By Michael
Volker
Stock Options Explained, NewMIC is born,
IPO Watch, Capital Pool Corp Update, Events & Footnotes
Stock Options Explained
There's rarely an occasion when stock options don't come up as a favorite
conversation topic among high tech entrepreneurs and CEOs. Just this week I was
chatting with the CEO of one of our New Media companies and he views options as the
way of attracting top talent from the USA to his Vancouver firm. He also sees it
as the way in which he is going to get handsomely rewarded for his own
efforts.
But, as much as I'm a big fan of options, I
thought it might be useful to devote most if this column to explain what they
are, how they work, and some very serious and onerous implications for both
option holders, the company, and investors.
In theory and in a perfect world, options are
wonderful. I love the concept: Your company grants you (as an employee,
director, or advisor) an option to buy some shares in the company. An option is
simply a contractual right given to the option holder (the optionee) whereby the
holder has the irrevocable right to buy a certain number of shares in the
company at a specified price. For example, a new recruit at Multiactive Software
(TSE:E) could be granted 10,000 options allowing her (let's call her Jill) to
buy 10,000 shares in Multiactive at a price of $3.00 (the stock is currently
trading at this price) anytime up to a period of 5 years.
It should be noted that there are no prescribed
rules or terms associated with options. They are discretionary and each option
agreement, or grant, is unique.
Generally, though, the "rules" are:
1)the number of options granted to an individual depends on that employee's
"value". This varies greatly from company to company. The Board if
directors makes the decision as to how many options to grant. There's a lot of
discretion.
2)the total number of options outstanding at any one time is generally limited
to 20% of the total number of issued shares (in the case of Multiactive, some 60
million shares are issued, hence there could be as many as 12 million stock
options). In some cases, the number can be as high as 30% and historically, the
number has been around 10% - but that's increasing due to the popularity of
options.
3)options are not granted to a company - only to people.
4)the exercise price (the price at which shares can be bought) is close to the
trading (market) price on the date of the grant. NB - although companies can
give a slight discount, i.e. up to 10%, tax problems may arise (gets
complicated!).
5)technically, shareholders must approve all options granted (usually done by
approving a stock option "plan").
6)options are generally valid for a number of years ranging anywhere from 1 to 5
years. I've seen some cases where they are valid for 10 years (for private
companies, they may be valid forever once they have vested. Options may be the
best way, taxwise, through which new people can be brought on board, instead of
simply giving them shares which have inherent value).
7)options may require "vesting" - i.e. if an employee gets 10,000
options, they can only be exercised over time, e.g. one-third get vested each
year over 3 years. This prevents people from benefiting prematurely and cashing
in before really having contributed to the company.
8)there are no tax liabilities (no taxes due) at the time when options are
granted (But big headaches can occur later when options are exercised AND when
shares are sold)
In the ideal scenario, Jill - the new technical
recruit at Multiactive - gets right into her work, and due to her efforts and
those of her co-workers, Multiactive does well and its stock price goes to $6.00
by yearend. After all, it's already been as high as $8.50 within the past year.
Jill can now (provided her options have vested) exercise her options, i.e. buy
shares at $3.00. Of course, she doesn't have $30,000 in spare change lying
around, so she calls her broker and explains that she is an optionee. Her broker
will then sell 10,000 shares for her at $6.00 and, upon her instructions, send
$30,000 to the company in exchange for 10,000 newly issued shares pursuant to
the option agreement. She has a $30,000 profit - a nice bonus for her efforts.
Jill exercises and sells all of her 10,000
shares on the same day. Her tax liability is calculated on her $30,000
profit which is viewed as employment income - not a capital gain. She
gets taxed as if she got a pay cheque from the company (in fact - the company
will issue her a T4 income tax slip next February so that she can then pay her
taxes in her annual return). But, she does get a little break - she gets a small
deduction which equates to her being taxed on only 66% of her profit, i.e. she
gets $10,000 of her $30,000 bonus tax-free. In this regard, her gain is treated
like a capital gain - but it is still considered employment income (why? Aha -
good old RevCan has a reason - read on).
This is how Canada Customs & Revenue sees
it. Nice and simple. And, it often does work exactly this way.
Stock options are often referred to as
"Incentive Stock Options" by regulators such as stock exchanges, and
they are viewed as a means for providing bonus income to employees.
They are not - as many of us would like to have
it - a way for employees to invest in their company. Indeed, this can be
extremely dangerous. Here's a real example of a story that I recently heard.
Just to be sure, I checked with the good folks at Deloitte and Touche and they
confirmed that this situation can, and does, occur.
