Technology companies are utilizing new option strategies to deal with the economic and stock market realities that have developed over the past year. Many, if not most, technology companies are struggling with flagging stock prices and “underwater” stock options (i.e., the company’s stock is currently worth less than the strike price of option grants). The economic and stock market downturns have led to many significant problems for investors and HR professionals alike.

While investors lick their wounds over losses in technology shares, HR professionals have to deal with the day-to-day psychological impact of poor financial results, underwater options and layoffs. Technology companies are utilizing a number of strategies to try and combat the morale busting impact of the dramatic drop in technology shares, especially of those in the Internet sector. The reality for many public (post-IPO) companies is that large portions of employees hired in the past year or two are now holding onto worthless underwater options.

One word of caution is worth mentioning, however. Much criticism, some of it quite justified, has been leveled against companies for re-pricing and replacing stock options and for using other methods that effectively take much of the “at risk” element of variable compensation out. While many dislike these practices in general on a philosophical basis, much of the criticism is particularly directed at executives who effectively re-set the bar for their own incentive compensation and thus removing much of the executives risk in being compensated for creating long-term shareholder value. Thus, while many of the practices below are effective strategies for reducing employee turnover and reinvigorating the general workforce, they are often viewed as anathema for senior executives.

Here’s a brief overview of what some companies are doing:
    • Restricted Stock – A small but growing number of companies have chosen to give restricted stock instead of, or in addition to, stock options, to insure that employees receive some ownership value for their service to the company. Of course, the primary reason for doing so is retention, and in that sense, Restricted Stock may be the best option, although one that many VC, investors and other outsiders like the least. The reason is because Restricted Stock is essentially a guarantee (unless the company goes under or never has a “liquidity event” such as an IPO or buy-out) of some monetary benefit, since Restricted Stock is actual stock (assuming certain service or performance requirements are met), not an option that must be worth more than its initial strike price to have any intrinsic value. In a stable public company, Restricted Stock is essentially a guarantee of some benefit. Many investors believe that options holders should at least take the same upside risk that real investors do; with Restricted Stock, the employee recipient of Restricted Stock is likely to receive a monetary benefit in all but the worst-case scenario.
    • Supplemental Options – Rather than go through the financial and psychological pain of re-pricing stock options, many companies simply issue new (and often previously unplanned) stock options to their employees at reduced valuations. Supplemental options take a variety of forms. Some firms just issue new options after a large drop in their firms’ stock price. Some do it at their normally scheduled granting time, but many don’t wait for that time to arrive. Many firms have also started to offer supplemental grants more regularly (see below). Of course, supplemental options are not “free.” The additional shares dilute the holdings of existing shareholders and often anger non-employee shareholders and the investment community. They also increase the company’s “overhang,” which is the percentage of outstanding shares that have been optioned to the company’s employees. Supplemental options do, however, offer an improved opportunity for employees to achieve some future economic benefit from their employers’ business success.
    • More Frequent Option Grants – Several firms have started offering options on a more frequent basis, to address the issues of flagging morale and lower stock prices. Some companies are just offering options on a more frequent basis, rather than issuing larger or “extra” supplemental option grants. Many companies that offered options annually are now doing so semi-annually or quarterly. By offering more frequent grants, employees get the opportunity to take advantage of lower option prices and get more frequent reminders of the stock holdings they have in their employer.
  • Re-priced Options – It used to be a lot easier to re-price options than it is today. Re-pricing is the practice of canceling previously-issued stock options, and re-issuing new options at the current lower price of the stock. The arguments against re-pricing options are many and persuasive, but many executives still feel compelled to re-inject financial viability into the their employees (and their own) stock options. For the reasons stated above, executives are often excluded from stock re-pricing programs.New accounting rules implemented in 1999 have made re-pricing a very expensive proposition. Companies must now take a charge against earnings to re-price their options, and the cost is prohibitive enough that until recently, instances of re-pricing had dropped dramatically. However, with many public technology companies now trading 50 percent or more (some a lot more) below their 2000 peaks, some companies have decided to take the hit and re-price their options anyway.

    In January 2001, Amazon.com announced an option re-pricing program. After its shares sank below $15, it allowed employees holding options with an exercise price of $23 or more to receive new options with an exercise price of $13.38 that begin vesting in August of that year. To reduce the potential financial impact, the options must be exercised within two and a half years.

