Stock option expensing

Jeff Nolan has a good overview of stock option expensing, and why we should get involved. While I agree for the need for complete transparency of stock options, I also do not believe that expensing all options at the grant date will get us closer to true economic reality. In addition, I believe the unfair burden of stock option expensing falls on private companies-FASB even recognizes this. As for public companies, the market will adjust and look at numbers with and without option expensing, converging on what all other investors use. So from a public market perspective, while hurting the perceived earnings of a number of companies, I do believe that expensing stock options will not make as big a negative impact as some think. We all know that investors will use a number of different proforma income statements to designate value anyway whether or not options are expensed.

Therefore, what concerns me is what happens to the non-executive employee at public companies and how stock option expensing affects private companies. Rather than go into a diatribe on the ineffectiveness of Black Scholes and the Binomial Pricing model, I want to focus my efforts on what happens when stock option expensing goes into effect. It will eliminate broad-based option pools for public companies and private companies. Why? It is easy for me to say that the market will be efficient and see through all of the numbers creating its own set of rules for valuation. However, companies will choose the path of least resistance which means keeping the income statement as clean as possible which means eliminating broad-based option plans and the variability that comes with it. If anything, companies may give restricted stock to executives and other key players but not to all employees. The bigger concern is that the extra reporting burden it creates for private companies will be quite costly and burdensome, possibly outweighing the positive effects of issuing broad-based options. Without options, this will make it harder for cash-starved private companies to attract talent as they will not be able to pay the cash compensation that larger companies can afford. Since I am in the business of funding private companies (a big engine for job growth) that use an ESOP as a competitive tool to attract talent, I am concerned by the FASB proposal. Therefore, I ask you to get involved while FASB is in its review period and write to them:

Go visit Jeff Nolan’s post for links to articles to further educate yourself on the stock expensing issue and to learn how to get involved. As per his post:

– emails should be directed to director@fasb.org with a cc: to jcdowling@nvca.org – if you have specific questions about the proposal, Michael Tovey is the project director for this at FASB, his email is mtwovey@fasb.org – your email should reference file # 1102-100

I would also keep an eye out for a new bill (H.R. 3574, the Stock Option Accounting Reform Act) being pushed around Congress. According to CFO Magazine,

The bill would require the Securities and Exchange Commission to complete an economic impact study before FASB is permitted to implement its proposed rule. In addition, the bill would require companies to expense only stock options granted to the CEO and the next four highest-paid officers. Small businesses would be entirely exempt from FASB’s rule; newly public companies could forgo expensing for three years.

While a compromise this bill does partially address my concerns about hurting private companies and the regular employee.

Has the individual investor learned a lesson?

There have been a number of IPO fillings recently, but the one that intrigues me most is the filing by Lindows. As many of you have read, Lindows/Linspire just filed an S-1 to raise $57 million in an IPO. WR Hambrecht is the lead underwriter and will utilize its dutch auction methodology to raise money from individual investors. In my mind, what happens with Lindows will be a barometer of the psyche of the individual investor. It well tell us whether or not the individual investor learned a lesson from the bubble. It will tell us whether or not speculation will run rampant again. As you know, I do find Linux on the desktop intriguing. That does not mean that I believe this is the year and that you should go public now on $2.1 million of revenue in 2003 with a net loss of $4.1 million. On top of that, of the $57 million they are raising, $10 million is going to pay off Michael Robertson, the CEO, for a line of credit he extended the company over the past couple of years. As per the filing,

The approximately $10,400,000 of net proceeds that we intend to use to repay outstanding debt obligations will be paid to Michael L. Robertson, our founder, Chairman and Chief Executive Officer, as payment in full of all remaining outstanding amounts under a revolving line of credit. Mr. Robertson has advanced us funds under the line of credit since July 2002, including advances of $5,600,000 during 2004. Amounts borrowed under this loan are used for our operating expenses. The loan bears interest at the rate of 10% simple interest per year and matures on June 30, 2005.

So not only is this a speculative offering, but also one where the largest shareholder gets paid back $10 million off the top. Michael did pay $4.5 million for the shares that he currently owns but 2/3 of his total capital will be off the table. So how much skin in the game will Michael really have to make this company work? Does this sound like a good investment to you? I am not opposed to the dutch auction and do believe that the methodology has a place in some deals. My big fear is that if this deal does happen, it will only confirm my belief that the individual investor never learned a lesson from the bubble. For the individual investor to forget so quickly about all of the pain and suffering we just went through really scares me.

