Consider the Options | Financial Managers

“We can really use your financial expertise, Brad, but we can’t afford to pay you right now. What if we give you stock options instead?”

There were times during the ’80s and especially in late ’90s when we heard that offer more than half the time with prospective clients. Of course, we were working frequently with start-ups in those years, and options were the coin of the entrepreneurial realm.

I have to admit that we were tempted on a lot of occasions, especially in situations where Smart Money had already made a significant investment. How could we doubt the opportunity?

Well, having five kids and a mortgage on a house big enough for all of us put a significant premium on cash. And having one Big Formative Experience early on when my investment in a client company went belly up – despite many signs that we had the winning combination – taught me you can’t control all of the circumstances that lead to small business success. Sometimes luck really does play a role. We subsequently decided to take luck out of the equation by getting paid up front by all clients and not hesitating to suspend our services when “overdue” crept beyond 30 days.

So we have missed some client winners and we’ve avoided some few client losers, but almost always we’ve left on good terms, paid in full and having helped our clients to identify and transition to our full-time successor. There’s no tail on the relationship, no minority stock interest that survives our involvement or requires us to be bought out. As a result, when an iBasis goes public or a Sensitech gets acquired (by Carrier Corporation), there’s no “liquidation event” to contribute to our comfortable retirement. At the same time, when a KaBloom or a Zoots never really achieves lift-off in the years after my departure, I’m glad that we left nothing on the table as we said our goodbyes. For all four of those companies, we were the “founding” CFO.

Thus it is that I have a particular bias when my newest client says to me last week, “We can’t afford a bonus for the staff right now; maybe we should consider a stock option plan. What do you think?”

This is a consumer product company that grew from $2MM to $10MM over a five-year period with almost total emphasis on the top line. When they stopped to catch their collective breath at the end of 2007, they realized that the bottom line had gone in the other direction. They then cut staff by 60%, outsourced some work, and asked everyone to work harder in order to keep the company afloat. Well, naturally, resumes immediately hit the street, and Monster and Craigslist became popular lunchtime (at least!) website diversions. Good people started leaving, despite the owner’s promises to guarantee four weeks of severance pay in the event of further lay-offs.

Here’s what I thought:

The majority of these employees are relatively unsophisticated, $15-20/hour workers, most of them probably living paycheck to paycheck. Their critical compensation issue is keeping ahead of inflation, especially at the gas pump, since most of them drive some distance to the plant.

Reassurance about their job security, when it comes, will be via the accounts payable clerk, who will no longer be getting daily dunning phone calls from all of the vendors. It will also be via the purchasing manager, who will be able to order enough incoming product to avoid expensive “short-ship” deliveries to customers.

They don’t want promises – they want to know that management has an economic model that’s going to work for the company. It doesn’t take a lot of sophistication for them to understand that with 50% margins on shipments combined with less than 8% returns and allowances, the company can make money. They know that when ship dates are missed, competitors’ products fill the retail shelves, and there’s a significant opportunity cost.

What are these folks going to do with a stock option? It can’t buy gas. It doesn’t pay the mortgage. You can’t offer it to the bank as security for a loan.

They need reasons to believe in the company. They need to see the number $800,000 at the top of the employee bulletin board each morning when they punch in, so that they know the sales target for the month. At the end of every day they need to see a record of their progress toward that goal.

Beyond that, they need some education. Management has to share the other components of a positive bottom line: here’s the average margin on today’s shipments vs. our target. Here’s the month-to-date return/rework percentage compared to our goal. Here’s evidence that overhead expenses are under control. Most importantly, here’s how each of you employees can contribute to achieving our goals.

It takes a couple of months. That’s all. When employees achieve their production goals and expenses stay in line with the plan, the bottom line turns black. People start getting reassured: everyone understands a positive bottom line. It means that the vendors get paid, the bank gets paid, and my job still exists.

It also takes timely and accurate financial statements. Because then you can establish incentives: a 10% bottom line this quarter means an extra week’s pay for everyone (effectively a 7.7% bonus). That’s what puts gas in the tank and food on the table for the vast majority of employees in this country.

Don’t get me wrong. Stock options can work out well, though a lot of dot-commers (dot commas?) were disappointed a few years ago. For senior managers and others with a strategic perspective for whom such awards constitute discretionary income, aligning rewards around an exit strategy can produce a powerful set of incentives. For the rest of the team, however, the absence of an immediate pay-off may mean “here today, gone tomorrow” as they consider their options.

Alligator Bites

“Francesco Pompei, president of Exergen, in Watertown, Mass., thought he was just dismissing a worker when he fired an employee who had been granted company stock. However, the employee’s lawyer claimed in court that his client was no ordinary employee. Instead, the lawyer argued, he was a minority shareholder whose fiduciary rights had been violated by the firing. The ensuing court battle lasted eight years. ‘I hadn’t the foggiest idea it would end up this way,’ Pompei says today of the long, costly legal dispute.

“Pompei was fairly lucky. Even though two lower courts had decided in favor of the employee, the Massachusetts Supreme Judicial Court ultimately sided with the employer. In the meantime, Exergen had bought back the employee’s stock.

“Is your company at risk? The most likely target for this type of lawsuit is a closely held company that has granted stock selectively to a small number of key employees. Although sharing equity can be a great way for small, growing companies to recruit and keep talented workers, too many business owners grant stock blindly, without writing sound shareholder agreements. Remember, if you grant equity selectively to an individual employee, your relationship changes forever. In particular, as Pompei found, you may encounter problems if you try to fire a minority shareholder. ‘The employee will argue in court, “the company didn’t fire me for cause but as an excuse to freeze me out of my investment,'” says Scott.

“If you do decide to give company stock to employees, notes Scott, many disputes can be avoided simply by putting both parties’ expectations in writing, up front. Here are five points that he thinks should be included in the shareholder agreements with your employees.

“State that the employee’s status is unaffected by the grant, i.e., that an at-will employee who owns stock remains an at-will employee.

“Give yourself the right to buy back the stock if the employee is fired, quits, becomes permanently disabled, goes bankrupt, or dies.

“Give your company first right of refusal if the employee wants to sell or transfer stock.

“Include a noncompete agreement. After all, shareholding employees have access to inside information.

“Recommend that employees have their own lawyers review the agreement. Otherwise, an employee might say later, ‘You put something in front of me that I signed. I was relying on the company’s attorney.'”

– from Inc.com, The Daily Resource for Entrepreneurs

Draining the Swamp

A Statistical Profile of Employee Ownership*

Type	ESOPs, stock bonus plans, & profit-sharing plans primarily invested in employer stock
No. of Plans	9,774
No. of Participants	11.2 million
Asset Value	$928 billion+

Type	401(K) plans primarily invested in employer stock
No. of Plans	748
No. of Participants	1.5 million
Asset Value	$133 billion

Type	Broad-based stock option plans
No. of Plans	3,000
No. of Participants	9 million
Asset Value	(several hundred billion)**

Type	Stock purchase plans
No. of Plans	4,000
No. of Participants	11 million
Asset Value	**

*as of February, 2008
**not realistic to estimate

Source: The National Center for Employee Ownership