  • Replacement Options (also known as “6+1” programs) – By canceling and re-issuing options in the future (a minimum of six months and one day in the future, to get around re-pricing rules and avoid having to take a charge to earnings, hence the name “6+1”), some firms are getting around the re-pricing regulations.Replacement options offer some risk as well, but may be a better strategy than re-pricing for some firms with a severely depressed stock price. One risk is that the options issued at a future date could recover in price, and therefore have to be offered at a similar or even higher price in the future. Like re-pricing, though, this strategy is reserved mainly for firms with severely depressed stock prices and little likelihood of the stock’s return to its formal glory at any time in the near-to-intermediate future.

    In February 2001, RealNetworks) went the replacement options route. The company announced a replacement options plan that would allow employees to replace their options in August of 2001, but employees had to agree to the plan in February. While there is some risk in the plan for employees, many options are so far out of the money that the risk seems quite small that the stock price would recover or go above the much higher strike prices of options issued before the middle of 2000.

According to a study by iQuantic (now part of Buck Consultants), more than 80 percent of the companies surveyed reported they had at least some portion of their outstanding stock options underwater. The Underwater Options Flash Survey of over 100 “new economy” companies reported that over one-third of the respondents had over 50 percent of their options underwater. The survey revealed that the most commonly used strategy was issuing supplemental options, and over 90 percent of the respondents cited the ability to attract and retain staff as the most important reason for taking actions to address underwater options.

Regardless of the choice of strategy, one often-overlooked element of getting the most positive impact for employee stock options is developing an effective communication strategy. Stock options, while they have become an expectation in the high-tech world, are not a gift, not a free lunch or an automatic ticket to riches (as just about everyone knows by now). What they are is a chance to create economic value for their holders when their employer achieves business success in the marketplace. A lot of things have to happen right, not the least of which is having solid products, strong management, a sound business strategy and good execution.

 

Entrepreneur University was a huge success by all measures. We had over 200 attendees representing entrepreneurs, sponsors, and investors. We doubled our sponsorship support over 2004’s EU. The location of the University of Washington proved to work well, and we were able to support several MBA students studying entrepreneurship. I have been getting fan mail from a large number of attendees reinforcing how valuable it was and how impressed they were with the caliber of speakers.

One of the most popular sessions was on working with boards. Arnie Prentice, Chairman of Kibble and Prentice and a long time investor and board director around town, as well as Artie Buerk, Managing Partner, of Buerk Craig and Victor. Turns out Arnie and Artie went to UW together! People were appreciative of seasoned board member suggestions as well as perspective on new roles for boards.

We will see vastly more expensive Directors’ and Officers’ Insurance which will be a challenge for emerging growth companies. Will potential directors agree to be on boards without such coverage? Probably not. The role of Chairman is likely to be split apart from the CEO role, and board members are likely to be required to spend more time in their roles as board members. This might change the compensation model for directors as well.

We might want to consider having advisors rather than board members in the early stages of company formation. This could reduce the need for D&O insurance but still provide important advice and guidance. It might be that the boards of private companies will become more like public company boards given the increased scrutiny on boards in general.

Board governance is something that’s always been important for the best boards and management teams according to Prentice and Buerk. But now there is a conscious focus on ethics in business, something that has not been as much an issue for emerging growth companies. We’re all growing up and learning more about how good governance should be done. It does mean a lot of work and a commitment to new ways of running boards.

 

Where will high–risk investment capital go? High–risk capital goes where there is a high return on money invested. When high returns do not happen, investors leave the industry segment. They have recently left Internet companies just as they left telecom companies a few years ago.

High–risk capital is not going into the Internet as it did before March 2000, but not because the Internet is going away. The Internet continues to have a profound effect on the way we live and work. Main Street still embraces it at a steadily increasing pace, as it has since Amazon.com opened its online doors as the “Earth’s Biggest Bookstore” in July 1995. Yet the high value of Amazon.com has diminished, and with it the value of all other online retailers. In many circles, “business–to–business” or “B2B” is a dirty word.

Why Internet Investing Dried Up

For years, the mantra of all Internet companies was eyeballs, the number of people looking at a site. But eyeballs did not translate into money as projected. Internet users voted with their wallets. They (we) bought billions of dollars of stuff, but did not abandon the mall or the corner grocery. Consumers simply reallocated a fixed amount that was going to be spent.