Merrill Lynch launches nanotech index

It was just a matter of time before an investment bank launched a nanotech index. During the bubble years we had an index for everything ranging from Internet ad-related companies to Internet commerce companies. Now we have a nanotech index. Is this a sign of another bubble? Well, it is true that nanotech is overhyped now, but I have no doubt that it will one-day be a pervasive technology that will drive growth in alot of industries ranging from materials to semiconductors to health care. Merrill Lynch’s Nanotech Index is an equally weighted index of 25 companies that derive a significant percentage of their future profits from nanotechnology. I encourage you to visit Merrill’s site for a copy of the report. Steve Milunovich, Merrill’s technology strategist, summarized as follows:

Mr. Milunovich noted that there are two significant differences between the Internet and nanotechnology. “Unlike the Internet, significant intellectual property and patents are barriers to entry, and yet barriers to adoption are low.”

Nanotechnology is the science of fabricating things smaller than 100 nanometers. One nanometer is one-billionth of a meter. Merrill Lynch believes nanotechnology is the next logical step in miniaturization and that it is only a matter of time before the impact is felt in many industries. “Building at the nano-scale enables new interactions in materials, semiconductors, and biological agents,” said Mr. Milunovich. “The new scale allows manipulation on the cellular level, which should enable new discoveries in pharmaceuticals, biodefense, and many healthcare industries.”

I am not a nanotech guy, but IMHO, I have no doubt that nanotech will be big someday and it is really only a question of when it will happen. While I am not actively pursuing this from a VC perspective now, I am going to track this index for personal interest to get a better understanding of what companies are doing with nanotechnology and how they perform over time.

Update-Rich Skrenta suggests visiting the Topix Nanotech page for those interested in daily updates which are not heavily research oriented.

The Street Does Not Forgive

I was with a banker today talking about the influx of new IPO filings and the end result of our discussion was the following:

1. Filing does not mean anything, the companies may never go public
2. Performance is key-revenue visibility is of utmost importance because the street does not forgive

Case in point-if you miss your numbers within the first two quarters after you go public, forget about it. Take a look at Callidus Software which is a provider of Enterprise Incentive Management software systems to global companies, used to model, administer, analyze and report on incentive compensation, or pay-for-performance plans. The company went public in mid-November, hit a high of close to 21 and was recently punished for preannouncing a shortfall in revenue. The stock now trades at $8.34.

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Here is what the CEO had to say:

“Callidus Software, like many enterprise software companies, transacts a significant portion of its quarterly business at the end of each quarter,” stated Reed Taussig, president and CEO of Callidus Software. “Our quarterly license revenues are dependent on a relatively small number of large transactions involving sales of our products to customers, and any delay or failure in closing one or more of these transactions could adversely affect our results of operations. In this quarter, we failed to close several transactions due to customers’ merger and acquisition activities. In addition, a number of customers failed to conclude contracts due to their timing or budgetary considerations. We are disappointed with these results. However, we continue to be optimistic about our business, given the potential of the emerging EIM market, our product position, and our strong customer base. We will address second quarter and full year guidance on our planned April conference call.”

So if you want to go public, please make sure you have the visibility in your sales pipeline to hit your numbers the first couple of quarters out of the gate. What this also shows is the enterprise software business is a tough game. It is difficult to sell large licensed software and have real predictability. Salesforce.com will be an interesting company as their hosted, subscription model gives real strong visibility on future quarters. That being said, if you want to go public, you need strong pipeline coverage to make up for potential end of quarter jockeying by potential customers. You need good recurring maintenance revenue. Don’t overpromise on your initial quarters post-IPO, give yourself some cushion to exceed financial expectations. Because if you don’t, the street will not forgive.

A tale of two IPOs

So while I was at PC Forum, my partner, Ned Carlson, sent me an email on the recent IPO filing of Seven Networks. Having talked to a number of bankers, we always thought that one needed $6-8mm of quarterly revenue, profitability for at least 1-2 quarters, and good visibility for the rest of the year in order to go public. It seems that the filing for Seven Networks goes against the grain. According to its website, “SEVEN is a leader in Out of the Officeâ„¢ technologies; our mobile email software makes it simple and affordable to access corporate and personal data while on the go. SEVEN’s software provides secure, real-time access to email and PIM information via a wide variety of mobile devices.” The company has a blue chip list of customers like Cingular Wireless and Sprint PCS in the United States; Globe Telecom, KDDI Corp, NTT DoCoMo, Optus and Singtel in Asia Pacific; and mmO2 and Orange in Europe. However, we still do not understand how it can go public with the following numbers: 2002 revenue of $6mm, net loss of $19mm and 2003 revenue of $7mm and a net loss of $13mm. What bothers my partner, Ned Carlson, even more is that some of the investors are even selling in the $100mm raise. What I hear is that they are going to execute a roll-up strategy. Isn’t Visto already doing this as well? Does anyone know the story behind this IPO filing?

