Tech Futures:
Stock Options Explained, NewMIC is born, IPO Watch, Capital Pool Corp Update, Events & Footnotes Stock Options Explained But, as much as I'm a big fan of options, I thought it might be useful to devote most if this column to explain what they are, how they work, and some very serious and onerous implications for both option holders, the company, and investors. In theory and in a perfect world, options are wonderful. I love the concept: Your company grants you (as an employee, director, or advisor) an option to buy some shares in the company. An option is simply a contractual right given to the option holder (the optionee) whereby the holder has the irrevocable right to buy a certain number of shares in the company at a specified price. For example, a new recruit at Multiactive Software (TSE:E) could be granted 10,000 options allowing her (let's call her Jill) to buy 10,000 shares in Multiactive at a price of $3.00 (the stock is currently trading at this price) anytime up to a period of 5 years. It should be noted that there are no prescribed rules or terms associated with options. They are discretionary and each option agreement, or grant, is unique. Generally,
though, the "rules" are: In the ideal scenario, Jill - the new technical recruit at Multiactive - gets right into her work, and due to her efforts and those of her co-workers, Multiactive does well and its stock price goes to $6.00 by yearend. After all, it's already been as high as $8.50 within the past year. Jill can now (provided her options have vested) exercise her options, i.e. buy shares at $3.00. Of course, she doesn't have $30,000 in spare change lying around, so she calls her broker and explains that she is an optionee. Her broker will then sell 10,000 shares for her at $6.00 and, upon her instructions, send $30,000 to the company in exchange for 10,000 newly issued shares pursuant to the option agreement. She has a $30,000 profit - a nice bonus for her efforts. Jill exercises and sells all of her 10,000 shares on the same day. Her tax liability is calculated on her $30,000 profit which is viewed as employment income - not a capital gain. She gets taxed as if she got a pay cheque from the company (in fact - the company will issue her a T4 income tax slip next February so that she can then pay her taxes in her annual return). But, she does get a little break - she gets a small deduction which equates to her being taxed on only 66% of her profit, i.e. she gets $10,000 of her $30,000 bonus tax-free. In this regard, her gain is treated like a capital gain - but it is still considered employment income (why? Aha - good old RevCan has a reason - read on). This is how Canada Customs & Revenue sees it. Nice and simple. And, it often does work exactly this way. Stock options are often referred to as "Incentive Stock Options" by regulators such as stock exchanges, and they are viewed as a means for providing bonus income to employees. They are not - as many of us would like to have it - a way for employees to invest in their company. Indeed, this can be extremely dangerous. Here's a real example of a story that I recently heard. Just to be sure, I checked with the good folks at Deloitte and Touche and they confirmed that this situation can, and does, occur. Jim joins a company and gets 10,000 options at $1. In 5 years, the stock hit $100 (really!). Jim scrapes together $10,000 and invests in the company, now holding $1million worth of shares. In the next 2 years, the market tumbles, and the shares go to $10. He decides to sell, making a $90,000 profit. He thinks that he owes taxes on the $90K. Poor Jim! In fact, he owes taxes on $990k of income ($1M minus $10K). At the same time he has a capital loss of $900K. That doesn't help him because he has no other capital gains. So he now has taxes owing and payable of more than $300K (i.e. 50% marginal rate applied to 66% of the $990K). He is bankrupt! So much for motivating him with incentive stock options! Under the tax rules, the important point to remember is that a tax liability is assessed at the time when an option is exercised, not when the stock is actually sold. Let's go back to the example of Jill buying Multiactive stock. If Jill wanted to keep the shares (expecting them to go up), then she would still be taxed on her $20,000 profit in her next tax return - even if she didn't sell a single share! Up until this year (as announced in February's Federal budget), she would actually have to pay the tax in cash. But, the recent budget now allows for a deferral (not a forgiveness) of the tax until the time when she actually sells the shares (up to an annual limit of only $100,000. The Province of Ontario has a special deal allowing employees to earn up to $1M tax free! Nice, eh?). Suppose that the shares drop (no fault of hers - just the market acting up again) back to the $3.00 level. Worried that she might have no profit, she sells. She figures that she has broken even, but in fact she still owes about $10,000 in taxes (assuming a 50% marginal rate on her "paper profit" at the time of exercise). Not good. But true! Even worse, suppose that the stock drops to $1.00. In this case she has a capital loss of $5.00 (her cost on the shares - for tax purposes - is the $6.00 market value on the date of exercise - not her exercise price). But she can only use this $5.00 capital loss against other capital gains. She still gets no relief on her original tax bill. I wonder what happens if she never sells her shares? Would her tax liability be deferred forever? On the other hand, suppose that the world is rosy and bright and her shares rise to $9 at which time she sells them. In this case, she has a capital gain on $3.00 and she now has to pay her deferred tax on the original $30,000 of "employment income". Again, this is OK. Because of the potential negative impact brought From an investor's perspective, there's a huge downside to options, namely dilution. This is significant. As an investor, you must remember that, on average, 20% new shares can be issued (cheaply) to optionees. The routine granting and subsequent exercising of options can quickly compound the outstanding share balance. This gives rise to "market capitalization creep" - a steady rise in value of the company attributable to an increased stock float. Theoretically, share prices should fall slightly as new shares are issued. However, these new shares conveniently get absorbed, especially in hot markets. As an investor, is it easy to find out