or liquid trading.
- The fact that such a system would empower workers and in effect grant them a larger share of the company’s profits means that current owners would generally be expected to oppose it.
- The fact that employees need to be compensated for the costs to hedge against their stock might be used as an argument against it.
- Tax codes would need to be modified to encourage such payment structures.
- The macro market effect of employee hedges against stock is unclear.
What do you think?