On another front, you have Brightmail (an anti-spam vendor) which recently filed with some nice numbers. Revenue for FY03 was $26mm up from $12mm the previous year. In addition, the company had net income of $1.2mm for FY03. These are definitely numbers in line with what we were told on the IPO front. Concerns could be the concentration of customers via Microsoft. According to the Computer Business Review in the UK, of the 305 million mailboxes they screen, 145 million are Hotmail and only 5 million are enterprise.

It is amazing how 2 companies with such different numbers can file. All I hope is that both of these companies can meet the expectations of investors and deliver on their respective stories. What we all do not need is a return of the speculative IPO. Tim Oren and Fred Wilson both comment on the action this week.

Citrix buys GoToMyPc maker, Expertcity-great day for ASPs

Congratulations to Expertcity and Andreas, John, and Klaus. It has been great to work with you from a board level over the last 4 1/2 years. When the transaction closes, I look forward to writing a little more about how you were able to persevere through some tough times, launch new product, stay focused on leveraging the core screen sharing technology, and build a high growth business in a completely new market. Not only were you an early player in remote access, but you also were one of the first ASPs out there.

Expertcity is not the only ASP making headlines today. Salesforce.com filed to go public and raise $115mm. As I mention in an earlier posting about Google and IPOs, pre-bubble, it took companies 4-6 years from their first round of funding to IPO/acquisition. During the bubble it took 1-2 years. While I am excited about today’s announcements and other recent deals like VMWare (bought by EMC) and Zonelabs (bought by Checkpoint), it is obvious that we have returned to a pre-bubble mentality and the companies that will be significantly rewarded are the ones that embody the philosophy of building real businesses with real revenue and cash flow. Well, isn’t that just business 101? Yes, and this is great news as it is something we can all understand.

Check Point makes first meaningful acquisition

So Checkpoint is going to buy Zone Labs for $205mm. Here are my thoughts on the deal. Zone is expected to do around $28mm of revenue in 2003 and $42mm in 2004. The revenue multiple is 7x for 2003 and 5x for 2004. That is pretty much in line with existing security multiples of 6-8x revenue. The more significant point is that Checkpoint made its first, meaningful acquisition. So for all of you security companies out there, add Checkpoint as another potential acquirer. Some future deals could include an SSL VPN player or network intrusion prevention provider. It seems that concerns over their revenue growth has finally hit management, and they are trying to find ways to accelerate the top line. However, I am not too sure that acquiring a desktop firewall product and competing against established competition like Microsoft, Symantec and NAI is the way to do it.

Google weighs IPO next year

Yes, this is old news and much anticipated.

Just one word of caution for us venture capitalists and entrepreneurs-let’s not equate this to a return to the mid-to-late 90s IPO boom. According to many investment bankers I have met with, today’s companies, unlike yesterday’s, need to have $10-20mm of revenue a quarter, be profitable now and not in 8 quarters, come from an established and not an emerging sector, and have a valuation based on real earnings and growth and not one on revenue. One additional note-many companies from the bubble era were able to go public 1-2 years from their first round of venture capital. If you assume a 2004 IPO for Google and Salesforce.com, both would have taken 5 years from their first round of venture capital. One can argue that Google could have gone public much earlier, but the point here is that patience is key. If you look at the historical data, subtracting out the bubble period, it traditionally took 4-6 years of development from the first round of venture financing for a company to go public.

Trust me, this is great news for venture capitalists and entrepreneurs, but let’s remember that when and if Google and Saleforce.com go public next year that the world has changed and real earnings and cash flow matter this time.

Where are they now?

Do you remember the name Jonathan Cohen? Jonathan, who was negative on Internet stocks in the late ’90s, was replaced by none other than Henry Blodget at Merrill Lynch. Henry’s $400 call on Amazon.com put him well on his way towards equity research fame or infamy. As I was catching up on my reading and looking at top performing funds for Q3, it was great to see Johnathan Cohen’s Royce Technology Fund top the charts. He did it by building positions in technology value stocks which sounds like an oxymoron but made a ton of sense if you began buying in early 2002. Many of these stocks like Maxtor were trading at or near cash at some point in time during the last 2 years.