Jim joins a company and gets 10,000 options at
$1. In 5 years, the stock hit $100 (really!). Jim scrapes together $10,000 and
invests in the company, now holding $1million worth of shares. In the next 2
years, the market tumbles, and the shares go to $10. He decides to sell, making
a $90,000 profit. He thinks that he owes taxes on the $90K. Poor Jim! In fact,
he owes taxes on $990k of income ($1M minus $10K). At the same time he has a
capital loss of $900K. That doesn't help him because he has no other capital
gains. So he now has taxes owing and payable of more than $300K (i.e. 50%
marginal rate applied to 66% of the $990K). He is bankrupt! So much for
motivating him with incentive stock options!
Under the tax rules, the important point to
remember is that a tax liability is assessed at the time when an option is
exercised, not when the stock is actually sold.
Let's go back to the example of Jill buying
Multiactive stock. If Jill wanted to keep the shares (expecting them to go up),
then she would still be taxed on her $20,000 profit in her next tax return -
even if she didn't sell a single share! Up until this year (as announced in
February's Federal budget), she would actually have to pay the tax in cash. But,
the recent budget now allows for a deferral (not a forgiveness) of the tax until
the time when she actually sells the shares (up to an annual limit of only
$100,000. The Province of Ontario has a special deal allowing employees to earn
up to $1M tax free! Nice, eh?).
Suppose that the shares drop (no fault of hers
- just the market acting up again) back to the $3.00 level. Worried that she
might have no profit, she sells. She figures that she has broken even, but in
fact she still owes about $10,000 in taxes (assuming a 50% marginal rate on her
"paper profit" at the time of exercise). Not good. But true! Even
worse, suppose that the stock drops to $1.00. In this case she has a capital
loss of $5.00 (her cost on the shares - for tax purposes - is the $6.00 market
value on the date of exercise - not her exercise price). But she can only
use this $5.00 capital loss against other capital gains. She still gets no
relief on her original tax bill. I wonder what happens if she never sells her
shares? Would her tax liability be deferred forever?
On the other hand, suppose that the world is
rosy and bright and her shares rise to $9 at which time she sells them. In this
case, she has a capital gain on $3.00 and she now has to pay her deferred tax on
the original $30,000 of "employment income". Again, this is OK.
Because of the potential negative impact
brought
about by acquiring and holding shares, most
employees are effectively forced into selling the
shares immediately - i.e. on the exercise date - to
avoid any adverse consequences. But, can you
imagine the impact on a venture company's share
price when five or six optionees "dump" hundreds
of thousands of shares into the market? This does
nothing to encourage employees to hold company
shares. And it can mess up the market for a thinly
traded security.
From an investor's perspective, there's a huge
downside to options, namely dilution. This is significant. As an investor, you
must remember that, on average, 20% new shares can be issued (cheaply) to
optionees.
The routine granting and subsequent exercising
of options can quickly compound the outstanding share balance. This gives rise
to "market capitalization creep" - a steady rise in value of
the company attributable to an increased stock float. Theoretically, share
prices should fall slightly as new shares are issued. However, these new shares
conveniently get absorbed, especially in hot markets.
As an investor, is it easy to find out what a
company's outstanding options are? No, it's not easy and the information isn't
updated regularly. The quickest way is to check a company's most recent annual
information circular (available on www.sedar.com).
You should also be able to find out how many options have been granted to
insiders from the insider filing reports. However, it's tedious and not always
reliable. Your best bet is to assume that you're going to get diluted by at
least 20% every couple of years.
The belief that options are better than company
bonuses because the cash comes from the market, rather than from corporate cash
flows, is nonsense. The long term dilutive effect is far greater, not to mention
the negative impact on earnings per share.
The term optionaire has been used to
describe lucky option holders with highly appreciated options. As these
optionaires become real millionaires, corporate managers must ask themselves if
their payouts are really justified. Why should a secretary earn a half million
dollar bonus just because she had 10,000 "token" options? What did she
risk? And what about those instantly rich millionaire managers who decide to
make a lifestyle change and quit their jobs? Is this fair to investors?
So, what's the bottom line? Whereas options are
great, like most good things in life, I think they have to be given in
moderation. As much as stock options can be a great carrot in attracting talent,
they can also backfire as we've seen in the above example. And, in cases where
they do really achieve their purpose, investors could argue that humungous
windfalls may be unwarranted and are punitive to shareholders.
NewMIC is born!
Last Friday (May 10th), the New Media
Innovation Centre (NewMIC) was officially launched. The Federal and Provincial
governments jointly announced an $8 million grant to kick off this new
initiative under the new WEPA (Western Economic Partnership Agreement). This is
good news for BC's high tech sector, especially those involved with New Media
technologies.
The stated vision of NewMIC is to support the
growth of interactive new media developments through pan-western Canadian
research and development initiatives.
NewMIC’s Mandate is: Attracting and retaining excellent
faculty and graduate students in the area of new media;
Building excellence in new media innovation; Creating more skilled IT workers;
Developing better industry-university
collaboration for the purpose of technology transfer; and Providing a
technology incubation facility.
For more information on NewMIC, please visit
the website at http://www.newmic.com.
