Sunday, July 23, 2006

 

Silicon Valley Invents Time Travel


Brocade Communications, a data storage company based in San Jose, has invented the time machine. What geniuses are responsible for this momentous development? Was it some phat guru of a Ph.D. in plasma physics, superconductivity or electrical engineering? Fat chance. Brocade's accountants did it. They devised a financial time chariot known as a back-dated stock option, and their CEO, George Reyes, was the intrepid chrononaut who pulled the switch. Mr. Reyes and his head of human resources have been charged with criminal fraud for artificially changing the dates on stock options offered to prospective employees so that they would appear to be getting the options at a lower price. Whether or not these stock options would actually have been worth anything when the employees eventually chose to exercise them is uncertain. What is beyond doubt is that the practice is unethical and dishonest. The courts will ultimately demonstrate whether or not it is truly illegal.

Observers of the scandal have noted that Brocade is unlikely to be the sole inventor of this dubious financial technology. They are just the only ones to be caught so far. Hundreds of other high tech firms have lured new hires with stock options before, during and after the dot com boom. It is a time-honored method of recruiting hot young cyberstuds to pump out the code for you at minimum salaries. Promise them a fortune in stock options to keep them from feeling underpaid. If your startup offers the stock options before an IPO takes place, the worst that can happen is the options become worthless, a mere sucker punch to the naive but greedy. Once the IPO takes place though, the stock options any spanking new company offers are real - or can be - but even then they won't be worth very much if the stock doesn't rise in price. Hence, the temptation to fudge the dates on the options so that the price will be as low as possible. Most business journalists believe such cheating was widespread, and constitutes yet another black eye to our already bruised memories of the dot com boom. Like Leibniz and Newton simulcasting calculus, CEOs all over Silicon Valley no doubt hit upon this shady innovation all at once.

Some journalists are unsure how harmful the practice really is. They emphasize that, since stock options are rarely exercised immediately, there is still a grace period during which the original prices of those stock options could be readjusted to what they would have been at the time they were offered. That would rectify the effects of the fraud, if not excuse the fraud altogether, and might just placate the SEC. The problem is that the employees who were offered the stock options at the lower price would still be cheated. The moral of the story, at least from the workers' point of view, is to always distrust any compensation other than cold hard cash.

"Scandal blights Silicon Valley " from the International Herald Tribune
"SEC, prosecutors file stock-option charges" from MarketPlace
"Companies Should Confess, Correct Backdating" from the New York Sun
"2 Are Charged in Criminal Case on Stock Options" from the New York Times

Comments:
Patrick
The question that still has to be answered is besides cold hard cash, when companies cannot offer that, what else could be offered to offset risk being taken.
Its very easy to say look only at cash. As you know most startups do not have excess amounts of money lying around to give prospective employees. So they give out options - so their employees benefit from it. Now, what is your suggestion to offset it.

I can think of possible restricted stock and maybe stock grants, but they have their own issues.

Mukund
http://blog.vangal.com
 
Karna,

You're entirely correct. Stock options are an effective and worthy incentive, when handled ethically. I am myself not entirely certain exactly who suffered most from the Brocade scandal - other than the truth. Stock options have indeed enriched many people who would not otherwise have earned so much so quickly. On the other hand, offering stock options in lieu of salary can (and has) generated false hopes and expectations in the hearts and minds of many. Also keep in mind that I counsel not outright rejection of stock options, but mere distrust - and distrust can sometimes be overcome.

Still though, I am always glad to engender a response with whatever I post on the White Collar Warrior.

Patrick Hellwood
 
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