Crusade against Options, Outrageous Salaries, Capital
Pool Corps Update, Local Events and Footnotes
Crusade against Options
Let's kill stock options. I never thought I'd say that.
I've always been a big fan of stock options but now I'm on a mission to seek
their abolition! Options are a great example of how a good idea can be totally
messed up when implemented in practice.
It wasn't that long ago when Harvard grads were
regarded as morons while the geeks with their hats on backwards that made
millions on stock options were regarded as the "new economy" geniuses.
A couple of weeks ago the Globe and Mail ran a
headline reporting that JDS Uniphase Corp's insiders made a billion bucks
by playing the options game. Options legitimize fraud and theft. They allow
companies like JDS to legally screw real investors and shareholders. What
argument can one possibly give to say that JDS' former CEO deserved to take home
a $245.9 million bonus during his tenure?
I've often written in this column about the
"options creep" phenomenon - the regular, on-going dilution that
occurs over time as options holders exercise their options. Companies have, on
average, issued options amounting to an additional 20% of their stock (when
exercised). Over time, as options get exercised and new ones granted, there's
a steady annual dilution in the 10% range!
I should note that 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 TSX Venture
Exchange's limit has been raised as a result of both corporate pressure to
do so as well as much higher maximum limits on the Toronto and Nasdaq
exchanges. Exchanges have tended to give company Boards more discretion in this
matter.
What's the rationale for stock options anyway? This is
where theory parts company with practice. The original idea behind options was
to use them as a proxy for stock ownership. They were created to allow employees
to participate in the equity growth of their companies - just like the founders
and investors. In addition to thinking like owners, options would provide
additional income to those who contribute to the company's success - an
honorable intent. After all why should the shareholders be the only ones to gain
from employees' efforts. Share the wealth.
When companies are created, the founders usually give
themselves "free" stock in their company. But, as a company grows, new
employees can't be dealt in as easily - especially if the company has grown,
received external investment, and has appreciated in value. It may be very
expensive for new participants to buy in. It may also be messy - especially in
private companies governed by shareholder agreements. That's why options are, in
theory, a good solution. New employees are granted a right to buy shares at the
price when they join - but without any pressure to do so until they decide to do
so.
The math is easy: your company's share value is $1.00
and you have the right to buy 100,000 shares at $1.00 for 5 years. In three
years (or 3 months as we saw in 2000), the stock goes to $2.00 ($20.00 as we saw
in 2000). You simultaneously sell (for $200K) and buy (for $100K) -
usually in that order since you may not have the cash to put in up front - your
100,000 shares for a cool $100K profit ($1.9 million as we saw in 2000!)
Canada Customs and Revenue Agency (CCRA), our
beloved tax people, make you take 50% of this $100K profit into regular T4-style
employment income which is taxed at your marginal rate. They make you include
only half of your profit so that your tax liability is the same as if you had
made the $100K as a capital gain. That's nice - but it causes a lot of problems.
For example, you are liable for the tax even if you do not sell your shares. If
the shares later drop in price and you sell them for a loss you still have the
tax liability. There's no relief on this, as silly as it sounds. It's true and I
can show you my T1 to prove it! (I've harped in this many times before in
earlier columns - but that's another subject). There are other tax problems as
well - depending on whether the company is private or public, whether the option
is granted above or below the so-called fair market value, when the option is
granted and how long you hold the stock before selling, etc, etc.
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 may preclude 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 5 or 6
figure options grant.
What are some other problems? In addition to the
creeping dilutive effect, companies are now under a lot of pressure (it's not a
mandatory requirement - yet!) to expense stock options to show that there's a
real cost to the company of granting options. That should make their issuance a
little more controlled and conservative. Another problem for companies is that
employees who are attracted by generous options grants may find themselves so
far out of the money (in falling markets - due to no fault of their own or their
company's) that they become demoralized. Many employees have learned to count on
options - not just treat them like a nice surprise, but even rely on them as
part of their compensation package.
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?
Options have been seen by tech execs as a panacea to the
problem of recruiting top (i.e. expensive) talent. It also makes them look less
greedy when they load themselves up with the bulk of their options pool.
