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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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