Netflix (NFLX 1.04%) CEO Reed Hastings is getting paid $850,000 in salary this year, which sounds like a lot to most people, but pales in comparison to the $21.2 million he will get in a stock option allowance. A stock option gives the holder the ability to buy a share of stock at a predetermined price (the "strike price"). In Hastings' case, and that of other Netflix executives, they have up to 10 years to "exercise" the options (purchase the shares at the strike price) so they are incentivized to run the business in a way that pushes the stock price up over the long run.

Netflix's system of steering a big chunk of executive compensation into stock options, which it describes as performance-based compensation, is shareholder-friendly for two reasons. The first is that it provides a tax advantage and the second is that it tends to align management's personal compensation with stockholders' interests. 

Stock chart going higher.

Image source: Pixabay.

Netflix has an interesting executive compensation plan

As a consequence of the tax-deductions rules as they apply to cash salaries, Netflix doesn't pay more than $1 million in cash annually to most of its senior executives. That leaves a large portion of their compensation as stock options.   

Netflix structures the options so that one-twelfth of the year's award is granted and 100% vested on the first trading day of each month at a strike price equal to the closing price of Netflix stock. The exercise period for the option is 10 years from the date of the grant.

The difference between the strike price and the stock price when the option is exercised determines how much the option is worth. If the share price is less than the strike price, the option is worthless.  People with options generally want the stock to go up so they will be able to buy a higher-priced stock in the future for a lower strike price.     

How much stock do Netflix executives own?

The table below shows the ownership stake of Netflix stock for three top executives, including vested options that have not been exercised. Notice the use of a family trust for CEO Reed Hastings. Sometimes critics like to say that the Netflix CEO does not own any Netflix stock, but this is an absurd claim when the family trust fund is considered.

NameTitleFamily Trust  OwnershipVested Options (not yet exercised)Number of Shares Beneficially Owned (includes vested options)
Reed Hastings CEO and Chairman 5,862,527 5,960,830 11,823,357
Ted Sarandos Chief Content Officer 0 679,088 679,088
David Wells Chief Financial Officer 0 192,756 192,756

Data source: Netflix.

Salary vs. options

The table below shows the amount each executive is slated to get in options allowances this year as well as his salary. As you can see, the options, which carry a risk, outstrip the salary for two of the three.

Name2017 Salary2017 Option AllowanceMonthly Stock Option Allowance (2017 allocation/12)Estimated Target Bonus
Reed Hastings $850,000 $21,200,000 $1,766,667 0
Ted Sarandos $1,000,000 $12,000,000 $916,667 $9,000,000
David Wells $2,500,000 $1,910,000 $159,167 0

Data source: Netflix.

Did management increase or decrease beneficially owned shares in 2016? 

The chart below shows the number of shares owned outright and controlled through vested options that executives had at the end of 2014, 2015, and 2016. The percentages indicate whether beneficial ownership increased or decreased; keep in mind that beneficial ownership doesn't necessarily mean ownership of shares, as it includes unexercised options.

Name2014 Shares Beneficially Owned2015 Shares Beneficially Owned2015 vs. 2014 Beneficial Ownership2016 Shares Beneficially Owned2016 vs. 2015 Beneficial Ownership
Reed Hastings 14,328,720 12,787,053 (11%) 11,823,357 (8%)
Ted Sarandos 467,488 511,619 9% 679,088 33%
David Wells 112,399 154,670 38% 192,756 25%

Number of shares beneficially owned includes vested options. Data source: Netflix.

Although Hastings has been reducing the number of shares he beneficially owns, his ownership stake via the family trust and his vested options was still a whopping 2.71% of Netflix as of the end of 2016. Sarandos and Wells have continued to accumulate vested options.

The numbers indicate that the executives running Netflix have as much interest as a shareholder could ever expect to create shareholder value through a higher stock price. The way the option portion of the compensation is structured allows for long-term focus by the executives. A 10-year exercise period means executives are not forced to boost short-term profits and can invest strategically for long-term stock appreciation. If you're a long-term investor like me, you can rest easy knowing that, at Netflix, executives are well-aligned with shareholders.