Somehow in all the business planning and financial modeling, “think big” outweighed “make a profit.” In March of 2000, Wall Street, and specifically the investors in NASDAQ stocks, rejected this model. The phrase “show me the money” dictated investor action, and they pulled out of the high growth, high burn rate companies.

The irony is that most of the publicly traded companies could have made a profit if they had so desired. They have proven not very nimble or are simply bullheaded on their business model. As a result, they paid dearly for their burn rate. Healthier companies lost as little as one–third of their stock value, while others lost all of their stock value and went bankrupt.

For example, in the first quarter of 2000, the now bankrupt company Pets.com spent $29 million on advertising to generate $5.5 million in revenues. That means they spent $5.27 to get just $1 from a customer. The burn rate to revenue ratio was much higher, since this figure does not include any other cost of doing business, only advertising. Apparently, having pet food shipped to your doorstep could not replace grabbing it at the grocery store when you ran out. Eyeballs on the cute site did not turn into money.

Where The Money Is Going

When one industry goes down, another goes up, and in this case the money being withheld from Internet companies is going into telecommunications companies.

Wait, telecom companies lost their value three years ago. What is happening?

For telecom, technology finally caught up with the aspirations many had for it years ago. Wireless capacity is full in most urban areas, and expected to be full soon in many other areas. People, that is, paying customers, who previously rejected cell phones now get one for every member of the family able to talk.

There has been a consolidation in the telecom industry that brings a critical customer mass to fewer players. This results in far lower customer acquisition costs. The telecom business model is essentially an annuity-based model, which means that once a customer is acquired, that customer spends a specific amount each month, ranging from $19.99 to $129.00 or more. Over the course of one year, the cost to acquire the customer amortizes to a fairly small amount.

The money is back for early and mid–stage companies that provide technology to help cut costs to wireless providers, and companies that are actually stand-alone R&D divisions are now ready to sell their products to the highest bidder. Wireless has become a proven market; a sufficient number of customers are paying for wireless services. Wireless companies that contribute to the industry – and survived the investment drought of the last two years – will be able to obtain funding this year. Instead of being an emerging industry, telecom is now a more mature industry and investors will treat it as such. The telecom bubble should not expand to the level the Internet bubble expanded, but then again, there is no accounting for unbridled optimism.

It’s The Business Model That Counts

Internet based companies will re–emerge much the same way, probably in about two years. When customer demand for Internet products and services expands to capacity, investor demand for these companies will increase.

Like the telecom companies that weathered the past few years, Internet companies that stay competitive will be those providing goods or services for which customers will pay. Also, like the telecom model, the most successful Internet companies will be those who develop an annuity–based revenue stream. The first companies to emerge successful from this winter of discontent will be the Internet Service Providers (ISPs) who have merged to become economically strong businesses, and Application Service Providers (ASPs) that make the Internet affordable for Main Street businesses.

Both the telecom and Internet industries have matured. For investors, the money counts all the way down. From top to bottom, it is what the specific companies within those industries do to create recognized value to customers that will define their profitability.

Compensation consultants regularly get the question “what’s the right amount of stock to give to my new (name your executive)?” Well, not to sound flip, but it depends. Several factors impact how stock options are doled out to senior level executives (and to other employee groups as well). See the example below, to get an idea of how option can vary among different sized technology companies, and how company’s developmental stage and demographics can impact how stock options are given at different technology organizations.

Typical New Hire Option Grant Ranges for a CEO (in terms of % ownership)*

Comparison Group 25th Percentile Median 75th Percentile
Over $250m in annual revenue 0.50% 2.217% 2.341%
Aggregate survey data (all sizes) 1.788% 2.895% 5.126%
Under $50m in annual revenue 1.175% 3.957% 5.951%

* – Assumes non-founder status. Data is from the 2002 edition of the NW Executives in Technology Salary Survey.

Some Influences on Option Grants

Company Demographics Influence on Option Grants
 

Company developmental stage

 

Very early and development stage organizations are generally much more liberal in granting options. These firms often have limited cash resources, and abundant stock available at their early age/stage. More mature organizations have already granted substantial options, and usually have fewer options available. More mature firms may have other constraints such as high overhang levels or limited shares remaining in the employee option pool.

