Can my company help if my stock options sink?

Sept. 1, 2001
I don't want to change jobs even though my stock options are under water. What can my company do to solve this problem?
1304qa Chang New
Q: I don't want to change jobs even though my stock options are under water. What can my company do to solve this problem?

A: This is a very complex issue because companies have to adhere to both accounting and US Securities and Exchange Commission (SEC) rules. I am assuming yours is a public company, because you implied there is a market price for the stock. Logically, you and the company can mutually agree to cancel your stock options and issue new ones at a lower price. But accounting rules require the difference between the new lower price and the value when you actually exercise the option at some point in the future to be charged against the company's earnings as compensation. That means lowering the company's earnings by that amount, which can be substantial and cannot be quantified up front. And we all know how Wall Street would view that! One can get around this accounting rule if the new options are granted more than six months after the date of the cancellation. This carries a risk for you since the stock price could go higher by then. A recent SEC ruling views this as a tender offer for the company to in effect "buy back" issued stock options. The company is therefore required to go through a lengthy process of filing for SEC approval. So, the short answer is it can be done but with a great deal of difficulty. It is worth your management's efforts to brainstorm with the corporate attorney and auditor. (Thanks to Judy O'Brien, my iNCUBiC partner, for her input.)

Q: Previous venture capital (VC) investment in my telecom company was $5 million, and the current investor is willing to invest an additional $10 million to get to prototype in 18 months. What's a fair valuation? How much control should they have on the board, and what restrictions would they place on the founders?

A: Most startups in this space are having a great deal of difficulty getting funding in the current environment. Given that you are still a long way from shipping products and breaking even, my recommendation is to take in as much as your investors are willing to provide. And within reason, do not bargain too hard for higher valuation. If you run the calculations, you'll find valuation has only a second-order effect on your ownership outcome if you started off with significant ownership.

My guess is that your investors would have a lot of say over what you do. If they have greater than 50% ownership, then for sure they have control because ultimately majority shareholders have control of the board. Even if there are more directors on your side, majority shareholders can always oust them and elect their own. If they have less than 50% ownership, they would likely demand the chairman position so they would be able to exert greater influence.

In terms of control over the founders, they will probably make you earn your shares over time, and want co-sale rights so that you cannot cash out without them. They may also invest a portion of the $10 million up front and have the investment of the rest conditional on meeting performance milestones. Have your lawyer explain all the conditions on your term sheet so you know what you are getting into.

Worrying about control is not a great starting point; you would be better off thinking about teamwork and relationships instead. Your investor's motive is for the company to succeed and to create value. That's not a bad starting point. It would be beneficial for you to align with your investors and to help them understand your business, so together you can make good decisions. When you have lemons, make lemonade.

Q: My competitors are promoting vaporware to confuse customers. What should be my response since we are an established conservative company?

A: This has been happening more often lately. Companies funded with venture capital usually have very aggressive goals, and they build complete management teams and full infrastructure early. In reality, products always take longer to complete, and people in sales and marketing wind up with nothing to sell. Still, they do what they are supposed to do, which is to go through the motions of product introduction. Witness the BIG booths startup companies had at NFOEC, with lots of company staff but few customers. What they do is confusing to potential customers. The likely backlash is for customers to ignore most if not all of the new vendors, instead turning to established vendors who have served them well. The reality is an OEM buyer will only give a new supplier one chance, so the first item must work really well. My guess is that these companies will get their just desserts without your doing anything. Ethical business practices may bring some setbacks in the beginning but will almost always win out at the end.

About the Author

Milton Chang

MILTON CHANG of Incubic Management was president of Newport and New Focus. He is currently director of mBio Diagnostics and Aurrion; a trustee of Caltech; a member of the SEC Advisory Committee on Small and Emerging Companies; and serves on advisory boards and mentors entrepreneurs. Chang is a Fellow of IEEE, OSA, and LIA. Direct your business, management, and career questions to him at [email protected], and check out his book Toward Entrepreneurship at www.miltonchang.com.

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