Playing the stock options game

Many Silicon Valley high-tech start-ups are using stock options as currency to buy services they need to get up and running.

5 min read
Doling out stock options to employees is nothing new in Silicon Valley, but a number of high-tech companies have modified that concept and are using stock options as a way to sidestep the hassles of hard currency.

An increasing number of start-ups, trying to get a foothold in the high-stakes world of high tech, are finding that their stock options are worth their weight in gold when it comes to paying for services rendered.

Many of these start-ups simply don't have the capital resources to invest in the types of services--such as marketing, executive headhunting, and legal assistance--that can be crucial to their success and survival.

In order to remedy this catch-22, many are quietly offering up options in their nascent companies in exchange for the services they desperately need to get off the ground.

Gerard Planet, president of Red Planet Productions, a multimedia promotion and marketing firm in Laguna Beach, California, has been on the receiving end of many such deals, and has taken to suggesting options-for-services exchanges if his potential clients don't suggest them first. In fact, he says he now prefers such transactions to receiving cash payments.

"These deals are more interesting for us, and better for everyone in the long term," Planet said.

Indeed, such deals often are mutually beneficial.

"Usually, cash flow is one of the biggest issues for a start-up," said Andrew Dietz, an executive search consultant for Interim Search Solutions. "Offsetting those issues in exchange for stock is usually not a problem."

It certainly is no problem for Planet, who is quick to point out that he normally gets paid $100 per hour for his promotional marketing work, whereas if he gets one hundred shares of a company's stock at $1 per share, those shares could easily end up worth ten times what he would have collected in cash, in a matter of only a few years.

Dietz, meanwhile, has found that options-for-services exchanges can be a good selling point in the headhunting business.

"The goal of a retained search is to have as much commitment to your client as possible. Stock ownership is an increase of that commitment," he said. "Many companies are concerned that you'll put someone in and take them back out, whereas options lead to greater protection, and lead me to looking out for that company's best interest."

While it's difficult to determine just how widespread such transactions are in the high-tech industry, anecdotal evidence suggests that the practice is becoming more commonplace.

"Everyone's doing it," said Planet, noting that, during the course of his business dealings, he has encountered several marketing companies and legal firms that have agreed to accept options in lieu of payment.

The Internal Revenue Service, meanwhile, has weighed in on the legality of the practice. Michelle Lamishaw, an IRS spokeswoman, said the tax agency views options-for-services agreements as standard barter transactions in the eyes of the tax law, which means that they can be reported using existing IRS forms. Vendors, therefore, have no reason to fear that payment in options will get them in trouble with the tax man.

Not that such transactions are without risk. Companies and vendors alike face a significant downside potential when foregoing cash deals for options packages.

Alex Rosen, an associate at Menlo Park, California-based Sprout Group, a venture capital affiliate of Donaldson, Lufkin & Jenrette, said companies that hand out options like candy might be shooting themselves in the foot, effectively "signaling" to vendors that the options they are so quick to dish out aren't worth much. He added that companies also have to contend with the necessity of keeping the number of their shareholders at a minimum, given restrictions that the Securities and Exchange Commission places on private companies that want to retain that classification.

For vendors, such exchanges are, quite literally, a gamble. While options from a budding high-tech start-up easily could be transformed into a mountain of money once the company goes public, those same options can just as easily backfire if the company never makes it to the public trough.

Rosen of the Sprout Group has seen this happen. He said he knows of several independent contractors who have come up empty while playing the options waiting game.

"[Contract] programmers in particular are looking at it as, 'We've got stocks we can use as poster paper in our bathroom,' " he said. "Once or twice burned, they're more reluctant to accept options instead of cash."

Planet is unfazed by the risk factor. From where he sits, not only is he making it possible to do business with smaller start-ups, and to possibly get exponential returns from that business, he also is moving toward a new business model--that of promotional marketer cum venture capitalist.

"My dream is to build a company that will only do business for options," he said. "That way I can build a portfolio, and, if it pays off, I'll go from being a businessman to being an investor. There will be a transition from being a company that sells services to becoming a partner in a dozen or 20 companies."

The downside to this model is that many companies are catching on, becoming more wary of the perils of such transactions and consequently taking steps to protect themselves.

Planet, for example, said he has had to sign exclusivity contracts with several companies from which he has received options as payment. Such agreements, which put vendors in the position of having to place their bets on only one company within a certain market, essentially preclude the vendors from making similar deals--which amount to taking a stake in the company--with any of the company's competitors.

"I'm holding my cards," Planet said, "I'll either get rich or go bankrupt. It's just like Las Vegas."

The various risks associated with such cashless transactions, however, seem to be having minimal impact on their popularity. In the digital gold rush, an age in which everyone doing business in Silicon Valley has seen someone they know hit pay dirt with stock options, the lure of an options windfall is simply too great for many to refuse.

"Realistically, times are good now. We are in an economic anomaly," said Interim's Dietz. "If you're not a glutton, then you're a fool."