Are Startup Stock Options a Form of Fraud?
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
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.
How to Make $1 Million in Six Months
No, it’s not a scam, it’s called entrepreneurship.
Qualified startups seeking their first angel funding usually get valued at between $1 million and $3 million and usually have little or no corporate track record. So what are the attributes of such valuable new companies? Surprisingly, it’s not so much the product, nor is it real earnings:
- Make a Team from Diverse Skills
- At its best, diversity in business means diversity in training and experience. One of the teams I know has among the six:
- a few small business owners for general acumen,
- an experienced numbers person for financials,
- a professional manager for coaching and shepherding,
- a programmer to develop the product and check the work of an outsource house,
- an industry insider,
- a savvy sales person,
- an intuitive marketer,
- and the visionary around which they all rallied.
- It’s okay for one or more to do double duty, as long as you legitimately have the skillset covered.
- At its best, diversity in business means diversity in training and experience. One of the teams I know has among the six:
- Build Relationships that Endure
- Define your roles and responsibilities among the team. That doesn’t mean silo off, but it does mean have a decision process (see Andrew Grove’s High Output Management).
- Know your customers and keep them engaged early on. Get them to pay for your good or service, even if you could give it away for free, as a vote in favor of your vision.
- In split market situations (e.g., you’re trying to connect two different groups of customers), get them to know one another.
- You need all this because your product and business model are going to change, and you need to carry folks through all the changes.
- Build a Product that Tests the Key Idea
- Eric Ries has done yeoman’s work popularizing this idea with his book The Lean Startup.
- Since entrepreneurs have no money and no time, you can barely test what matters. Don’t put time into what doesn’t.
- Have a Good Business Model
- I think a lot of high profile companies like Groupon give the wrong message when they grow big without making public their ideas on profitability. I’m sure they have them. If you think they don’t, you should call your stock broker and shout, “sell! sell!” (Oh wait, I see you did already.)
- Don’t think it’s okay just to get “eyeballs” on your site. You must have a plan to make (and keep) money.
- It helps a lot if your idea has a potentially big ($1 billion) market. You can rework a piece of the $70 trillion world economy, or you can tack your new billion onto the end.
So to summarize, you’re in good shape if you have a diverse team, some paying customers, a de minimis product, and a plausible way to make (and keep) money (a lot of it). Go to it.
Too Few (likable) Women at the Top
Sheryl Sandberg is the Chief Operating Officer of Facebook. If you haven’t heard about her new book, Lean In, you’re missing out. Her fifteen minute TED talk gives a recap. At 7 minutes 30 seconds in she cites a Harvard Business School case study, which you can listen to her describe, or read my summary below the video.
The summary: The professor running the case distributed nearly identical text to two groups of students. One group was led to believe the protagonist of the case was a man; the other, a woman. Both groups agreed the protagonist was competent, but men and women of the first student group wanted to hang out with the male protagonist, whereas men and women of the second student group weren’t sure they’d want to work for the female protagonist. To sum it all up, in Sandberg’s words, “Success and likability are positively correlated for men, and negatively correlated for women.”
See the full talk and comments here. (If you’re interested, you should watch the full talk.)
Or buy her book.
What Entrepreneurs can learn from Vaseline
Marketing will make or break a new venture, so why not study some good examples? Here’s a new commercial I like a lot, with features any startup should emulate:
Why I like it:
- Lead with the product
- Get folks thinking along the right lines. This commercial leads with a shiny bottle featuring the brand prominently, which gets us thinking “health and beauty,” and a visible tagline, “Spray and Go,” which gets us thinking “fast.”
- Grab their attention
- Someone remarkable (attractive, not yet dressed) does something surprising (runs in and grabs the product).
- Demonstrate and differentiate
- “Oh, so she’s spraying it on… that’s different!”
- Delight
- When the actress sits down and flips her top on, you’re surprised by how fast it is. That carries forward with the hat, pants, and shoes.
- This sense of surprise accentuates the message from the beginning about being fast.
- Motivate
- The uplifting soundtrack does more than set the pace, it inspires action. You want folks to buy this.
- Summarize
- Right at the end you have a narrator explaining what we just saw in six words, “Moisturizes deeply and absorbs in seconds,” with visuals reminding us about a single rub to get it in and how it sprays.
- End quickly
- All this happens in 30 seconds. This gives you plenty of time to watch it again for the delight factor (how many times did you watch it?).
Use the buttons below to comment or share this commercial if you like it, too!
