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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:
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:
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:
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%.
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:
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:
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”).
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.”
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.