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Commentary: A Time of Reckoning for Stock Options
When Web entrepreneur Andy Raskin moved to Silicon Valley, his landlady caught wind that he was launching Gazooba Corp., an online marketing-software company. She offered a $200 break on his $1,500 monthly rent in exchange for stock options in Gazooba.
Raskin refused. But his experience shows that if money talks, stock options shout--especially in high-tech towns where competition for commercial space, top talent, and other services is fierce. Despite April's dot-com bust, options are still coveted. The promise of a pre-initial public offering share of a high-tech company looks as good to many as a guaranteed winning lottery ticket.
Even politicians can't seem to resist. John Witchel of Red Gorilla, creators of Web-based applications, has rallied entrepreneurs to launch pac.com, an online political action committee that offers shares to New Democrats in return for favorable consideration on Net commerce and education issues. Says Witchel: "Options are the New Economy's currency, plain and simple. It's the way we do business."CONFLICTS. Maybe so. But it involves risks. In exchange for the right to buy shares, the city of Oakland, Calif., sold Zhone Technologies Inc. a $6 million parcel of land for $1.6 million below fair market value. If the telecom stock tanks, taxpayers will be left holding the bag. Mayor Jerry Brown says it's worth the gamble: "We've been an old blue-collar, Rust Belt city. We have to try harder."
Now, tech entrepreneurs are rightly showing more caution about using options. Many admit they don't really understand them. Artistdirect Inc., for example, ran afoul of Securities & Exchange Commission rules by issuing too many shares to investors and artists. The music company, as yet unprofitable, must now buy back those shares for $11 million. Says a spokeswoman: "Options are part of our core business plan. We wanted the artists to feel like partners."
Now, startups seem to realize that with fewer options in circulation, the less any profits get diluted and the less chance of ethical conflict. "We realized that the stock was even more scarce than the cash," says New York transplant Raskin. Gazooba reserved 20% of its outstanding shares for options, offering 2% to contractors, 2% for equipment leasing and a bank loan, and 10% for its new CEO. Barbara Nyegaard, co-founder of San Diego human-resources outfit Eriss Corp., pays one consultant in options, as well as an annual six-figure consulting fee. "This is our baby; to give a piece of it is pretty serious stuff," she says.
Companies don't have to count the cost of stock options against profits. Eventually though, their dilutive impact will be felt: If computer-networking companies, for example, had deducted the fair value of options in 1999, operating income would have been 29% lower, according to Bear, Stearns & Co.
All the same, some tech consultants want more than just their share of stock options. "We're running a business, not a casino," says Alan Burgis, president of Exile on Seventh, a full-service ad agency that counts eBay, AutoTrader, and Webvan Group among its clients. Burgis had no qualms about asking for not only a 5% equity stake but also a board seat from one potential client. "They thought that was extravagant," he says, adding that he has cut only one option deal so far: 20% of the monthly retainer fee, which averages between $70,000 and $120,000.
Ethical questions about stock options are finally dawning on startups. Jeffrey Haas, a securities law professor at New York Law School, says consultants with a big equity stake can't offer objective advice. While Silicon Valley lawyers have gobbled up options, "white-shoe East Coast law firms found it distasteful." Particularly with pre-IPOs, a consultant's advice about when to go public could be self-serving.
Options might still work as golden handcuffs for employees. But other uses could eventually tarnish them for good. By Mara Der HovanesianReturn to top