Archive for September, 2008

When to Issue Stock Options

September 26th, 2008

Lately I have run into the same issue several times with different clients.  Small businesses looking to grow bring in non-founder staff and want to offer them an equity stake.

It used to be relatively simple and inexpensive to create an option plan for the company and issue options to the employees.  The plan document itself is pretty close to “boilerplate” and depending on how organized the client is I could usually prepare the plan, related Board and shareholder consents, California securities filing and issue option grants to the employees for somewhere between $1,000 – $2,000.

No more.  IRS Code Section 409A now gets involved and raises the cost by about 10x.  409A was enacted to put a stop to backdating and intentional option mispricing shenanigans.  It imposes severe penalties on option holders who receive stock options granted below fair market value.

This is ok for public companies that can point to a clear stock price on a daily basis.  For private companies, 409A says that stock price may be determined by a valuation done internally by someone with significant relevant experience or externally by a valuation expert.  Most startups don’t have an internal person with the required experience, so this means an external valuation and that can cost $5,000 – $10,000.

I understand that fast-growing companies like Facebook do external 409A valuations quarterly to avoid problems.  For them, it is an unfortunate expense.

What if a company raises only a tiny amount of money, or perhaps no money, and still wants to offer options?  The cost of the valuation makes this prohibitively expensive and leaves three practical alternatives:

1)  Grant the options when the company is brand new.  If we grant options at the same time the founder stock is created, we can be confident that the value is quite low.  Obviously, though, this only works in the early days of the company.

2)  Get the valuation.

3)  The third option is to grant options that aren’t exercisable at will.  If an employee gets an option that is exercisable only on a change of control event or other external trigger, then the option is not covered under 409A.

There are downsides to this approach, including the fact that if the option can only be exercised on a merger or sale of the company the option holder loses any chance at capital gains treatment of the resulting gain.  The difference in tax rates could be as bad as the 409A penalties (noting that California now tacks on its own 20% penalty to 409A violations, which would make the effect of violation much worse than mere ordinary-income treatment).  Not an appealing option.

All of this makes me say that 409A needs a blanket exemption for non-public companies.  409A only went into effect this year.  Let’s hope the IRS sees the light soon and fixes this problem so that companies can offer equity incentives to employees without breaking the bank.

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Robert Reich’s Blog: The Bailout of All Bailouts is a Bad Idea

September 18th, 2008

I tuned into to Robert Reich’s blog recently, and it is currently one of my all-time favorite things on the Internet.  I like his segments on NPR as well.  As a Cabinet member under Bill Clinton, the man has the credentials to charge a bunch of money for his opinions.  It’s fantastic to see him offering them up for free instead.

Robert Reich’s Blog: The Bailout of All Bailouts is a Bad Idea

The post linked above lobs out a fascinating idea for a kind of mass-bankruptcy proceeding for every ailing bank on Wall Street, or perhaps a financial Truth and Reconcilation Committee proceeding. 

The idea is to bring out all the skeletons, wipe out the banks’ bad debt- and the equity of those who bought stock in the banks- and let them start fresh without putting US taxpayers on the hook for a super-massive bailout, BUT with improved disclosure and minimum capitalization rules.

Disclosure rules certainly need to evolve with the times, but for the record I’m not sure they are the main answer.  As my friend Sam put it, almost no one actually understands what a credit default swap really is.  As long as everyone was making money, understanding the mechanics didn’t seem that important.

All that said, Reich offers a lot of food for thought on a regular basis.  Definitely worth reading.

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Open Source Angst

September 10th, 2008

I started poking around in some open source software issues recently, and then a significant case came down on almost exactly the same point, making the whole thing highly blog-worthy.  Here are my thoughts on the Ninth Circuit’s Jacobsen v. Katzer decision along with the clusterf*ck of conflict between developers and lawyers on how to manage open source code.

Jacobsen v. Katzer – Open Source Licensing Requires Compliance with Attribution and Version Terms

The Jacobsen case contains a valuable lesson. Jacobsen developed software and made it freely available under the under the Artistic License, which says that a licensee is free to use the software and incorporate it in free or for-pay products, but that the licensee must provide full attribution of the licensed material and if the licensee changes aspects of the source files he is required to make the original versions available as well along with a description of the changes.

Katzer picked up Jacobsen’s code, changed files names and other aspects and used the modified versions in his own for-pay software without giving attribution or providing original versions as well.  Jacobsen brought suit for copyright infringement.

Katzer then attempted some legal sleight of hand by saying that the license to Jacobsen’s software allowed Katzer to use the software freely.  The attribution and version terms were not actually part of the license, but were a separate contractual issue.  In other words, if Katzer screwed up, the remedy was not to rescind the license but to pay economic damages.  Since Jacobsen didn’t charge for his product, damages were $0.

The court’s response was “No way”. The attribution and version terms are part and parcel of the license.  Fail to comply and you lose the right to use the software.

My View – Right on, Ninth Circuit

The court has this right.  If it had somehow found for Katzer it would have ripped the heart right out of open source licenses by saying that there is no penalty for failing to comply with the attribution and version control provisions- frequently the only conditions in an open source license agreement.  The license conditions would be completely unenforceable.

[Note, however, Prof. Eric Goldman wondering whether, if the act of downloading and using the code subject license terms is enough to create a defensible contract]

. . . And Yet the Devil Remains in the Details

At the same time, I have worked with companies that use open source code regularly.  They don’t just use one component- they use dozens or hundreds of open source elements by different authors, made available under different license terms.  Good faith, meaningful compliance becomes genuinely difficult in that situation and requires careful documentation, oversight and management.  No problem there- good developers and good lawyers both create clear trails of documentation to support their work product and tracking the elements being used is doable.

What may not be doable is figuring out exactly what the license terms are.  I searched for several open source elements on a recent project and found them available on two web sites.  The first site listed the applicable license as GPL (a more restrictive open source license) and Artistic License (less restrictive).  The latter said GPL or Artistic License.  GPL and Artistic License are similar, but have some important differences.  Which one did the publisher intend to apply?  There is no way to know from the sites on which the code resides.

[Again, see Prof. Goldman with an example of a photo posted on Wikipedia under the mutually incompatible Creative Commons and GFPL licenses and wondering how one might comply with the license requirements.]

Open source licensing also borrows from the software community by attaching version numbers to its licenses.  GPL v3 is signficantly different from GPL v2, but developers frequently don’t indicate which version they intended to apply.  As a good faith user, do I need to comply with both versions of the license?  That doesn’t seem to help the open source cause much- it is hard to upgrade to v3 if we need to remain backward-compliant with v2 indefinitely as well.

Where the Developers Miss the Lawyers

My own theory here, and I would love to hear other views, is that the license terms are an afterthought for developers.  Someone creates some code, uploads it to sourceforge or elsewhere and checks a box for GPL, Artistic or some other license terms.  I believe that in most cases developers would like attribution and to see their code further developed by the community, but don’t care much about the details beyond that such as which version of GPL should apply.

All of this makes good faith compliance really difficult.  The Software Freedom Law Center has an excellent guide to compliance with GPL that provides very good advice on how to document and comply with GPL’s requirements.  The document assumes, however, that a good faith user can readily tell which licenses to comply with.  In my experience that is not the case at all, which is a shame.  Open source software is useful and pervasive, and is being enforced with more and more assurance.  It will be too bad to see well-meaning companies dinged because of this lack of clarity.

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Why Deferred Salaries Don’t Work for Startup Founders

September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

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