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Time to Pay the Piper

Lured by the prospect of Internet gold, your best and brightest are pouring out the door. But maybe there’s something you can do about it.

Some blame the stratospheric salaries of folk like Margaret Whitman of eBay and Richard Braddock of Priceline.com; others grumble about those pesky venture capital firms that insist on having experienced management at the helm. But culpability aside, the fact is every day seems to bring another headline: “Something.com hires John Doe of [Fortune 500 firm name here].”

In the last eight months alone, Amazon.com filled three top seats with such defectors, snaring its new president, Joseph Galli, from Black & Decker in June, then enticing a new CFO, Warren Jenson, from Delta, and a chief logistics officer, Jeffrey Wilke, from AlliedSignal. Even the brand name powerhouses aren’t immune-AT&T, Microsoft, and Disney have all seen leadership talent succumb to the temptation of equity stakes in the dot-com world.

And who can blame them? After all, the upside potential can be enormous-witness Robert Glasser, chief executive of Real-Networks, who left Microsoft in 1993 to found the Web media delivery company and by 1998 had amassed a whopping $1.12 billion in equity. Assaulted with a litany of similar tales, executives like Bill Malloy, who walked away from AT&T’s $6 billion wireless business to head Peapod, the nation’s leading Internet grocer, are following suit. “If somebody gets an offer that’s just astounding, there’s nothing I can do,” shrugs Michael Armstrong, chief executive of AT&T. “You shake the guy’s hand and say, ‘I understand what happened and good luck to you.’ “

It’s a given that such leaps are fraught with peril. “With all the great, successful IPOs, there are thousands more that never make it,” points out Dan Rosensweig, president and CEO of ZDNet. “You can have dreams of making instant billions, but the majority of Internet start-ups, as we’ve seen, fail.”

Yet the rash of high-profile success stories has potential recruits discounting the downside, which is easy to do. While statistics show that only one out of every 30 dot-corn start-ups actually go public, the true risk is hard to gauge. “There’s really no way to quantify what percentage of companies are successful-whether you define that as one, going public; two, being a sustainable entity even if you don’t go public, or, three, being a public company that then increases its share price over a given period,” notes Russ Miller of SCA Consulting. “Everyone hears about the successes and that’s what is skewing the perception. There are hundreds of thousands no one has ever heard of because they never never get on the radar screen.”

What’s more, where in the past dot-com recruits usually swallowed a cut in pay along with a loss of perks for the privilege of stomaching uncertainty, such sacrifices are often no longer necessary. “Because of the infusion of cash from the venture capital firms, many dot-com start-ups can offer competitive salaries plus rich option plans,” says Carl Weinberg, a principal at PricewaterhouseCoopers, which recently published a study on compensation at public Internet firms. “A $6 billion Silicon Valley firm we’re working with recently told us: ‘We never lost employees to start-ups before, because our people have mortgages to pay. But now the start-ups offer the best of both worlds-decent base salaries and more options than our institutional investors will allow us to grant.’ “

And then there’s that start-up high. “Some people are excited about working at an earlier stage company,” says Anthony Scott, managing director at A.T. Kearney. “It can be more exciting than working at a traditional firm where there’s so much inertia, so much history, that your ability to put your own stamp on it is limited.”

With risk dismissed as negligible and pay cuts no longer an issue, what began as a trickle from bricks to clicks has swelled to Mississippi River proportions-sending mainstream firms scrambling for creative ways to shore up the flood walls. “Mature firms are clearly trying to increase the stock option rewards they offer not only to senior executives, but throughout the company,” reports Scott. “Many are also creating, or looking at creating, measures like long-term deferred rewards, phantom equity, tracking stocks, and spinoff subsidiaries.”

At well-established firms, the move toward distributing equity incentives down the line rather than solely to company officers has gathered momentum over the past decade. One of Michael Capellas’ first acts as Compaq’s new CEO was to decree that all employees “down to the people on the shop floor” receive options. “That’s normal for a start-up,” he says. “It’s not so normal for a manufacturing company. But these days, if you want to stay in business, you have to run your business like a start-up.” Progressive companies like Johnson & Johnson, Intel, Pfizer, Hewlett-Packard, and Motorola already grant options to between 96 percent and 99 percent of employees. But most mainstream firms lag behind, allocating the lion’s share of grants to the CEO and top officers.

“I’ve always been appalled at the lack of ownership that exists outside Silicon Valley, where stock option programs have been the methodology of financial incentives for years,” says Kevin Kalkhoven, CEO of Uniphase, who credits his company’s policy of granting equity to 100 percent of employees for contributing to its low turnover. “It’s new in the mainline businesses. If you’re a retailer selling coats who hasn’t given options, you’ll have to with coats.com. But maybe you should have been doing that for the last 20 years anyway.”

