Options

There is a very interesting discussion of stock options going on at VentureBlog, the excellent blog written by the guys at August Capital.

The post was initiated by a survey by Deloitte and Touche that found that 73% of public companies surveyed have either decreased or have plans to decrease the number of options they issue. And David Hornik's concern was that reduced employee ownership levels would ultimately result in reduced innovation, which is clearly a bad thing.

I personally think this is a natural response to the overheated talent market of the late 90s when you had to pay exorbitant amounts of equity to retain and keep valuable employees. Now that the job market is back to normal, equity ownership levels will come back too. I think that is all that is happening.

I loved the comment made by Tubby Bartles that this isn't something to get all that worked up about because markets are efficient. Tubby argues that the cost of options has always been something sophisticated investors have known about and have taken into account and that reducing the number of options issued now that they have to be expensed isn't going to make a difference one way or another.

I agree with Tubby. First, cash flow is what matters. Expensing options won't impact cash flow. Sure options impact the true ownership. But venture capital firms and sophisticated public investors have always looked at "fully diluted" ownership levels so they have been taking into account the dilution from options for a long time.

Markets are self correcting. The people who buy public stocks or buy companies (in other words the people who ultimately pay us for the ownership we buy or earn in startup companies) will figure out what the companies are really worth and won't have too much trouble dealing with whatever the new accounting rules throw at them. And the people who run companies (CEOs and their Boards) will do whatever it takes to attract, retain, and reward the talented people who are needed to make their companies succeed.

That is capitalism at work. And that's why its the greatest economic system ever invented.

Comments

[gordon gould]

do you have any thoughts on the idea of issuing restricted shares instead of options to employees, or @ least management? It seems that owning actual stock may better align management's incentives w/investors since they own the stock outright, know its value, and it can't be underwater.

Having been both an investor and a manager in start-ups, I have to say I find management's attitudes towards investor dollars often very cavalier, mainly because I don't think they really feel they have much at stake (other than their time).

I understand that pricing stock in private companies is tricky but it seems you have that problem w/options as well.

GRG

[Fred Wilson]

i think you'll see a lot more companies issuing restricted stock when the price is low (ie at or near the start of the business or at a point where there's been a turnaround where there is little or no value). that's because you can do it wihtout creating a material tax problem for the employees.

later on, when the company has real value, restricted stock is a problem because of the imputed taxable income that results.

one way to avoid the tax problem is to have the employee actually buy restricted stock. that can be costly.

another way is to loan the employee the money to buy the stock. but the IRS requires some of the loan to be full recourse which is also a problem.

and then there's the appearance problem of loaning money to employees.

so, in summary, i don't think restricted stock is the answer in most situations. but we'll see more of it where it can work.

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