 

Company size/revenue level Larger organizations often have most of their equity already spoken for by various investors groups, and have lesser equity available (as a % of total ownership). Larger firms also typically have fewer cash constraints and other forms of compensation available, such as cash incentives, richer pension plans, etc.

 

Pre-IPO/Publicly held status Publicly held companies have greater restraints on their use of options, and often far greater overall equity and market value. Thus, fewer shares and option percentages are needed. Other forms of compensation are also generally higher in public companies, so the emphasis on equity (stock) is usually reduced somewhat.

 

So, when considering what is the “right” amount of options to offer an executive, a better question might be: “what is a reasonable range for stock options, given our organizations’ size, stage of development, financial resources, and current equity situation?” There is no one correct amount of options that are right for any one, or even most organizations. Look at the competitive data (such as this survey), and consider your current situation, the availability of non-equity resources and other issues before making a decision.

Some of you may have seen the series of articles in The Seattle Times on executive compensation (June 2001). The Seattle Times partnered with Wm. Mercer & Company to report on executive compensation at the largest Northwest-based companies.

In the article, the average base pay (excluding bonuses and option-related compensation) reported was $513,709. Wow! While that is certainly a lot more than the reader of this article are making, consider that the study only looked at companies with over $200 million dollars in annual revenue, and many of the companies were well over a billion dollars in revenue.

When it comes to pay at the executive level, company size really does matter. This is far less so for non-executives. Generally speaking, the larger the company is, the higher the pay of top executives, especially for CEOs.

Company Size and CEO Base Pay

Company Size (Revenue)
Average CEO Base Pay
Data Source
350 largest public companies
$870,000
Wm. Mercer/Wall Street Journal study

NW-based firms greater than $200 million
(many over $1 billion)

$513,709

Wm. Mercer/Seattle Times study

Greater than $50 million (most under $150 million)
$264,076
Executives in Technology study – Applied HR Strategies
$10-50 million
$248,250
Executives in Technology Survey
Less than $10 million
$213,819
Executives in Technology Survey
Between $2-5 million
$148,000
Officer Comp. Report at Small and Medium Organizations – Panel Publishers
Under $2 million
$139,000
Officer Comp. Report at Small and Medium Organizations

Incentive pay also tends to increase with company size, both in absolute dollars, and as a percentage of base pay. In very large companies, it’s not that rare to see the CEO earning annual bonuses of 100 percent or more of their base pay, while this is very uncommon in smaller organizations. For instance, the typical target bonus for CEO in a small firm is 35 to 50 percent of base pay, while in very large organizations of over $1 billion in revenue target bonuses of 75 to 100 percent of base pay are more the norm.

The ownership status of a company also affects executive pay level, although not as clearly with company size. Generally speaking, pay levels (both base pay and incentive/bonus pay) are higher in public organizations, than in privately held ones, although size still matters. At any given size, generally (but not always) pay levels are typically somewhat higher in the publicly held organization.

In addition, since most privately held organizations offer no liquidity for their stock options holders, this boosts the pay differences even further. The vast majority of executives in publicly traded companies receive sizable stock options, in addition to base pay and cash incentive compensation. While executives in most privately held firms also receive stock options, in many of these organizations, there is no way to capture the potential profits of those options, unless a “liquidity event” (an IPO, sales of the company, merger with a pubic company, etc.) occurs.

When I work with companies to determine appropriate pay levels for their executives, I always consider current and likely future company size in fashioning an appropriate recommendation for pay levels.

By 2003, e-commerce revenues are expected to equal 7% of the U.S. GDP. But what does “e-commerce” really mean, and what might this prediction mean for you? E-commerce is a broad-stroke term that may include the capabilities to initiate, process, and complete business transactions with your supply chains and customers. A first step in e-commerce for many businesses is accepting orders and payments from customers.

e-commerce a growing market

Online sales will reach $126 billion by 2003. Should an online store be part of your Web strategy? If so, what is the best approach to integrate online sales into your business? Here are five steps that will help walk you through the e-commerce maze.