For most companies, dramatic changes to carefully constructed-and inevitably political-compensation structures are anathema. And the annual grants of 15 to 20 percent of total stock to employees and 25-plus percent in total overhang typical for start-ups are simply out of the question. “It’s a huge departure for mainstream companies who are familiar with annual grants of 1 to 3 percent and total overhang of 10 to 15 percent,” says Miller. “So instead they say, ‘We’ll increase our standard compensation practices for our Internet divisions to approach the Internet marketplace, but not to reach it.’ “

The theory is that lower risk assumption balances out the lower upside opportunity. But employees of mature firms don’t always see the risk-reward tradeoff that way. “In terms of attracting and retaining talent,” reports Miller, “mainstream firms are having some success, but they’re not hitting as high a number as they would if they were fully competitive.”

Of course, even if all mature firms were to adopt the standard Silicon Valley practice of bestowing options on all employees, the value of the grants would pale in comparison to equity stakes in fast-growth companies like Ebay, Amazon.com, and Priceline. The dot-corn envy spawned by this gap is particularly acute for employees of firms with Internet initiatives, where share price potential can be weighed down by the parent company’s stodgy image. “There are two types of companies involved, those that don’t have an Internet business, but are losing executives to Internet opportunities, and those that have Internet businesses within their mainstream company and are losing those Internet executives to other Internet opportunities,” adds Miller. “A year ago, most of the mature firms with Internet divisions were just doing business as usual. But companies have started to realize that they need to be more competitive with the Internet marketplace in order to attract and retain talent.”

Most look first to money, instituting retention bonuses or phantom stocks for employees of their Internet businesses-usually with varying success. “We tell clients not to bother with retention bonuses, because they rarely succeed in retaining employees,” says Weinberg, who points out that cash-rich dot-corns can easily counter with a deferred signing bonus. “When retention bonuses succeed they hold the wrong people-the ones who hang around for their bonuses because they don’t have compelling counteroffers.”

More complicated, phantom or shadow equity uses internal methodology-a formula tied to revenues, for example-to award additional pay to employees of a business unit as the value of the unit increases. The flaw here lies in the lack of marketplace funding. “Most Internet businesses are not using phantom plans, and one of the key reasons is because of the funding requirement,” says Miller. “A true stock option plan is funded ultimately by the market.”

Such ghost stocks also do nothing to fill the company coffers. “Shadow equity can be helpful for a certain group of employees because it gives them incremental cash compensation down the road,” points out Rosensweig. “But what it doesn’t do is create a currency for acquisitions, and that’s incredibly important to grow at the rate the Internet requires you to grow.”

MAKING TRACKS

Increasingly, traditional firms are exploring a controversial solution to the talent dilemma-issuing tracking stocks for rapid growth tech-oriented divisions. “Disney had a huge problem attracting and retaining talented people for its on-line ventures because it can’t offer the same kind of upside potential on the equity that employees could get somewhere else,” notes Scott.

After losing several executives to high-flying Infoseek, Disney took the if-you-can’t-beat-’em-eat-’em approach. In November of 1998, it bought a 42 percent stake in the upstart search engine to jointly develop the Go Network portal, and then acquired Infoseek outright a year later. Disney now plans to package Infoseek and Go Network with its other Internet assets in a new Go.com tracking stock. Similarly AT&T, which already has a tracking stock for its Liberty Media division, recently announced plans to float a stock for its cellular business. Tracking stocks for its Internet and business services divisions are reportedly on the drafting table.

But whether the share prices of Go.com and AT&T’s new issues will go the rapid ascent route of their standalone Internet peers remains to be seen. “The problem with a tracking stock is that it’s intended to trade based on the performance of the division, but it trades at a significant discount to what it would if it were really a bona fide stock,” explains PricewaterhouseCoopers’ Weinberg. “One of the things that buoys the value of Internet stocks, particularly smaller ones, is the potential acquisition premium, which is anticipated and built into the stock price. You don’t have that with tracking stocks because there’s no fiduciary requirement for the parent to be mindful of minority shareholders. The parent has control and would have to decide to sell the division or its assets.”

Yet Disney and AT&T are far from the only mainline companies planning to float tracking stocks. Microsoft, Oracle, and Staples are among the many firms adopting or considering similar measures. Issuing new classes of stock will highlight the performance of the individual business units and offer a clearer look at their impact on overall earnings. The hope is that even if the share prices of these new classes of stock don’t climb as fast-or as high-as their standalone sisters, they can also achieve the twin purpose of raising capital and stemming the brain drain. After all, it worked for companies like Ziff Davis and Donaldson, Lufkin & Jenrette, both of which followed on-line launches with tracking stocks. Ziff Davis, which moved onto the Internet in 1996 with ZDNet, floated its ZDZ tracking stock in March of 1999. “We began to understand that in order to have a currency to acquire companies and grow on the Net, as well as have a currency that re ally motivated employees in the new Internet economy, we needed to have our own public offering,” explains Rosensweig. ZDZ hit its $55 high for the year immediately after the float, then tumbled to $13 before climbing back to where it now hovers at $25.