Interestingly, and to their credit, Bill Gates and Steve Ballmer
of Microsoft have not granted themselves any options. They're the exception,
though. It's not unusual for a CEO or VP to be given 500,000 options by a
company with 20 million shares outstanding (i.e. 2.5%) on top of a their
regular, bulging (see next article) paycheques.
When there's a bull market with rising stock prices,
everyone is happy and everyone can make money. Companies can pay their employees
mega bonuses through the exercise of stock options. In roaring markets this may
even have the added benefit of keeping prices down slightly as demand for stock
picks up (as more stock is created upon exercising). Shareholders don't complain
because they, too, are smiling as they see the value of their stock increase.
This applies even to non-performing or pre-profit companies as well as to those
who get carried along by the tide. But, when the markets are weak (such as they
are now) even those companies that are performing (i.e. reporting real profits),
suffer from falling prices and the use of options to motivate and reward has the
opposite effect.
Of course, to deal with falling prices, companies often
re-price their options (this also has tax issues). Shareholders can't, however,
re-price their stock purchases. Doing so is akin to paying themselves a dividend
for lousy performance! This is very offensive to shareholders whose "brave
money" carries the can.
Now you can see why I've soured on options - a good idea
turned bad. Let's get back to basics - taking real risks with real money for
real gains! Kill options and emphasize real ownership! They're bad for the
company, bad for the investors, and possibly even bad for the optionee!
Outrageous Salaries
Reading the top 100 executive compensation list in Business
In Vancouver recently got me thinking about the whole question of
compensation. Now, if you're a guy like Jimmy Pattison who starts a
company, and turns it into a money machine with a strong bottom line, you're
likely paying yourself last and, if done well, a lot! Fair game. But, is it fair
for a CEO in a company with a bottom line hole, to enjoy the same fruits for his
effort?
There seems to be an attitude among tech company
executives that they are worthy of a hefty salary by virtue of their title and
responsibility.
Over the years, I've been involved with dozens and
dozens of entrepreneurial startups. The founders of these companies would pay
themselves a very low salary - usually just enough to make personal ends meet.
As their companies grew, they could afford to pay themselves higher salaries and
even dividends. There was a direct relationship between their personal income
and their corporate performance. No cash, no pay.
In the past five years or so, it has been easier for
tech companies to attract external investors (although that's abating somewhat).
As a result, companies had more cash up front rather than as a result of
performance. Hence, salaries started creeping up. More cash, more pay! To hell
with performance. My non-entrepreneurial peers working for bigco are getting a
good "market wage" (love those words!), so why shouldn't I? And,
investors and boards bought into this. As a result, we've seen salary packages
get bigger and bigger. Admittedly, some companies wanted to recruit external
managers with track records and had to offer them these market wages in order to
attract them (plus options, of course!).
I see many young 1-2 year old startups which have no
products and no revenues which are paying their top people well over $100K/year.
I take less of an issue with this if these people are proven executives brought
in to work with the company's founding team. But, I find it particularly
unpalatable if the big earners are also big shareholders. But even for the
seasoned managers that join the team, there needs to me a better solution - for
example a stock ownership/purchase (not options) plan and/or a highly leveraged
results-oriented bonus plan (e.g. instead of giving them 5% in stock options,
give them 5% of the corporate profits).
What does this mean for you, the tech investor? Before
you buy into a company - check the salaries of the management team and compare
these to the company's stage of development and its cash flow. Will the company
bleed to death by paying exorbitant wages before you, the investor-risktaker,
gets looked after?
Capital Pool Corporation (CPC) Comments and
Update
In this column, I keep track of Capital
Pool Corporation ("CPC") companies as defined by the TSX Venture
Exchange (the former CDNX) because they may provide funding and management to,
and in the process acquire, technology companies. They provide companies with an
alternative to traditional venture capital financing. It lets the public
investor get into the game.
Check our Capital
Pool Corporation chart (in .pdf format) for a complete list of the CDNX's
CPC and VCP companies, thanks to David Ing of Pacific
International Securities. This list is updated on a regular, e.g. monthly
basis. It is now current to the end of August, 2002. (previous update was July,
2002).
New additions to the list are: A
S Technologies Inc., Inter Energy Corp., Rita Capital Corp., Tern Energy Inc. and
Ventaur Capital Corporation.
