Stock Options: The Ugly Truth

With stories of Internet start-ups trumpeted day and night, sometimes it seems like everyone who can spell computers is getting rich. So it's only natural for IT pros to dream of a professional short-cut to the good life -- one paved with stock options.

It's little wonder that options have become a standard tool in corporate compensation kits. A stock option is a promise that someone can buy shares of a company in the future at a previously fixed price.

It sounds great: If the stock does well, employees can make healthy profits with no outlay until they exercise the option, either when a start-up has an initial public offering (IPO) or when the stock of an already publicly held company rises. But be cautious. Options can be a big gamble and they come with strings that pull you when you want to push on.

Not everyone in information technology gets stock options. Many Fortune 500 firms often provide them only to senior managers or those with skills that are in especially high demand and short supply. The real options bonanza is at start-ups, which don't have the money for high salaries but hope to make good on their tremendous growth potential. But a start-up's stock options don't come with guarantees.

David Alward and Anup Patwardhan worked at Sun Microsystems Inc., where stock options were available "only to various elite people," says Alward. Rather than dream of options, both men left within a few months of each other to work for the same Internet start-up: Inc., a San Mateo, Calif., firm that provides free Internet messaging services.

"Living in the [Silicon] Valley, you're out of luck in buying a house, and stock options make that dream a possibility at some point," says Alward, an operations engineer. Patwardhan, a systems engineer, says he also hopes to buy a house -- as well as have some financial reserves when he gets married next year.

They may get their stake, but the odds are against it. Many companies fail before getting to the point of launching an IPO, making the options worth nothing more than a pile of scrap paper.

Before heading the IT practice in the Oak Ridge, Tenn., office of consulting firm Radian International, Ken Hill experienced the downside of stock options at a venture capital-backed start-up. He had options to buy stock at well under $1 a share at the start-up, but the company went belly-up, not public.

"In a venture-funded company like that, they will go and go and go until some point when you can't quite make the payroll," says Hill. He received no options at Radian, but he says options are just one factor to consider when weighing a job opportunity.

"The reason for accepting at Radian was the stability and the opportunity for growth," says Hill. "They were expanding their information technology business, and I had a chance to be a large part of that."

It's important to remember that stock options aren't a form of altruism. Companies have specific reasons for offering them. One reason is that they might expect employees with a vested interest in the business to work harder. Another is to decrease the amount of money they have to spend on salaries. A start-up, for example, is unlikely to have as much money as an established company would have for payroll. Instead, it can offer more modest compensation and sweeten the deal with options.

What many potential stock recipients forget, though, is the third purpose of stock options.

"The whole point of options is to put handcuffs on people," says Jeff Leon, managing director at the New York office of recruiting firm Russell Reynolds Associates Inc. Employees usually don't receive all their options at once. Rather, options typically vest, or become active, over three to five years.

Someone receiving $30,000 in options might get 20% of them per year, with receipt of each block contingent on remaining at the company. Leave prematurely, and those nonvested options go up in smoke.

That's if the company plans to file an IPO. A recent Ernst & Young LLP survey of Internet start-ups, showed that almost half of the companies studied had no plans to go public in the foreseeable future.

However, even if an employer does makes it big with an IPO, there's no guarantee that employees will too. According to Christopher Loiacono, a certified public accountant and a tax partner at Richard A. Eisner & Co. in New York, having an option doesn't mean you always make money off stock. The bulk of options are so-called nonqualified, which, upon being exercised, are treated as income and are subject to withholding taxes.

"Between coming up with the exercise price and the taxes, you could be left with less than 50% of what you think you have," says Loiacono.

Furthermore, when a company goes public, the underwriters -- financial people who make the process possible -- typically require a lockout period of six months to a year during which employees can't sell their stock. If the stock price peaks early and then drops, gone is the chance for a quick killing. There's also no guarantee when shares will be registered, a necessary step to being able to sell them. Employees may have nonliquid assets for a long time.

The best strategy is to look at options as gravy, not as the main reason to take a job, says David Schnitt, national director of IT services at Santa Ana, Calif., outsourcing company Resources Connection Inc.

If people don't have that outlook, they "may end up working at companies they don't like or working with people they don't like," says Schnitt.

Copyright © 2000 IDG Communications, Inc.

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