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The Greatest Stock Option Plan You’ll Probably Never See

If you’re running a company — a real one or a startup — you’ll want to remember the story of Fred Futile, CEO of Stagnant, Inc.

The compensation committee of Stagnant, Inc. saw fit to award Fred stock options equal to 1% of the shares then outstanding.  This was intended to give Fred an owner-like interest in the business and incentivize him to increase the value of the company.  Stagnant was at the time earning $1 billion each year on $10 billion of equity.  There were 100 million shares outstanding, so earnings per share were $10.  The company traded at a price to earnings of 10, so the option price was set at fair market value, $100 per share.  Here’s a table summarizing the vital statistics:

futile_options_v1

Now Fred did an ingenious thing.  Rather than work hard to change Stagnant into something more than the marginally billion-dollar business that it was, he used the year’s earnings to repurchase shares.  Look what happened:

futile_options_2

The one billion dollars of earnings bought ten million shares at $100/share.  Assume the company traded constantly at a P/E of 10 and you can see the trick: just by withholding money from shareholders, Fred was able to put his options in the money and make himself $11 million.  He didn’t have to improve the business at all.  And if that doesn’t surprise you, look at this:  if in Year 2, instead of holding constant, earnings had actually declined by 5% due to Fred’s negligent management, Fred would still have been in the money on his options:

futile_options_3

Fred was gaming the system then, to be sure, so let’s look at what would have happened if he had tried to reinvest the earnings into some seemingly worthwhile project that earned 5%.  We’ll add one row at the bottom for “return on equity”.  We started with $10 billion in equity, and then Fred will reinvest $1 billion at 5%.

futile_options_4

Do you see how the return on equity decreased?  Fred’s seemingly worthwhile project gave his investors a worse return on investment than if he had done nothing at all.  And oh, Fred is still making millions on his option plan.

The lesson here is that Fred’s option plan is flawed.  It’s okay to want to incentivize Fred with options, because as CEO he does have an impact on the overall success of the business.  But his options should have a cost of capital or time factor.  This way, it’s clear to Fred that if he can’t use company earnings to match the current return on equity, he should pay the money out to shareholders. Take a look at this new and improved option plan where Fred’s strike price increases at 11% each year:

futile_options_5

Now if he tries his repurchase scheme, he doesn’t get rewarded (at least, not as much; I left off some pennies and he’s still technically in the money here).

The same is true (even more true) if he tries his unsuccessful project:

futile_options_6

Option plans with hurdle rates should be used for every CEO or other executive that insists on option plans.  This much better aligns his or her incentives with those of the investors, and comes as close as you can get to having them just buy in to a large amount of stock, which would be best of all.

The inspiration for this article, including Fred Futile and Stagnant, Inc., is owed to Warren Buffett and his annual Letter to Shareholders, 2005 (click here to read and search for “Futile”).

What the Market Thinks about North Korea

north korean parade

Is South Korea going to be attacked?  Well, we can get a sense for market opinion by analogy with World War II.

Back in 2004, Financial History Review published an article correlating market events with World War II events.  In particular, they looked at the prices of Nazi German bonds and Belgian bonds.  Below is an example of Belgian bonds traded in Zurich.  Before the invasion, starting in about 1936-37, the market slowly started demanding lower and lower prices (higher and higher yields) for taking the risk of buying bonds from Belgium.  When Poland was invaded in 1939, Belgian bond prices dropped sharply.  When Belgium itself was invaded, trading was briefly suspended (break in data), but then resumed at far lower prices (higher yields):

belgian bonds in zurich

You can read the full article here.

So what’s going on with South Korea’s borrowing?  Are investors demanding a high risk premium for buying South Korean debt?  The answer is basically “no.”  Here’s a graph of yield for South Korean bonds (you’ll have to mentally invert it to compare it to the graph above, which shows prices):

south korean yield

Over the last two years, buyers of South Korean bonds have been accepting lower and lower yields (higher and higher prices).  There’s a slight uptick at the very end there, but overall, investors in aggregate seem to be saying that South Korea will be just fine.

But it’s hard to say, especially with menacing North Korean displays like this.

The Surprising Math Behind Startup Dilution

This recently blew my mind, so I thought I’d share some simple math with you.

Imagine an investor wants to invest in your startup.  He says it’s worth $1 million and he wants to invest $500,000.  He’s going to take half your company, right?  Wrong.  He’s going to take one third.  At least, that’s the usual math.

In publicly traded stocks, it works the way I’d expect.  If I buy $500,000 worth of stock in a company with a capitalization of $1 million, I’ll own half the company.  That’s because my stock came from other stockholders.  My money went to pay out existing owners.

In the startup world, that’s very unusual.  All the old money has to stay to keep the business alive.  There’s no “capitalization” yet, not in the sense of capital sitting there doing its job.  So when someone invests in your startup, they don’t buy shares from existing owners.  They add to its value.

dilution

So in the example above,

image004

Don’t believe me?  Think about it in terms of share price.  Say you have 1 million shares.  A $1 million valuation divided by 1 million shares = $1/share.  The new investor buys 500,000 shares in your company at $1/share, equaling his $500,000 investment.  You create those shares by issuing new shares, rather than by selling him existing shares.  Now there are 1.5 million shares out there, and he owns 500,000.  So what does the investor own?  One third.

Are Startup Stock Options a Form of Fraud?

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Wikipedia’s page on securities fraud says, “Offers of risky investment opportunities to unsophisticated investors who are unable to evaluate risk adequately and cannot afford loss of capital is a central problem.”

