A REPORT ON

EQUITY ON DEMAND:
NETFLIX APPROACH TO
COMPENSATION

GROUP MEMBERS OF A4
20PGPM011 ASHUTOSH BARNWAL
20PGPM017 DEBARGHA DEY
20PGPM022 KUNDAN KUMAR JHA
20PGPM050 RISHAV SAHA
20PGPM045 SAKSHI SURI
20PGPM050 SHIVANI BURMAN
20PGPM054 SOURAV SINGH
SUMMARY OF EQUITY ON DEMAND: THE NETFLIX
APPROACH TO COMPENSATION
Netflix was among a small group of Silicon Valley companies of the late 1990s a clear winner in terms of growth,
market share, and profitability. It was largely attributable to the culture of freedom and responsibility inculcated by
founder Reed Hastings. It was a culture that emphasized hard work, initiative, creativity, and accountability among
its employees. To foster this culture, the company adopted a series of unique employment practices that were
meant to attract, retain, and motivate the type of employee that Netflix valued. Whereas most companies
provided compensation packages with a predetermined mix of cash and equity-based awards, Netflix turned the
model on its head and allowed employees to request their own mix.

The Netflix business model

First, Predicting customer behavior was also important. Because the subscription price was constant but the cost of
services were variable with each movie delivered, customers who frequently rented movies were more expensive
to Netflix than infrequent renters.

Second, delivery service was important. Netflix leased a network of shipping centers near concentrated customer
populations.

Third, Netflix needed to maintain a website that was easy to navigate and encouraged usage.

COMPETITION AND INDUSTRY TRENDS

First challenge came in October 2002 when retail giant Wal-Mart announced that its Internet subsidiary
(Walmart.com) was launching a competing online movie subscription service, at a price that was $1 per month less
than Netflix.

In August 2004, Blockbuster entered the online movie subscription business. It also boasted a retail network of
5,500 stores across the country. It also allowed customers the convenience of returning movies either in the store
or through the mail. Blockbuster also announced that it would discontinue its practice of charging customers late
fees.

A third competitive threat also came late in 2004 when Amazon announced that it would launch an online movie
subscription in the United Kingdom. Amazon’s dominant position in online retailing and its extensive logistics and
delivery system. In response to the news, Netflix reversed a decision that it had recently made to expand into the
United Kingdom,

The technological standard for watching movies at home was shifting away from the DVD format to instant viewing
over the Internet and recognized it as a fundamental threat to Netflix.

CULTURE AND EMPLOYMENT PRACTICES

Netflix had a high-performance culture as encompassing “freedom and responsibility.” The company expected its
employees to work hard, take ownership, show initiative, and act like owners by putting the company’s interests
first. In return, Netflix afforded them considerable flexibility in how they performed their duties. Company as
having a “fully formed adult” culture. In hiring, the company targeted high-performance employees who were
capable of doing the work of two or three people. To attract these individuals, the company was willing to pay top-
of-market wages. Netflix did not want a talented employee to leave the company to work elsewhere in a similar
position for the same or higher wages. The company did not budget annual raise pools Instead, management
considered the most recent market data on compensation and any changes in the employee’s role and
responsibilities, and if necessary, the salary was adjusted to reflect current conditions. Employees were granted
unlimited vacation during the year, with the expectation that they would take only the time that was prudent,
given the level of performance the company required.

Netflix also offered a 401(k) and an employee stock purchase plan (ESPP), which allowed employees to invest up to
15 percent of their salary in company stock purchased every six months at a 15 percent discount to the lower of
the starting and ending trading price for that six-month period.

THE ECONOMICS OF STOCK OPTIONS

Employee stock options are contracts that give employees the right to purchase company stock at a
predetermined price over the life of the contract. Employees who voluntarily resign or are involuntarily terminated
by the firm are typically given a 30-to-90 day window to exercise all vested, in-the-money options and forfeited if
not exercised.

Companies attempt to determine the optimal mix of cash and equity incentives to attract, retain, and motivate
employees:

Attraction - stock options are used to attract employees.

Retention: Vesting and termination restrictions serve to retain employees by restricting their ability to realize the
full value of options if they leave the firm.

Motivation: Stock options are used to motivate employees by tying the value of their compensation to overall firm
performance.

Q1(a). Describe the key features of Netflix Compensation Program?

 The key features of Netflix compensation program are:
 Compensation Mix: Netflix allowed employees to request their own mix of cash
and equity.
 Pricing: Option grants were made monthly, with one-twelfth of the annual
allocation granted and priced on the first trading day of each month.
 Vesting: No vesting restrictions were attached to stock option awards.
 Termination: Voluntary and involuntary
 Cash Bonuses: No cash bonuses were offered by the company.

(b) Explain the program consistent with

company’s culture, strategy, and
business model.
 Yes, the compensation program is in sync with the company’s culture, strategy, and
business model.

Netflix’s compensation program reflects and

supports the company’s strategic goals of
 ahigh-performance culture through their competitive wages, choice of compensation
package, and atypical benefits.

The employees receive top-of-market wages to encourage their high performance, as

Reed Hastings, the Netflix CEO, explains in the article “one outstanding employee gets
more done and costs less than two adequate employees”

The following reasons that we deduced from the case suggest this.