A S and Tern are from Alberta.
Inter, Rita and Ventaur are from Ontario.
Since the previous update, the
following companies have come to trade: First Integrated Enterprises Ltd. and
K45 Capital Corporation.
Since the previous update, the
following companies have been removed from the list because they have completed
their Qualifying Transaction: Arta Enterprises Inc., Corra Capital Corp. and
Emerging Ventures Corp.
An introductory
article explaining CPCs may be found at http://www.bctechnology.com
Local Events
The Vancouver Enterprise Forum kicks off
its Fall event with an early-stage venture financing event on September 24th.
Check the new website at www.vef.org
for details!
The BC TIA will hold its third annual BC
TIA Fall Golf Classic to be held on September 10, 2002. This is turning into
a key charity event for BC’s technology community.
Organized by the Technology Committee for
Children’s Hospital (TECCH) and the BC TIA, this year’s event has
already secured sponsorship from Telus, Nortel Networks, Cisco
and Digital Pioneer. The net proceeds will go towards much-needed
equipment, research and programs at BC’s Children’s Hospital. More info on
this can be found at www.tecch.com.
Coming up on September 19th, Industry Canada is
putting on its Innovation Conference in Vancouver which will lead to the
national November 6th Innovation Summit in Ottawa.
A complete calendar of technology events can be
found on T-Net's
Events page. Without getting too tacky, there's a new group in town
called TACI (Technology Associations Collaborative Initiative) which also
has a tech calendar - check www.techvenue.com/calendars/taci.
Footnotes
In last month's column, I was
commenting on the idea of the TSX forming a Junior-Junior Stock
Exchange. I mentioned that many Nasdaq-listed companies were finding
themselves short of meeting the Nasdaq listing requirements and that many of
these were facing a de-listing from the esteemed Nasdaq exchange. Just after
writing this, there was a column in the Vancouver Sun noting that some 300
companies have been delisted and another 250 companies were finding themselves
in this predicament. It noted that these 250+ companies were trading at less
than $1.00 per share - the Exchange's minimum price for maintaining a stock
listing. The list of companies facing expulsion doesn't just consist of little
known brands. Even Ericsson AB of Sweden with its US$6 billion market cap
was trading in pennies. Companies are put on notice by Nasdaq if their closing
bid price falls below $1.00 for 30 consecutive days. Companies then have 90 days
to "correct" the problem. Correcting the problem means either a
stellar turnaround in the company (or the markets) or a reverse stock split. Palm
Inc is one such company that proposed a reverse split.
The British Columbia Securities
Commission (“BCSC”) is taking back the responsibility for vetting
company prospectuses. In recent years, the Exchange (i.e. the TSX-V) undertook
the primary review of preliminary Prospectuses filed to qualify distributions by
companies made exclusively in British Columbia (“BC Prospectuses”).
Effective September 1, 2002, except in relation to CPC Prospectuses, these
arrangements are terminated and the Exchange will no longer undertake the
primary review of BC Prospectuses. The BCSC has re-assumed its role as the
primary reviewer.
If you're an entrepreneur looking for a place
to get your company started; there's some great space available at Harbour
Centre downtown. The New Media Innovation Centre (NewMIC) and SFU's
TIME Centre have teemed up to provide not only office space but also access
to various resources, e.g. tech advisors, access to capital, mentors, etc.
Worried about the high cost of being downtown? Well, not to worry - they'll even
reduce the fees and take some payment in the form of equity. Check www.sfu.ca/time
for contact info.
A reminder: SFU's TIME Centre is open for
business - business folks, that is. TIME is an acronym for Technology,
Innovation, Management, and Entrepreneurship. TIME supports the growth and
development of the tech industry in B.C. TIME features a "Business Centre"
(looks like an airport business lounge) which is open to technology
entrepreneurs and business people to use as a drop-in downtown office facility.
Need to plug-in? Make some calls? Do some work? Hold a meeting? There are some
great facilities for holding your company's AGM. Why hang out at MacDonald's
when you can work productively at the TIME Centre? Drop by and check it out! It
is located at SFU's downtown campus at 515 West Hastings St.
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