Let’s go down the line:

Are Stock Options Risky?

Imagine you were given options with a strike price at 25 cents per share, and then suddenly, due to circumstances beyond your control, the company stumbles badly.  Have your options lost value?  Yes.  If the company goes bankrupt, they’re worthless.  If the company raises another round at anything less than 25 cents per share, your options are temporarily worthless, possibly for as long again as it took you to get to this point, possibly indefinitely.

Are Options an Investment Opportunity?

Not in dollars directly, but in time, yes they are.  Most folks take options in lieu of full market salary. This means there’s a very real opportunity cost associated with working at a startup.  If you’re an MBA at half market salary, we might be talking $50,000/yr plus interest.

Are Startup Employees Unsophisticated?

You don’t have to be accredited, which has a very specific legal definition, but you do need to be able to “evaluate the risks and merits of an investment” before you can be called “sophisticated.”  So, how many skilled technicians can perform a discounted cash flow analysis?  How many gifted programmers think in probabilities?  How many of the potentially dozens of super-star employees who get stock options are also successful value investors, small business owners, accountants, or other money-savvy people?

Are They Unable to Evaluate the Risk?

Here comes my main point.

I was at a networking event recently where an attorney said, speaking to startup founders, “You want to have a lot of shares authorized and a big option pool so you can give eye-popping numbers of options to your employees.”

Someone said, “But it only matters what percent of the company they could get.”

To which the attorney said, “But most folks don’t think to ask.”

That’s terrible.

The standard form “employee incentive stock option agreement,” of which I’ve now seen a couple, doesn’t offer a cap table, doesn’t offer a fully diluted number of shares, and doesn’t offer anything that a sophisticated investor would need to properly value the incentive.  So how can an unsophisticated investor value it?

It’s completely dishonest to withhold the relevant financial information from a would-be optionee.  

You shouldn’t even have to ask.  All this should come standard on the agreement with a link to somewhere that explains how to value it.

Finally, Can the Employee Afford a Loss?

According to CNN Money, a lot of folks are going to retire with too little cash.  Nine out of ten startups fail to hit it big.  Odds are good that your options package is going to fail to materialize, and then your years of hard work at that startup are going to impact your retirement plans.

So what do you think?  Fraud or not?  Use the comments below and let me know!

And follow me here on RSS or WordPress to watch for a future article on how to value options step-by-step.

How to Count in Sklansky Dollars

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Here’s a neat concept that everyone can use, from professional poker players to Warren Buffett.  In Alice Schroeder’s biography, The Snowball, she describes how in his youth, Warren was good at assigning odds to each horse in a race.  This is called “handicapping.”  Schroeder uses this as an analogy to explain how Buffett calculates investment probabilities.

It’s also the same concept underlying my previous post, How much is my startup worth?

Here it is in simple terms:

Your roof is leaking somewhere.  The roofer offers a complete replacement of the roof for $10,000.  He offers a 100% guarantee that your roof will be leak-free for three years, or else he’ll come back and completely replace it again for free.  He gives you an alternative, as well:  he can patch this one mossy spot for $2,000.  He estimates that there’s a 25% chance this patch will fix the leak.

If you choose the patch, you have a 25% chance of saving yourself a $10,000 replacement.  That’s kinda like saving 25% of $10,000, or $2,500.  To get this chance, you have to spend $2,000 for the patch.  In mathematical terms,

Value of Patch = -$2,000 + 0.25*$10,000 = $500

The $500 is what I’m calling Sklansky dollars, and it represents the increased economy of trying the repair first.

Crucially, these 500 Sklanksy dollars were still there even if you elect the repair and it doesn’t work.  Now you’re in for the cost of the patch, $2,500, plus the cost of the replacement, $10,000, or $12,500 total.  It hurts.  But it was justifiably the right call to try the patch first because you had positive Sklansky dollars for that decision.

For further reading, read it in poker terms.

Financial Figuring for Landlords: What’s the Most Important Thing In Rental Real Estate?

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People usually say there are three important things: “Location, location, location!”  But in rental real estate, it’s mostly just price.

The Economics of Real Estate

In any decision to purchase — any decision to invest — you always look at “what you get and when you get it” vs. “what you pay.”  But there are a few things you should keep in mind about real estate as an investment class, regardless of the rents you get.

The majority of costs for a rental property are related to the property as an asset.  They’re things that even brilliant management can do very little about once the property has been purchased.  They all scale with purchase price:

  • interest
  • real estate taxes
  • insurance premiums
  • base depreciation

Let’s take a typical property as an example.  The purchase price was $250,000.  Twenty percent was put down at time of sale, so the interest payment at 4% is about $8,000/year, or $667/mo.  Real estate taxes might be, say, as high as 2% of asset value per year, or $417/mo.  Insurance for replacement value might run you, say, $170/mo.  Base depreciation as a residential property, per the 2012 IRS tables, might be $5,000/yr, or another $417/mo.

Now here you might object, saying that depreciation is not cash out the door, so it shouldn’t count.  But it does represent a real long-term expense, namely, what you’ll need to keep putting into the place to keep it from falling apart.  Pricier properties generally need bigger budgets.

Add up all those expenses and you find that $1,671/mo of expenses have nothing to do with how well you manage the building as a rental property.  They’re just tied to the purchase price.

So you can see that if you buy the wrong property, a management strategy to reduce utility costs, avoid lawsuits, and get the best tenants will matter comparatively little at the beginning.  It can take long time for this cost avoidance to show itself on an income statement.

The moral is “shop around before you buy.”

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