 In sync with the Fully Formed Adult culture

 Followed the Freedom and Responsibility culture
 Rising number of subscribers needed the best, high performance employees
 The company encourages their employees to take responsibility, one of the company’s
main values, for their work and consistently exceed expectations by rewarding them
with high salaries.

Q2 Evaluate the economic efficiency of the Netflix compensation

program. In what ways is it more efficient than the more standard
practice whereby the firm decides the compensation mix for employees
at the beginning of the fiscal year? In what ways is it less efficient?
A-Following are the reasons why the compensation program of Netflix was efficient:

 Large Cash Salary: Employees were given a huge cash salary which was more than the
industry standard.
 Compensation mix between stock and cash: At the end of every year, employees were given
a chance to choose a compensation mix for them. Employees were given a total
compensation amount and allowed to allocate it between base salary and options in the
manner they felt was best for them (up to a maximum of 60 percent in options). They were
also given a chance of changing the compensation mix for them at the end of each year.
 Annual allocation granted and priced every month: Option grants were made monthly, with
one-twelfth of the annual allocation granted and priced on the first trading day of each
month. For example, an employee electing to receive $12,000 of the total salary in stock
options would receive a monthly stock allocation of $1,000.
 Stock option vested immediately: No vesting restrictions were attached to stock option
awards. All stock options vested immediately. Management believed that vesting
restrictions encouraged employees that were not appropriately engaged with the company
to stay until more of their option awards were vested.
 No forceful vesting of stocks for terminated employees
 Unique and efficient method of incentivising employees
Key Features of the Compensation Mix Program:
It was in sync with the freedom and responsibility culture: This compensation offered by the
company gave more freedom to the employees as to how they want to receive their salary. This
is in sync with the culture which existed in the company.
It had a low voluntary turnover rate: Although the involuntary turnover rate was high, the
voluntary rate was low. This shows that the employees were really satisfied with the
compensation package which was being offered.
It attracted top performers: The company policy was to go for top performers. As it is stated in
the case :The company’s philosophy was, “Pay them more than anyone else likely would. Pay
them as much as a replacement would cost. Pay them as much as we would pay to keep them if
they had a higher offer from elsewhere”. This shows that the company attracted the best talents
in the market.

Downfalls of the compensation Mix:

 Zero forfeiture period give employees benefit of 10 years even if they did not have much
input in growth
 The involuntary turnover was high resulting in maximum of employees opting for 100% of
cash salary.
 There is no linkage between the performance of an employee and the pay.

Q3 What economic and behavioral factors might explain the findings in

Exhibits 6 and 7
Regarding:
an employee’s election to allocate a portion of his/her salary to stock
options,
demographic variables that influence this decision,
correlations between electing to receive stock options and job
performance, and
The decision of when to exercise stock options
ans.
Exhibit 6 describes the determinants of participation in the stock option
program. Using a multivariate logistic regression, whereas Exhibit 7 shows the
exercise behavior of employees who participated in the stock option program.
The major finding from exhibit 6, it was found that male employees and
employees with longer tenure were less likely to participate, while female
employees, employees with higher salaries and employees at the vice president
 level were more likely to participate. Employees who were involuntarily
terminated were less likely to have participated in the stock program in the
preceding annual pay cycle. Also, employees who received larger raises were
more likely to have participated in the stock option program the year prior.

Findings from Exhibit 7, Employees did not typically hold all of their stock
options for the full 10-year term. Approximately 50 percent of stock options
were exercised within 4 years of the grant date. On average, employees
exercised their stock options when they had a 40-60 percent gain over the strike
price.

a. When it comes to employee’s election to allocate a portion of his/her salary to

stock options, we can see from exhibit 6 that there is a positive co relation
between salary and likelihood of equity participation. Employees with higher
salaries are more likely to participate in the equity option, economically they
have more cushion to withhold the weight of risk associated with equity
option. Higher the salary, higher available fund to exercise the stock option.
They are also looking for higher intrinsic value of the stock. Economically the
employees also want the valuation of the company to increase. Behaviorally
higher motivation level, no vesting and termination restriction gives
employees a free hand to allocate a portion of their salary to stock option.
These individuals may be looking for a risky employment opportunity that can
produce substantial personal wealth if the company is a success.
b. Demographic variable , gender(Male, Female),Job tenure, Salary , Job Level
can be attributed to different economic as well as behavioral factors, male
employees and employees with longer tenure were less likely to participate,
while female employees, employees with higher salaries and employees at the
vice president level were more likely to participate. Behaviorally males and
employees with longer tenure are more risk averse, they want to preserve the
intrinsic value of their holdings. Whereas female employees and employees
with higher salaries and employees at the vice president level are looking for
higher intrinsic value and wealth maximization they are more on the risk
taking side.
c. Employees who were involuntarily terminated were less likely to have
participated in the stock program in the preceding annual pay cycle. Also,
employees who received larger raises were more likely to have participated in
the stock option program the year prior. In case of involuntarily termination it
shows lack of motivation, risk averseness and some where they were hedging
as they were aware that they aren’t performing well. Moreover they wanted to
preserve the intrinsic value of their holdings. On the other hand employee
with larger raises are more motivated, ready to risk their salary for more
returns and think themselves as the owner and were aligned to the company
culture.

