Silicon Valley North #48 ††††††††††††††††††††††††††††††††††††† October, 2002

 

The Way I See ItÖ by Michael C. Volker

 

Unjust rewards: The case against Stock Options

Let's abolish stock options. I used to be a big fan of stock options but now I believe that there are better alternatives for boards to consider.

The original idea behind options was to use them both as a performance incentive and as a proxy for stock ownership. They allow new employees to participate in the equity growth of their companies - just like the founders and investors.Itís problematic, for tax and regulatory reasons, to simply give shares to new executives when theyíre recruited. Thatís why options are popular.

Whatís gone wrong? Excessive options grants are the main culprit. Theyíve been regarded as a panacea to the recruiting problem. It's not unusual for a CEO or VP to be granted the right to dilute shareholders by 5% by exercising options. For tech companies, share options can approach 30% of a firmís issued shares. For public companies, this has led to a steady, annual dilution in the 10% range.

As long as share prices keep climbing, shareholders have not been too concerned and companies have been able to bonus their executives without impacting their bottom line. But now, companies are being pressured into expensing options. In up markets, executives become too distracted by watching share prices and in down markets, out-of-the-money options can demoralize employees. And re-pricing them is very offensive to shareholders whose "brave money" carries the can.

Abuse is a gentle word for whatís happened. Greedy executives have made millions on under-performing companies. How can one possibly justify a $245.9 million bonus to JDS Uniphase's former CEO? What kind of risk or pain did he endure to deserve such a reward? Even secretaries and geeks with their hats on backwards made millions on stock options. Interestingly, and to their credit, Bill Gates and Steve Ballmer of Microsoft have not granted themselves any options.

Options allow people to participate in stock price appreciation but without taking any risk. Why should anyone get something for nothing? And just how much is appropriate? What's a fair allocation for a stock options pool and how should options in the pool be divvied up among all the optionees? What's fair and reasonable?

The former Vancouver Stock Exchange (VSE), which was affectionately referred to as the "Scam Capital" of the world by our American friends, had the wisdom to limit its junior listed companies to a maximum of only 10%! The VSEís successor, the TSX Venture Exchange, has relaxed this limit as a result of both corporate pressure to do so and the fact that there are higher limits on other stock exchanges. Exchanges have tended to give company Boards more discretion in this matter. And thatís the way it should be. Iíll be the last one calling for more rules and regulations. This is a matter of of prudent corporate governance Ė balancing shareholder interests against those of management.

Contrary to the original idea of encouraging ownership, the tax treatment of options forces one to sell stock in order to be able to cover the tax liability and to lock in the gain rather than have a subsequent loss that cannot be offset against normal income. 

Here in Canada, we still have a wonderful tax break to reward successful entrepreneurship - the $500,000 lifetime capital gains exemption which allows you to enjoy a tax-free capital gain provided you've held stock in a private company for at least two years. Holding options is not the same as holding stock and precludes enjoyment of this particular benefit. 

The alternative to options - and one that I suggest could replace options altogether - is a form of stock ownership plan whereby employees actually buy stock in their company and thus become real shareholders - just like you and me. Companies could subsidize such a program and/or make low interest loans available to employees in order to do this. The main advantage is that tax complications (you get real capital gains treatment) are avoided and the question of "how many" shares should be acquired is determined largely by the employee/investor as opposed to some lofty six figure options grant.

The way I see it, options are a good idea turned bad. Let's get back to basics - taking real risks with real money for real gains!

 

Michael Volker is a high technology entrepreneur and director of Simon Fraser Universityís Industry Liaison Office. He oversees Vancouverís Angel Technology Network and is Chair of the BC Advanced Systems Institute and past-Chair of the Vancouver Enterprise Forum. He may be reached at mike@volker.org.