Foolishness over stock options

All around Silicon Valley, companies once given up for dead are returning to life. It's an old Valley story of deferred success after a down cycle. But it's also a story far less likely to repeat itself. That's because this generation of re-emerging companies will probably be the last that's able to hold itself together during tough times with broad-based employee stock ownership.

In other words, the Valley mythology of visionary entrepreneurs combining with tight-knit teams to overcome all obstacles and build great companies--the Suns, Ciscos and eBays of the world--is about to suffer a huge blow.

We're talking, of course, about the gathering regulatory momentum to make stock options an expense. The most recent draft decision by the Financial Accounting Standards Board marked the latest--and probably the most serious--move in that direction. Not only does the FASB plan to rule options as "compensation" and thus an expense to be entered on the income statement, but it would also mandate that those expenses be assigned to each operational category.

The loss to Silicon Valley and U.S. innovation will be significant.

In other words, options granted to product assemblers would go into financial statements as manufacturing expenses, options granted to salespeople would go in as a cost of sales, and so on. Just keeping track of which option goes where is an administrative hassle and a several-hundred-thousand-dollar expense on its own. Add all the costs, and you have much greater deduction for worker compensation and lower reported profits--all coming at a time when young companies most need to attract public capital in order to grow.

And how should we assign value to those option expenses? Any Valley veteran will tell you that in the early, private stages of a company, option values are largely irrational--an excuse to tell your wife that you have left a secure job for an exciting one that might lead to a "new house."

Even options in shares of small public companies don't lend themselves to rational evaluation. The Black-Scholes methodology, often suggested by large company accountants as a way to accurately value public stock, is rigid and arbitrary, and has found no believers among our Silicon Valley peers.

That's more than academic, since new Sarbanes-Oxley legislation requires chief executives to vouch for financial statements--including stock option expenses--under the potential penalty of prison. Why would any rational executive agree to do that?

Given the existing challenges of creating new growth companies, most Valley CEOs we know say that, for their next start-up, if there is one, they don't know how they will build and hold a strong team without stock options. For the founders, there is always founders' stock, but for the people you have to attract later, during hard times, there is not a clear answer. They won't bother with stock options or their equally affected relative, employee stock ownership programs.

If so, the loss to the Valley and U.S. innovation will be significant. As the CEO and founding venture capital investor, respectively, of Endwave, we know how critical stock options were. In 2000, Endwave just managed to go public at several dollars a share before the telecommunications bubble burst. Revenue and orders, which had been on an upward growth curve, dropped, and so did any immediate hope of profit.

Small companies are the victims of the poor large-company governance that saw boards of companies like Tyco and WorldCom shower their top executives with unearned options.

In that situation, it would have been easy to give up. In fact, a number of us in management actively thought about "hanging this one up" and trying something new. But Endwave's ability to continue granting options without incurring further expenses provided significant financial incentive to the management team to stay in place.

Moreover, options provided a bond for everyone in our company--all 120 of us. When we stood in front of everyone at plant meetings during tough times and said, "OK, this is what we've got to do," everyone did it--executives, engineers, secretaries, salespeople and assemblers.

Options aligned our interests with those of other shareholders in a way that bonuses and salaries could not. We saw that difference first-hand, when we acquired a unit from a large corporation. Our former big-company workers came to us with a stereotypical 8-to-5 mentality. That culture changed, however, under the direct influence of stock options. In the end, everyone worked hard for tangible share price benefits. Today, growing and profitable, we all take satisfaction in Endwave's share price, which has increased by more than 10 times its low point.

Some may ask whether the ability not to expense stock options isn't just another special-interest corporate loophole. Why should small companies be beneficiaries of accounting gimmickry? Actually, the reverse is true.

Small companies are the victims of the poor large-company governance that saw boards of companies like Tyco and WorldCom shower their top executives with unearned options--seriously defrauding shareholders. The legislative and regulatory response to these shenanigans has caught all companies, large and small, in its grip. Where are the small, growth company abuses of stock options that must be corrected? We haven't seen them. On the contrary, easily grantable, nonexpensable stock options for small companies have created significant value for the economy as a whole.

That brings us to the most logical appearing argument in favor of expensing stock options. Critics ask whether stock options just boil down to another form of compensation, which, like salaries and bonuses, are a cost of doing business. Even if they have proven a key element in driving innovation and growth, why pretend that they are something different?

Here's our answer: Because they are different. Indeed, this is the intellectual crux of the matter. The granting of stock options is an equity transaction that has no more impact on the income statement than the addition of new investment capital. Employees invest their work in the same way that venture capitalists put in money. What's more, venture capital and management shareholders actively encourage workers to join in. We also believe that broad employee ownership helps make emerging public companies attractive to the larger class of public investors--future shareholders.

The problem comes where large-company inertia leads to a divergence in management and shareholder interests. That's where management-friendly boards, giving lip service to the interests of broader shareholders, have essentially defrauded them by pouring out options on handfuls of top managers.

But that's a special problem of large-company governance, not accounting. What regulators are doing is applying a pickax to a problem that needs to be solved with a jigsaw. Their foolish reaction makes the job of building more companies like Endwave unnecessarily difficult. As a result, the future of innovation in America is looking much worse.