Category: Investing/Markets

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.

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.

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.

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.

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 Office™ 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.

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.