“We were able to grant equity to 100 percent of ZDNet employees,” reports Rosensweig, who feels that while ZDZ is undervalued relative to its standalone competitors, the tracking stock has achieved its purpose. “They recognize that we’re undervalued and they know that if they keep plugging away, building our unique visitor multiples and our revenue multiples, we will realize that value, and that’s exciting to them.”

Presumably, Rosensweig’s employees also know that ZDNet isn’t going to go away. In fact, the recent sale of Ziff Davis’ education unit and print publishing holdings underscore the parent’s commitment to the future of its e-business division. “Having a parent company gives us a nice balance,” says Rosensweig. “We have the security of a non-startup, which means there was no question about whether we would get appropriate funding and do an IPO, or whether our employees’ jobs were at risk.”

SPIN CYCLE

While Ziff Davis and Rosensweig seem content with the parent-offspring relationship, many view tracking stocks as a first step toward the preferable route of hiving off an Internet business altogether. “Analysts and the financial community aren’t really accepting tracking stocks,” says Pat Pittard, chief executive of recruiting firm Heidrick & Struggles, “because they’re really nothing more than an accounting gimmick. I would much rather see an honest-to-God corporation-a real spin-off-that’s held responsible for its operations.”

A true spin-off can also help create the entrepreneurial working environment seen as contributing to the lure of the Internet -and its success. Barnes & Noble launched a tracking stock for barnesandnoble.com before spinning the venture off into a separate entity, as did Creative Computers with its uBid on-line auction site and Delias with the teen site iTurf.com. The drawback? With the financial machinations required, spinning off a division is a lengthy and involved process-and one not to be taken lightly.

“If you’re going to commit to this new vision of the world, you have to commit to it,” cautions Weinberg. “As employees transfer to the dot-corn business, it should be understood that they have one-way tickets. Often when traditional companies designate someone for a spin-off, if things don’t work out you can reapply to the mother company. That’s not a smart move in the Internet world. The people who are going to make the business work are the ones who believe in it. You don’t change the world on a trial basis.”


 

The Waiting Game…

 How Much is Hype?

Not everyone is panicking at the prospect of a mass exodus to the dot-com prospect of a mass exodus to the dot-com world. Some see the Internet gold rush as just another natural business cycle-which, like any other, will soon run its course. “It’ll be interesting to see what will happen when you roll this out three to four years,” says Ron Burns, president of global business at J. Walter Thompson. “By then we’ll have seen whether the dollars really exist the way that the initial period suggested they would or if a more rational view of the world evolved-such as that you actually have to make money to build equity or value.”

Uniphase’s Kevin Kalkhoven is betting on the latter. “It’s not as if this is a huge social revolution that will overturn the wealth in the U.S.,” he says. “First, a lot of this new wealth is on paper, and, second, it’s time dependent. Most of the stock option programs vest over four to five years. When we look back at the end of that period I think we’ll find that those people really didn’t make such vast amounts of money.”

As Kalkhoven sees it, the dot-com explosion-like any other trend in the high tech industry-will have a limited lifespan. “It’s a natural cycle,” he shrugs. “The pendulum swings too far in one direction and then it swings back again. If you go back to the late ’60s, computer technology was all about time sharing, and executives in that industry got paid huge amounts for four years until it sank beneath the ocean. The reality is that within three to four years 80 percent of dot-corns will have disappeared.”

In the meantime, some attrition is inevitable-which is just fine, says ZDNet’s Dan Rosensweig. “There’s a percentage of the Internet economy that’s driven totally by money,” he says. “There are a lot of companies where employees are staying because they’re equity locked. They’re no longer contributing. Those people are just punching a clock. They’re just going to jump from company to company to company. We’re not interested in them.”

For the rest, good management coupled with equity incentives will stem the tide, adds Kalkhoven. “If you build a successful company, people won’t want to leave,” he asserts. “Part of the recognition of that success is the value of their stock options and another part is that the image of the company you’re with is a reflection on you. People say, ‘Wow, you’re with Sun Microsystems.’ “

Effective mentoring can also help debunk the myths of Internet gold, adds Burns. “Having young folk today with visions of sugar plums dancing in their heads and the thrill of reading headlines that somebody can go from zero to $100 million in 30 minutes is one of the pressures of business today,” he concedes. “We have to match that with the vision that developing both sides of the ledger-the power of traditional brand building and the nontraditional side of things like Web sites, e-commerce, and digitized media-is as exciting, if not more so. That, along with the fact that, yes, it is possible to make money in this business today, gives you the opportunity to talk to them. It’s our responsibility to excite the young people of today about those possibilities.”

About Jennifer Pellet

As editor-at-large at Chief Executive magazine, Jennifer Pellet writes feature stories and CEO roundtable coverage and also edits various sections of the publication.