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Are We Out Of Options?
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
May 10th, 2002

By Brent Holliday
Greenstone Venture Partners


"But Oz never did give nothing to the Tin Man
That he didn't, didn't already have "
- America, Tin Man

After Enron, Bernie Ebbers, the BC Liberals and world peace, nothing is taking a beating these days more than employee stock options. To wit:

    - Alan "The Fireman" Greenspan (so-called by Mark Anderson because he doused the hot economy in 2001), went on a tirade against corporate accounting practices relating to treatment of stock options. He believes that the true value of a company is being artificially increased by not expensing the "cost" of disbursing stock options. Given that he was not raising or lowering interest rates in the US, I guess he needed to say something noteworthy.
    - Message board after message board on the Internet has filled with despondent and/or irate employees in the US who exercised stock options in hot public companies in 2000, didn't sell the shares, watched the company's share price dive like a Canadian submarine, and then have the IRS tell them that something called the Alternative Minimum Tax meant that they owed more in tax than the current value of all of their shares. Ouch.
    - Enron executives exercised and sold buckets of options just after the iceberg hit the hull, but well before the people in 3rd class were aware that they needed to jump overboard. Class action suits have been filed by thousands of employees that used their 401(k) (RRSP) to hold their exercised options which they did not get to sell.
    - Gerald Levin, CEO of Time Warner is but one poster boy (John Roth of Nortel is another) for executives that raked in cash in exercising options over the past two years (Gerry pocketed $166 million) while their company's stock lost between 60 and 90% of its value. How many nanoseconds a week do you think these guys spend thinking about you and me losing money holding their company's shares?
    - One issue that CEOs have had to grapple with for employee stock options is what to do when the stock has fallen miles below the exercise price of most employees. It boils down to three equally distasteful choices: 1) do nothing, meaning that your employees have no upside benefit in your company stock 2) re-price the options, which puts a massive hole in your earnings for years to come 3) issue new options at the lower price, which will potentially dilute all shareholders making them even more grumpy.

And, of course, there are the thousands upon thousands of jaded, cynical employees of the New Economy that currently hold options, vested or unvested, that are underwater or just plain wallpaper. All of those in the technology economy that were told to get options because they were the ticket to massive riches are not much richer than the salaries that they have already spent. And quite a few don't even have that bi-weekly paycheque now.

Are options as compensation passé? Is the Employee Stock Ownership Plan going the way of the pet rock? There is no doubt that they have fallen out of favour with a horrific stock market in technology and the great crashes of 2000 and 2001 in Internet and Telecommunications respectively. Rather than disappear, employee stock options, like so many other facets of starting a technology company today, are getting back to reality. They are part of a mix of compensation for doing good work. They are a benefit. They are not lottery tickets.

While it ain't perfect, the best way that the capitalist system has shown us that matches the interests of the employees, management and shareholders/investors in happy unison is stock ownership. Regardless of private or public, illiquid or liquid, stock value is a common thread of interest for everyone in the corporation.

Investors buy stock at a price. Employees that join a company after its birth can get stock by buying shares directly or receiving options to buy shares at a later date. But there is a price for them as well. So when you sell, you get the spread or the sale price minus the purchase price. The best kept secret of stock ownership is that when you form a company, you get Founder's Shares. These are typically issued at $0.0001 or essentially, nothing. Owning Founder's Shares is the most beneficial stock to own as everything is upside. If you want to make some real big cash, then that is the way to do it. Alas, with reward comes risk. Starting a company from scratch is fraught with danger and will require expertise, investment and time. It is not easy street, especially when you consider that the tax man starts to pay attention as soon as those shares have any value.

An option is just that. It's an option given to the holder to buy a share of the company at a pre-determined price (the exercise price). The seller (the company in our discussion) is obligated to sell that stock. Easy so far, right? Well, it gets more complicated, arcane and mind-numbing quickly, so get a coffee.

An Employee Stock Option Plan (ESOP) is created by the Board of Directors of a company. They set aside a number of shares (in a seed stage company it should be 20-25% of the total, in a pre-revenue company it should be 15-20% and in a revenue generating private company it should be at least 10%) and set the general terms of the plan. Main terms are the exercise price, vesting schedule, what happens when an employee is laid off or resigns, etc. The CEO and HR department, in turn, stick to the plan and hand out individual agreements to each employee when they are hired. The number of options and incentive related option grants (rewards for making milestones, achieving quotas, etc.) for each employee are decided by management, with the exception of the CEO, whom the Board deals with directly.

Vesting is the awarding of the options to the employee over time. A "cliff" is the time worked before awarding any options at all. A total grant to a new software engineer might be 10,000 options with an exercise price of $0.50. The terms are typically 3 or 4 year vesting with a one year cliff. The employer wants to use the options as an incentive to stay at the company and the vesting means that 25% of the options are awarded each year (in a 4 year vest). The cliff means that if the employee is not with the company in a year, they get nothing. But if they are there past the one year anniversary, then they get their full first year award on that date and start accumulating the second year right away.

The key numbers for options are the exercise price and the total number granted. A practice of private early stage companies is to set the exercise price below the price of the most recent round of financing in order to give employees, in a company where their stock can't be sold in the short term, a situation where they are "in the money" right away. Remember, price times number of shares equals the total value of the company. So the total percentage ownership of the company is more important than the actual number of options granted. 10,000 options in a company with 1,000,000 total shares is more valuable than 10,000 options in a company with 1,000,000,000 total shares if price is constant. A recent study in the US shows that a junior software engineer in the US at companies in the 20 -100 employee range (early stage) should expect to own 1/20th a percent of a company. Twenty such engineers would account for 1 percent of the total equity, in other words.

The government has taxed capital gains in Canada in a favourable way (50% of the tax rate on your income) so that you are incented to take stock and entrepreneurial risk. Having said that, tax implications always need to be considered by employee and employer. In general if an individual holds stock and sells it for more than they paid, they pay capital gains tax. Even holding actual shares with a loss or a gain without actually selling the shares has tax effects. Un-exercised options do not have tax implications until the minute you exercise them, so they are the preferred method of incenting employees over stock purchase plans. But once you exercise an option, all hell breaks loose. Consult with an experienced accountant before exercising any options so that you know all the latest rules including the Canadian government's recent positive changes.

Today, without a doubt, most employees will say that salary is the key compensation metric. It is the end of a long tough down cycle in the markets and no one is making money on stock options right now. But going forward, the stock options will be important again. If your company is wildly successful, you will make some money. It is not the ticket to champagne wishes and caviar dreams (unless you are in very early or have founder's stock).

Here is what to remember about options today and why they are important:

1. There is no downside to options. You don't lose money if they aren't above the exercise price.
2. The earlier stage the company is at, the more valuable these options are as compensation. Think risk/reward.
3. The public market doesn't get much lower than today.
4. Think ownership, not absolute number of options. When exercised, you are a part owner of the company. You should feel ownership, pride and loyalty commensurate with the size of your grant. Otherwise, it's a merely an employment benefit.
5. While salary is important, remember that taxation of capital gains from sale of stock is far, far lower than income tax on salary.

Random Thoughts -

- Finally, Some Good News - ALI Technologies getting $543M in cash from McKesson is a very good shot in the arm for BC's technology industry. Fourteen years in the making tested the most patient of investors, to be sure. But those that stuck by the belief in their technology and their market (which as recent as 1995 was nascent at best) were rewarded handsomely. In this market, to receive a premium of 13 x trailing revenue is nothing short of astounding. Congratulations and here's hoping that all employees make some significant capital gains on their options.

What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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