d. Employees did not typically hold all of their stock options for the full 10-year
term. Approximately 50 percent of stock options were exercised within 4
 years of the grant date. On average, employees exercised their stock options
when they had a 40-60 percent gain over the strike price. Because the options
themselves are non-transferrable, the only way for an employee to realize
value from them is to exercise them.by not holding the stock option for the
full ten years they forfeit the remaining time value of the options, which may
be significant. . Early exercise can be attributed to several factors, such as
using a heuristic for exercising. The desire to monetize a vesting allotment to
enable consumption, and acting on private information about future stock
price movements.

Q4) What changes would you suggest that Netflix make to its
compensation program?
Netflix’s compensation practices were in line with Reed Hastings’s ideas of “The most efficient
form of compensation” which includes a large cash component. While Reed firmly believed that
stock options as a component of compensation was a great way to make employees participate
in the success of the business more actively, he was also very cognizant that there are
inefficiencies involved with stock options that make employees undervalue them.
This was the driving idea behind devising a compensation strategy that allowed employees to
select their own personal compensation mix of cash component and stock option.
In light of the above mentioned compensation plan, and after carefully evaluating all aspects of
the compensation structure detailed in the case and the attached exhibits, we would like to
propose the following changes to the compensation program of Netflix.

 Decide upon a forfeiture period for ex-employees.

Netflix’s culture of only having exceptional employees in the team results in high in-
voluntary turnover of employees. If ex-employees aren’t required to forfeit their
unexercised stock options, they may be more tempted to move out of the company.
This would increase voluntary employee turnover.
 Variable factor in the compensation structure.
While Netflix’s strategy of only retaining exceptional performers has been fruitful for
them, the management should also consider lack of motivation as a reason for
underperformance. Hence, linking pay with performance can be a great way to
motivate employees.
Performance based variable pay will make employees aspire to do better at their jobs
and will also have an impact on the involuntary employee turnover of the company,
which is above industry average.
 Stock options valuation
The formulae used by Netflix for calculating monthly stock allocation:
Number of shares = monthly allocation / (stock price on grant date * 25 percent)
 This meant that stock valuation for the employee was roughly 50% less then Black-
Scholes calculation for an option with a 10-year term. We feel this will be an unfeasible
practice in the long run as employee strength grows.

Ques 5 Why would an executive or employee desire to hedge their

stock options? Why would the board adopt the Insider Trading Policy
described in Exhibit 8?
 The word hedge means restricting or confining to protect. The purpose behind
hedging is to reduce the risk in stock trade. Hedging is a risk-reduction strategy.
 Why would an employee want to hedge their stocks? The first reason that comes
clearly to mind, is that individuals are risk-averse. Without hedging, employees tend
to undervalue stock options as their wealth is accumulated in company stock. The
company stock is not well diversified and hence the risk associated increases.
Employees need liquidity of their wealth for running their households. Excessive
concentration of wealth in the company stock discourages employees from taking
appropriate risk on behalf of the firm.
 Being able to hedge their stock options, will be a source of motivation for employees.
If the options cannot be hedged (are non-transferable), the only way for an employee
to realize their value is to exercise their options. The same reason also decreases their
chances of holding the stock for larger time period. Since they have to exercise their
options, and cannot hedge, they tend to exercise their options well before the 10 years
expiration time. This leads to a major loss in time value of money. This becomes
another reason as to why employees would desire hedging their stock options.
 Employees may be forced to exercise an option early in cases of involuntary
termination, and the exercise time period provided as per company policy may/ may
not be favorable for the same. In such a picture again, an employee would like to
hedge their stock portfolio in case asked to exit. *Netflix allows employees to hold
their unexercised options to the rest of the 10 years term regardless of voluntary or
involuntary termination.
 Adopting Insider Trading Policy by the Board: Employees desire to monetize a
vesting option if they get material non-public (private) information about future stock
price. The Insider Trading Policy restricts the rights of an employee to trade the
company stock in case they possess insider information. It also discourages
employees from trading in derivatives relating to their organization’s stock.

Q6 What is the broad applicability of the type of compensation

program used by Netflix?
 Reflected the company culture of freedom and responsibility
 Emphasized on hard work, initiative, creativity and accountability and putting the
company’s interest first.
 Attract, retain and motivate employees Netflix valued
 In what type of companies or industry settings would such a system
work?
 Would work in service industry and in companies like Netflix where employees were
given freedom yet where they are accountable for high standard job which was
required to be performed. This could be understood by the company culture of
giving flexibility or by the incident where chief talent officer told that Netflix does
not track the vacation time of the employees. Instead they were given unlimited
vacation with the expectation that they would take only the time that was prudent.

In what settings would it be less effective?

 Would not work in companies and industry setting where employees were not given the
freedom to work independently. Concept of golden handcuffs that is deferred payment by
employer to discourage an employee from taking employment elsewhere make the
compensation program less effective.