The CEO of NewMIC is well known in BC's tech
sector. He's Alan Winter and you can email him at: alan.winter@newmic.com.
NewMIC is the result of the efforts of many
dedicated individuals at SFU, UBC, BC/ASI and many others, notably
ann lévi-lloyd who can be reached at ann@newmic.com.
ann (she likes lowercase letters) is NewMIC's Business Development Officer.
IPO Watch
On the IPO (Initial Public Offering) front, it
looks like Autoskill International Inc of Ottawa will be floating an
issue. You can see a preliminary prospectus at SEDAR (wwww.sedar.com). In
checking with TD Waterhouse I was informed that preliminary pricing on the
offering is in the $3.75 to $4.25 range with final pricing expected to be
announced on June 2nd.
The IPO market is a little uncertain at the
moment. Many recent local IPOs (Absolute Software, 360Networks) are trading
below their offering prices.
Capital Pool Corporation (CPC) Update
In this column, I keep track of Capital Pool
Corporation ("CPC") companies (see chart below) as defined by the
former CDNX because they may provide funding to, and in the process acquire,
technology companies. CPC's are the continuation of the former VCP and JCP
programs on the Vancouver and Alberta Stock Exchanges.
I like CPCs from an investment perspective.
Although one may regard them as speculative (indeed, they are), they are also an
inexpensive way of getting in early and inexpensively. You can pick up 10,000
shares of a typical CPC for less than $1.00. And when it does what is expected,
you can reap a nice reward.
Since the May 5th update, new CPC additions to
the list are Advanced Sensing Systems
Inc. (Calgary), Baden Technologies Inc. (Calgary), Caliente
Capital Corp., Copacabana Capital Limited, eVenture Capital Corp., First Trimark
Ventures Inc., French Riviera Capital Inc., SNL Enterprises Ltd., and
Southport Capital Corp.
French Riviera Capital originates from Quebec, and Copacabana Capital originates
from Bermuda.
The following companies have now come to trade: Bearclaw Capital Corp.,
Kingfisher Ventures Inc., and Sitec Ventures Corp. have come to
trade.
Check our
Venture Capital
Pool chart for a complete updated list of the CDNX's CPC and VCP companies,
thanks to David Ing of Pacific International Securities.
Upcoming Events
The upcoming May 23rd event will feature Rory
Holland (of Itemus, formerly Vengold - one of BC's internet incubators)
as emcee on the subject of CEO War Stories. Come and get the inside scoop from
leading high tech CEOs. We'll hear about the Good, the Bad, and the Ugly from Ian
Wilkinson, CEO of Radical Entertainment, Rick Moignard, CEO of
Chancery Software (see full page story in this week's May 3rd issue of
the Globe and Mail) and Greg Kerfoot, President of Seagate Software.
Book now - this will be another sell-out event.
The annual dinner event on June 27th will
feature Jim Yeates, CEO of Burntsand Inc (TSE:BRT) as the keynote
speaker.
Information on these events may be found
on-line at http://www.vef.org.
Footnote
The Numbers Game - Canadian Internet related
companies are down 58% from their 52-week highs BUT up 352% from their 52-week
lows according to Research Capital Corp of Vancouver which surveyed 61 Internet
companies ranging from Nortel Networks Corp (TSE:NT) to smaller CDNX
ventures like eDispatch.com Wireless Data Inc (CDNX:EWD) which is up
1319% from its 52 week low.
Vancouver's Province tabloid newspaper paid
tribute to Totally Hip Software (CDNX:THW) for its web design products.
Totally Hip took two of the eight top awards at the Apple World Wide Developers
Conference in San Jose, Calif. It won "most innovative entry" and took
second-place honours for "best adaptation of technology."
The article noted that while QuickTime's cut of the market may be modest, many
professionals consider it to be the
best technology. "RealPlayer is leading the market share, but it's nowhere
near as powerful as QuickTime," said Totally Hip general manager David
Dicaire. Presently trading around $.70 (52-week range $.27 to $1.60), it may fit
into your speculative portfolio. Perhaps it'll become a corporate takeover
target.
Finally, keep an eye on Pivotal Corp (NASDAQ:PVTL).
There are some interesting rumours (of the positive kind) floating around.
Michael Volker is the
Director of the University/Industry Liaison Office at Simon Fraser University,
Chairman of the Vancouver Enterprise Forum, and a technology entrepreneur. He
owns shares in many of the companies he writes about. Contact: mike@risktaker.com.
Copyright,
1999.
What Do
You Think? Talk Back To Mike Volker
Tech Futures is a bi-weekly column that
focuses attention on new and emerging BC publicly listed technology companies.
Mike Volker is the Director of the University/Industry Liaison Office at Simon
Fraser University, Chairman of the Vancouver Enterprise Forum, and a technology
entrepreneur. He owns shares in many of the companies he writes about.
Contact: mike@risktaker.com
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