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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