How NOT to treat your employees
A company I’ve done some work for in the past recently lost a major bid. The super-boss called the entire team into a conference room and said, “You lost the bid, you’re all fired.” Some of the team had been with the company for over thirty years. The carnage hit multiple rungs of the ladder, from some new engineers all the way up to a vice president. All of them had been working hard right up until the meeting.
The particulars of the situation — how the message was actually conveyed, the extent to which there were equitable severance packages, the degree to which each may have failed to perform his or her duties — matter a great deal, and because I wasn’t there, I shouldn’t pass judgment. I can say, however, that the company culture could have grown in a petri dish. It was the worst I’ve seen of leadership in corporate America. The folks who were let go might rightly miss their lost paycheck, but at least they get a chance at a more ethical work environment somewhere else.
When it comes right down to it, the people associated with your business are your business. If your customers all quit, or if your employees all leave, you’ve got nothing. The effects of this are obvious from small-time real estate, where sole proprietorships only ever sell at book value (the cost of the house), all the way up through corporate America, where “succession planning” is a big deal.
Good companies recognize this by offering training and development. In terms of performance reviews, outside training courses, and other self-improvement perks, employees at mid-size companies like the one I mention above probably receive over $5,000 a year in improvement-related perks. At some companies, like UTC, benefits can be far more substantial. My favorite example is Toyota, who (although I can’t remember where I read it) didn’t lay off anyone at their US Sienna factory and instead set them in motion on a circular assembly line, honing and improving their techniques until the recession picked up enough where they were on A-work again.
Suppose GAAP required capitalizing employee training and holding it on the books as a form of goodwill. Then when you fired someone, you’d be forced to recognize the true impact of your decision: you’d have to write down all that training. Talk about restructuring charges.
Suddenly “you lost the bid, you’re all fired” might not seem like such a good idea. Maybe there’s another way to make some money with that team…
How much is my startup worth?
This is the question for any startup looking to measure their personal wealth creation, take on additional capital, or sell their business. Unfortunately, the answer is usually, “Somewhere between nothing and a whole lot.” You can do better.
Working Backwards: Step One
Think about what your business is going to look like when it’s big and stable (or stabilizing). For instance, “we’re going to be selling units (or service hours) to about 35% of the market, which will be growing at 3% a year, and increasing our penetration of that market by about 5% a year.” This sets some top-line revenue numbers.
Compare yourself to other businesses in similar roles and apply similar operating margins, R&D budgets, or other ratios to your business. This gets you to the bottom line.
Think in terms of different scenarios (“best case,” “worst case,” dissolution, etc.) and how likely those scenarios are.
Working Backwards, Step Two
For each scenario above, run the forecast from Step One for about seven or ten years, from a period of no earnings (you’re reinvesting everything) to a period of justifiable margins. If you’re going to be the first arrival on the scene, you can justify higher margins; if you’re second or third to market, you’re going to have smaller margins.
Use a discounted cash flow analysis to create a valuation for each scenario as of the start of your “stable” period.
Product-sum the valuations and the probabilities to derive a weighted valuation.
Working Backwards, Step Three
Use your detailed project plan (perhaps using EVMS) to estimate the total capital and amount of time needed to get from where you are to where that future forecast begins. Give yourself lots of margin, because it’s not going to go according to plan.
The time required is the time horizon over which you further discount that valuation from Step Two.
The capital required is how much money you’re going to need, altogether.
For more information
Leave your comments below! Or if you feel like going to the library, see McKinsey & Company, Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, 5th Edition. Hoboken, New Jersey: John Wiley & Sons, Inc., 2010. Print.
Who gets to choose their customers?
Well, pretty much every service or knowledge business. Let’s look at landlording, manufacturing, and small business consulting as three examples.
Landlording is one of those embarrassingly interpersonal businesses: “Hello? I’m here to unclog your toilet.” “I’m not dressed! Just take care of it please!” Even with toilets that flush buckets of golf balls and other modern housing marvels, you’re trusting a breakable piece of a very expensive asset to a relative stranger. If they stop paying you or start causing problems, it’s very expensive and time consuming to end the relationship. After all, their basic home and shelter are at stake, so third party mediation (e.g., the courts) usually comes into play.
Different troubles await manufacturers, especially those offering fixed-price contracts. If you’re going to accept a job to make 100 of a new kind of widget, you want to feel warm and fuzzy about having the right drawings and knowing that they’re not going to change quantities or specifications once you start the run. In this case, you have to negotiate for up-charges, or offer concessions, or arrange a (hopefully) peaceful walk-away.
