Silicon Valley North #20 Jun'00

The Way I See Itů by Michael Volker

Stock Option compensation can be a double-edged sword

Stock Options are viewed by most corporations as an essential component in an executive compensation package. They have the potential to provide a major windfall to their holder - not just a small performance bonus. However, they have their darker side, too.

Stock options are supposed to be a form of incentive compensation. If the holder of options works hard and is a team player, she will be handsomely rewarded when the market bids up the company's share price. Unfortunately, though, a company's share price often bears no resemblance to its underlying financial performance, let alone the performance of any one individual. Hence, a new hire, lured by the sizzle of stock options, can become discouraged if they don't meet her expectations.

From an investor's perspective, there's a huge downside to options, namely dilution. Companies, especially the Silicon Valley variety, typically have between 20% and 30% of their shares under option. As these options are exercised, investors who have paid market price for their holdings can be substantially diluted. Not only that, but those shares purchased under option by an optionee are likely to be sold into the market for a profit, rather than be held by the employee as a loyal co-owner of the enterprise.

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. I've seen companies double their stock base in less than two 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.

In bullish market sessions, options can indeed provide huge benefits to their holders. However, as we've seen recently, stock prices can drop mercilessly. When they do, employees with deep out-of-the-money options can become discouraged by feeling that something has been taken away from them. Instead of doing their work, they become obsessed with watching stock prices.

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?

In return for being a director of a junior public company, options may be one's only compensation. A colleague of mine was given an option to buy 50,000 shares at $.40 per share, good for five years. For three years, the stock languished, trading under $.50. In the early 1998 run-up in prices (just like we're seeing now), the shares jumped up to $2.00. At this price, it made a lot of sense to exercise these options but he was asked by the CEO to hold off on the basis that the company was planning a financing and it wouldn't look good for directors to be selling stock. By mid-summer, the market slumped and the financing was cancelled. He finally exercised the options in the fifth year - just before their expiry - when the stock was trading at around $.60. Needless to say, he did not reap any huge windfall for his commitment to the company.

The way I see it, as much as stock options can be a great carrot in attracting talent, they may not be the panacea which we'd like them to be. Less aggressive stock option plans would be less punitive to shareholders yet still offer incentives to key employees.



Michael Volker is a high technology entrepreneur and director of Simon Fraser U's University/Industry Liaison Office. He is a former executive director of the BC Advanced Systems Institute and is chair of the Vancouver Enterprise Forum. He may be reached at mike@risktaker.com.

Copyright, 2000.