This is a reprint of an article that appeared in... Business Journal as part of a special section on the...

This is a reprint of an article that appeared in the September 20, 2002, issue of the Portland
Business Journal as part of a special section on the first Oregon Business Plan Competition.
Lane Powell was a sponsor of the Competition, in which over 150 early stage companies
submitted their business plans with the hope of being selected as one of the top three contestants.
The Portland Business Journal is publishing a series of articles that follow the progress of the
three winning companies over the next year.
Jeff Wolfstone
Lane Powell Spears Lubersky LLP
Venture capital and angel investor funds are scarce as compared to the heyday ‘90s. Like
most emerging companies, the Business Plan Competition winning companies closely monitor
their cash “burn rate.” As these young companies work to build their core management teams,
they use stock options as a key part of the compensation package both to conserve cash and to
provide incentives tied to growth in stock value. In this article I will briefly comment on the
issues faced by these companies as they develop and implement stock option plans.
First, a remark on the current public debate over stock options. Much of the controversy
turns on the proper accounting treatment of options issued by public companies. Several
prominent companies, including GE, Coca-Cola and Boeing, have taken the lead by announcing
that they will begin deducting from earnings the estimated cost of new options. At the other end
of the spectrum, adherents to the so-called Silicon Valley model argue that current earnings
disclosure practices are adequate. Taking a position somewhere in the middle, Intel asserts that
the real issue is not the accounting expense (which is difficult if not impossible to accurately
determine) but rather whether shareholders understand and approve of the dilution resulting from
option exercises and whether options are broadly or narrowly distributed in the company’s
workforce. The bottom line is that we should expect to see more changes in the accounting
treatment and perhaps a decline in the prevalence of options, but that they will continue to be an
important feature on the financial landscape.
In an emerging company, the issues surrounding the use of options are closest to the
position advocated by Intel. The accounting treatment of stock options in an early stage
company typically is not a central point. The company is usually at a stage where there are little
or no revenues. Investors are focused on whether the company has a successful business model
and a viable pathway to future earnings. They are also concerned that cash, including their
invested funds, should be conserved. They are no less interested in seeing that the company is
able to bring key employees on board. So, at least from cash management and team building
perspectives, the investors see stock options as a positive.
However, there are limits to investor enthusiasm regarding the use of stock options.
Typical early stage angel and venture investors hope to see a return of 10 or more times on their
invested funds. A key term of their investment is protection against dilution (meaning the
issuance of securities for a lower price than paid by the investors). The protection is usually
implemented by automatically giving the investors a bigger slice of the equity pie if a dilutive
transaction occurs. If applied without allowance for the grant of stock options, the anti-dilution
protections can result in a windfall to the investors if options are granted at a relatively low strike
price. This tension is commonly resolved by the investors’ agreement to a carve out allowing the
grant of employee options representing 10 to 20 percent (and sometimes more) of the company’s
equity without triggering the anti-dilution protections.
The current economic downturn serves as a reminder of both the utility and the
limitations of stock options. Most early stage companies will continue to use options as a key
element of their growth strategy. But with the euphoria of the late ‘90s now faded, prospective
employees may well view options more skeptically and place greater value on current cash
compensation. In a time when cash is tight and equity has lost some of its luster, the Business
Plan Competition winning companies will work to wisely balance their use of cash and equity
based compensation.