And for small business consulting, where you might feel you want every client you can get, you really want your customers to sing your praises and give you word-of-mouth traffic and their own repeat business. You definitely don’t want to try to please a habitual grouser, or to keep quoting a lookie-lou, or to otherwise commit to helping someone forever dissatisfied.
So What Can be Done?
Good landlords have a rigorous screening process (never discriminatory, always based on economics!) and so might lots of other businesses, except I very rarely see open communication about customer screening. As a potential customer for a lot of different services, sometimes I wish I could get feedback:
Dear Prospective Client:
You have had us requote variations of the same thing for the last three months. We’ll be happy to continue working with you after a one month hiatus, or you can sign and return one of our quotes and we’ll get started right away.
But when does that ever happen?
The best general advice that I can give is that sometimes it’s okay to say no to a prospect. As soon as you do, you’ll be thinking about the next prospect. Much better than wishing you weren’t locked into a bad situation.
Financial Figuring for Landlords: Real Estate Moats
A moat was a medieval form of security. Just pull up the drawbridge and watch as your enemies fail to get across the water, or if they do, to scale the wall of your castle. Although physical moats have no place in modern real estate (can you imagine the lawsuits?), an “economic moat” is Warren Buffett’s choice metaphor for what makes a business resistant to competition. Real estate as a business has a few good economic moats.
First of all, it’s very expensive for a tenant to change their real estate provider. This is called “high switching costs.” Think about the search for a new apartment, giving notice, cleaning and repairing the apartment to get a security deposit returned, moving all that stuff, and unpacking it all on the other side. This could take days, and if some of the security deposit is withheld or a moving company is hired, it could cost hundreds of dollars on top of that. This means that a rational consumer of rental housing will grudgingly accept any rent increase below their moving costs. That’s good for your business.
The second moat is the potential to be the low cost provider. A lot of real estate businesses are run suboptimally. They’re saddled with high debt, old equipment, and bad rental agreements. A business run with reasonable debt, reliable equipment, and good tenants (or else, good conflict negotiation mechanisms) can operate at a lower price than average. This helps you get the best tenants and keep them, translating into lower turnover and lower vacancies, both good for business.
The third moat can be location. Although I poo-poo’d it in my last column, saying that price mattered most of all, location can be a valuable intangible asset. You might reasonably pay more to acquire a property on a public transportation route, for instance, because it makes your property more desirable to prospective tenants. Once you have it, this kind of benefit is hard for competitors to replicate.
So the next time you think your rents are a bit low, or you paid too much for a property in a prime location, remember that these moats may be contributing to your economic success. On the other hand, a little rent raise probably wouldn’t hurt, either.
How to Predict (part of) the Future
For complex projects, it’s hard to know whether you’re going to finish under budget. The signal that you’re going over usually comes too late. Ever tell a customer you need another $50,000? They’ll probably say, “$50 K? I don’t have $50 K! Where am I going to get $50 K?!” It’s not fun for either of you.
Fortunately, there’s a way to put a little careful thought and diligent accounting into a single picture. It’s called “Earned Value Management.” It’s the best graph a manager of a project will ever know. And you can make your own in Excel. No fancy software required.
Start by making a blank graph of dollars vs time:
You’re going to draw a couple lines on this graph. The first line is your plan:
This represents the steps that need to be done, when you think it will happen, and what you think it will cost. The total is cumulative over time. Here are some example steps that would fit the graph:
The second line is your accomplishments to date (green is good):
This represents the value of what you’ve done according to the original plan. In this case, we bought our metal (a $130 value) on February 11, two days later than we planned. We’re behind schedule, which we can see because on February 11, our accomplishments line is below our plan line.
The third line is your cost to date (red is bad):
I like to leave the line out to reduce clutter. This represents how much time and money it’s taken you to get where you are. In this case, our purchaser was late two days because it’s taken much more time (and therefore labor cost) to find the metal we need. We can see that we’ve used up more than $250 of our $328 budget. Unless we over-estimated the remaining work, we’re going over budget. Best of all, we could start to see this back on February 9.
So that’s all there is to it. This is something I’ve used in real life, and it’s been very helpful.
Let me know in the comments below if you want my Excel template for making your own EVMS graph!
For Further Reading
I recommend this article on Wikipedia for a more in-depth view and some great graphs. The first three sections (stop at history) are as far as you need to read for the next level.
