The Downside of Options

Minus 23 degrees. That was the absolute temperature this morning as I went out to the airport. This probably nets out to minus 30-40 wind chill. This redefines how icy cold the financial markets are. This is also what makes Midwesterners so decent and hearty. Winter puts everything in perspective !

With that said, I wanted to throw out a topic that I have pondered quite a bit — how effective are options at aligning the interests of management and Investors?

The rationale behind options is that by giving employees equity in their firm, they will think and act more like shareholders. Therefore, they are incented to act so as to maximize the future value of their stock. Additionally, this allows them to participate in the, hopefully, significant increase in company value driven by their efforts.

On the surface, this appears to make sense, especially on the upside. However, things begin to breakdown on the downside. For one, if the company underperforms or requires significant equity, Investors will suffer significant dilution unless they continue to put ever increasing amounts of money to work. Management will push for additional option grants to be made whole. This begins to make them less dilution sensitive while also further diluting Investors. Management pushes for options, which are in essence free, rather than asking to protect their ownership by buying shares. This often leads to tense discussions between Investors and management.

The second, and I would argue more troubling, issue is that options create asymetrical alignment of interest. Investors are committed and have their capital wed to the company in both the upside and downside scenarios. Options, unlike purchased stock, have no downside cost or “loss” (other than lost upside) to their holder. As a result, this does not create the stickiness or alignment that having financial skin in the game does.

Before the craziness of the Bubble, it was standard for VC’s to look at how much networth an entrepreneur had invested in the business. The reasoning went that if this was high, then the entrepreneur, having “burnt the ships”, would fight like a caged tiger for the success of the business. However, as money poured into venture and deals grew more competitive, fewer and fewer teams had large chunks of skin in the game.

Where this creates a disfunctional situation is when management, or more often a hired gun CEO with a big option package, underperforms. There is little cost to leaving. If conditions worsen and it looks like the business will need massive effort for a period of time to turn around, management may begin to look at opportunity cost. Would they be better off spending the next three years at a more promising start up?

Sure, they walk away from future option value, but are relatively unencumbered. They are not nearly as tied to the company as managers with money in the deal. This fact creates surreal negotiating leverage for them as they can threaten to leave the Company if not given more stock. Investors, on the other hand, have their capital locked up in the firm (as they should).

Sometimes, managers ask to be able to buy stock so as to start their capital gains clock. However, they often ask for a non-recourse note from the Company to do this. The result is that should the firm fail to perform (or they fail to perform), they can walk away from both the stock and note (as it is non-recourse).

Unfortunately, this downside scenario is much more common than one would expect (or than Investors would like).

My trouble with this is that Investors and Managers enter into a pact to build a company together and remain committed in good and bad times. This contract falls apart when one party can back out of the deal.

This post is not to rail against hard working entrepreneurs. Far from it, as the great majority of them stay committed and fight hard to the very end. Rather, this a complaint against an incentive structure that is flawed and can undermine the Investor/Entrepreneur relationship. I would argue that requiring management to purchase a portion of their equity (options for the remainder) would actually lead to a more stable company and stronger alignment of interests. Will this feature come back into focus or will VC’s push for disfunctional features for protection like 2x liquidation preferences. We will see.

There are an array of investor centric factors that also undermine this contract but those can be saved for a future post…

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