what a company's outstanding options are? No, it's not easy and the information isn't updated regularly. The quickest way is to check a company's most recent annual information circular (available on www.sedar.com). You should also be able to find out how many options have been granted to insiders from the insider filing reports. However, it's tedious and not always reliable. Your best bet is to assume that you're going to get diluted by at least 20% every couple of years. The belief that options are better than company bonuses because the cash comes from the market, rather than from corporate cash flows, is nonsense. The long term dilutive effect is far greater, not to mention the negative impact on earnings per share. The term optionaire has been used to describe lucky option holders with highly appreciated options. As these optionaires become real millionaires, corporate managers must ask themselves if their payouts are really justified. Why should a secretary earn a half million dollar bonus just because she had 10,000 "token" options? What did she risk? And what about those instantly rich millionaire managers who decide to make a lifestyle change and quit their jobs? Is this fair to investors? So, what's the bottom line? Whereas options are great, like most good things in life, I think they have to be given in moderation. As much as stock options can be a great carrot in attracting talent, they can also backfire as we've seen in the above example. And, in cases where they do really achieve their purpose, investors could argue that humungous windfalls may be unwarranted and are punitive to shareholders. NewMIC is born! Last Friday (May 10th), the New Media Innovation Centre (NewMIC) was officially launched. The Federal and Provincial governments jointly announced an $8 million grant to kick off this new initiative under the new WEPA (Western Economic Partnership Agreement). This is good news for BC's high tech sector, especially those involved with New Media technologies. The stated vision of
NewMIC is to support the growth of interactive new media developments through pan-western Canadian research and development initiatives. For more information on NewMIC, please visit the website at http://www.newmic.com. The CEO of NewMIC is well known in BC's tech sector. He's Alan Winter and you can email him at: alan.winter@newmic.com. NewMIC is the result of the efforts of many dedicated individuals at SFU, UBC, BC/ASI and many others, notably ann lévi-lloyd who can be reached at ann@newmic.com. ann (she likes lowercase letters) is NewMIC's Business Development Officer. IPO Watch On the IPO (Initial Public Offering) front, it looks like Autoskill International Inc of Ottawa will be floating an issue. You can see a preliminary prospectus at SEDAR (wwww.sedar.com). In checking with TD Waterhouse I was informed that preliminary pricing on the offering is in the $3.75 to $4.25 range with final pricing expected to be announced on June 2nd. The IPO market is a little uncertain at the moment. Many recent local IPOs (Absolute Software, 360Networks) are trading below their offering prices. Capital Pool Corporation (CPC) Update In this column, I keep track of Capital Pool Corporation ("CPC") companies (see chart below) as defined by the former CDNX because they may provide funding to, and in the process acquire, technology companies. CPC's are the continuation of the former VCP and JCP programs on the Vancouver and Alberta Stock Exchanges. I like CPCs from an investment perspective. Although one may regard them as speculative (indeed, they are), they are also an inexpensive way of getting in early and inexpensively. You can pick up 10,000 shares of a typical CPC for less than $1.00. And when it does what is expected, you can reap a nice reward. Since the May 5th update, new CPC additions to
the list are Advanced Sensing Systems
Inc. (Calgary), Baden Technologies Inc. (Calgary), Caliente Capital Corp., Copacabana Capital Limited,
eVenture Capital Corp., First Trimark Ventures Inc., French Riviera Capital Inc., SNL Enterprises Ltd.,
and Southport Capital Corp. Check our Venture Capital Pool chart for a complete updated list of the CDNX's CPC and VCP companies, thanks to David Ing of Pacific International Securities. Upcoming Events The upcoming May 23rd event will feature Rory Holland (of Itemus, formerly Vengold - one of BC's internet incubators) as emcee on the subject of CEO War Stories. Come and get the inside scoop from leading high tech CEOs. We'll hear about the Good, the Bad, and the Ugly from Ian Wilkinson, CEO of Radical Entertainment, Rick Moignard, CEO of Chancery Software (see full page story in this week's May 3rd issue of the Globe and Mail) and Greg Kerfoot, President of Seagate Software. Book now - this will be another sell-out event. The annual dinner event on June 27th will feature Jim Yeates, CEO of Burntsand Inc (TSE:BRT) as the keynote speaker. Information on these events may be found on-line at http://www.vef.org. Footnote The Numbers Game - Canadian Internet related companies are down 58% from their 52-week highs BUT up 352% from their 52-week lows according to Research Capital Corp of Vancouver which surveyed 61 Internet companies ranging from Nortel Networks Corp (TSE:NT) to smaller CDNX ventures like eDispatch.com Wireless Data Inc (CDNX:EWD) which is up 1319% from its 52 week low. Vancouver's Province tabloid newspaper paid tribute to
Totally Hip Software (CDNX:THW) for its web design products. Totally Hip took two of the eight top awards at the Apple World
Wide Developers Conference in San Jose, Calif. It won "most innovative
entry" and took second-place honours for "best adaptation of technology." Finally, keep an eye on Pivotal Corp (NASDAQ:PVTL). There are some interesting rumours (of the positive kind) floating around. Michael Volker
is the Director of the University/Industry Liaison Office at Simon Fraser
University, Chairman of the Vancouver Enterprise Forum, and a technology
entrepreneur. He owns shares in many of the companies he writes about.
Contact: mike@risktaker.com.
What Do You Think? Talk Back To Mike Volker Tech Futures is a bi-weekly column that focuses attention on new and emerging BC publicly listed technology companies. Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Chairman of the Vancouver Enterprise Forum, and a technology entrepreneur. He owns shares in many of the companies he writes about. Contact: mike@risktaker.com |
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