Planning Stage. To develop a solid e-commerce strategy, first evaluate your products and services, your customers, your business goals, and your strategy. Despite its high profile in the media, e-tailing still only accounts for about one percent of all retail sales. Is your product a good candidate for online sales? Evaluate its feasibility with such criteria as ease and costs of shipping, product liability, custom product features, the need for personalized salesmanship to help with selection and product use, price points compared with brick-and-mortar retail prices, and customers’ readiness to buy your particular product online.

Look at your entire sales and order fulfillment process from promotion to after-sales service. Which tasks would it make sense to carry out online? How would that help acquire customers, increase value to your customers, expedite the sales process, and reduce costs? A top e-commerce Web site may cost $50 million to build. Yours probably has a much more modest budget. Nonetheless, adding e-commerce functionalities varies greatly in cost, depending on various factors including the technological complexities of your site. Setting realistic expectations based on your business requirements will go a long way to implementing an e-commerce solution that’s just right for your business

Technical Evaluation. The technology used to facilitate online transactions can be as simple as creating an online form to accept credit card information via a secure server. The credit card information is processed much like a telephone purchase. If you opt for a higher degree of automation, you will need shopping cart software to accept credit card information, an Internet merchant account with a bank to accept charges, and a credit card clearing service.

A sophisticated e-commerce solution may automate the entire process of processing payments, issuing the order to the production department, tracking the order progress, managing the customer database, and supporting customer relations. The right solution for your business depends on your anticipated sales volume, your online strategy, and your budget.

Site Design. Equally important to the e-commerce back-end is the design of the Web site where your customers visit, browse, and buy. An effective site design is built to maximize your target customers’ positive experience. It should be clear and easy to navigate, and the pages should load fast enough for the speed of Internet connections of your customers.

If you do not have the talent in-house, partner with a professional Web design team who understands your customers and your business and knows how to effectively integrate your Web site design with the back-end e-commerce technology.

Operations. Your online store faces many operations issues similar to those of brick-and-mortar catalog stores: handling shipping and shipping charges, calculating applicable taxes, processing orders, handling returns, and offering customer services. Pay attention to the jurisdiction issues, as your online store may be subject to the laws of jurisdictions where your customers reside. If you sell to customers in other countries, you will need to consider customs, taxes, and other issues such as privacy and warranties. These issues are not trivial, and undoubtedly will impact your profitability and even the viability of your business.

Customer Experience. What do you like your customers to expect from you? Your online store is an excellent vehicle to extend your brand online. On the other hand, poor customer experience online will cause harm to your reputation and hurt sales. A successful online store builds customer loyalty, and offers the same great service during and after sales that customers expect from doing business with you. Pay attention to customers’ privacy, to product warranties, and to what steps you will take to rectify situations if you fail to meet your customers’ expectations. Optimize your site design and focus on your customer service policy to maximize usability and user experience.

Internet technologies continually evolve. So will your customers’ experiences and expectations for doing business with you online. An online store can be a crucial factor in a company’s growth strategy. Maybe you should be part of that 7% of the U.S. GDP that e-commerce is expected to create by 2003.

Congratulations to those of you who survived 2002! Business bankruptcy is at an all time high. If you’re still in business you’re beating the odds and you should pat yourselves on the back and celebrate this huge accomplishment. Chances are you focused on watching every penny spent in the business, many of you did not take a salary so others could be paid, and you focused on revenue rather than fundraising.

So, how are you going to survive and even thrive in 2003 when the Pacific Northwest is classified as still one of the worst regions in the country affected by the downturn? It’s more of the same and 2003 is likely to be very much like 2002. Good news is that it means you’re halfway through the pain and challenges. Bad news is that this year is going to seem like a long road through customers being in the driver’s seat and taking a long time to make purchase decisions (still!).

Coming out on the other end of 2003 will make you a company more likely to be successful and be able to thrive. You are likely to own a larger percentage of your company because you raised less money from investors and got more money from government funding sources and revenue. This means you will be more in control of your destiny and your company will be worth more in 2004 when things get better.

We’re working hard at the Northwest Entrepreneur Network to deliver speakers and events and opportunities that are in synch with the times and your needs. Remember, we have terrific free seminars, we hold a fundraising event called the Early-Stage Investment Forum, on March 27, and our monthly events allow you to meet resources to help your company survive and even thrive.

2003 will feel better, though, because you have gotten used to slogging away and having a lot of people say no to you. And it means that next year (2004) will be the really happy year we’d like to see more of.