FOOL ON THE HILL
An Investment Opinion
Options Overhang II: The Real Deal Louis Corrigan (TMF Seymor)
August 25, 1999
Last week I looked at a New York Times article that made much ado about the supposedly dangerous overhang of stock options held by the employees of Nasdaq 100 companies such as Cisco (Nasdaq: CSCO). I argued that the potential gloom and doom scenario laid out by columnist Gretchen Morgenson was overblown, in part because the employees who hold these options aren't worried about these tech giants blowing up. So these option-holders aren't glued to the ticker ready to panic on a market sell-off, even a major one. After all, we're talking about 100 of the largest, most vibrant companies on the planet.
Whereas the Times engaged in mere spookery, however, Wall Street Journal reporter E.S. Browning offered an insightful overview of an options overhang that really should concern investors, especially those who invest in Internet stocks.
As the Journal's August 16 article pointed out, 1999 has brought an absolute explosion in the number of new Internet companies tapping the public markets via initial public offerings (IPOs). According to CommScan, 29 Internet-related companies went public during 1997. In 1998, the number jumped 52% to 44. In less than 8 months of 1999, the tally of public Internet wannabes has run to a stunning 166, a 277% increase versus all of 1998.
These stats confirm what we already knew: The Internet is creating huge market opportunities, and the capital markets are doing their part to fund new enterprises that are trying to tap into those opportunities. And this frenzy of financing won't be slowed down if the venture capital (VC) firms can help it.
The PriceWaterhouseCoopers Money Tree National Survey, also released August 16, found that VCs invested $7.67 billion in non-public companies during the second quarter of 1999, good for a 104% increase over the amount invested during the year-ago period. The Q2 amount also crushed by 78% the first quarter's then record high investment total of $4.31 billion. Nearly all of this money went into technology companies, with funding of Internet-related businesses quadrupling to $3.8 billion from $947 million a year ago. Indeed, more VC money was channeled into Internet companies last quarter than in all of 1998.
With such an outpouring of new Internet issues and the widening pools of even younger upstarts hankering to go public in the next few years, investors should sit back and consider a handful of relevant facts.
First, the VCs and other early investors funding these upstarts almost certainly want to cash out some of their profits relatively soon. That's just the way VC firms operate. Second, the executives and other employees who accepted fat risks but slim paychecks in exchange for a boatload of options will want to exercise some of those options and sell the related shares in order to purchase a well-deserved new house and, yes, maybe even a sports car.
Yet, these dynamics play out against a backdrop that's not altogether favorable. For starters, not all newly public companies see their stocks shoot to the moon and then go onto Jupiter, despite the plethora of 100% plus opening day advances. Indeed, many solid Internet businesses have hit their highs on the first day of trading and then simply fallen -- and kept on falling. That's what happened to Marketwatch.com (Nasdaq: MKTW) and TheStreet.com (Nasdaq: TSCM). Insiders at other Internet-related companies may see such massive depreciation of paper profits as a sign that they might want to cash out some or all of their exercisable options as soon as possible.
In other words, new issues are completely different from the Ciscos of the world because these companies generally aren't market leaders with multi-billion-dollar market caps. They're upstarts, and increasingly, upstarts fighting for market share on the fringes of terrain staked out by giants like America Online (NYSE: AOL), Yahoo! (Nasdaq: YHOO), eBay (Nasdaq: EBAY), and Amazon.com (Nasdaq: AMZN). To put it bluntly, some of these scrappy companies simply won't be around a few years from now. The IPO money will get spent on marketing pacts that don't pay off, and they'll become also-rans and perhaps bankrupts. Or, at the very least, many of these upstarts will get eaten up by competitors, usually at a stiff discount to their market highs. N2K is proclaimed the leader in CD music sales one year only to merge a year later with CDNow (Nasdaq: CDNW), which shortly thereafter decides it must merge with the Columbia House operations of Time Warner (NYSE: TWX) and Sony (NYSE: SNE).
Employees at these companies simply don't think like Cisco's employees. They can't afford to given that their employer's long-term existence remains very much in doubt. These employees will be a bit more anxious about the market's daily action. In other words, the concerns Morgenson raised in regard to Nasdaq 100 options holders is simply far more applicable to the employees who own options in a newly public Internet company.
In a broader sense, though, such post-offering underperformance is less the exception than the rule when it comes to IPOs. The best academic data indicate that new issues generally underperform comparable companies for up to three years after hitting the market. There are many reasons for this. For starters, these are relatively unseasoned companies that can encounter serious challenges. Moreover, the underwriter's job is to guide the company to go public only when market conditions are most favorable, and to help management sell the company to the investment community. So while underwriters usually price the issue for an expected first day gain of 10% or better (to guarantee the purchasers a profit), the issue price is usually rich compared to what the stock might fetch under less favorable market conditions.
In part, though, a simple supply and demand dynamic is at work. With very few shares initially sold to the public relative to the total number outstanding, strong investor demand for an IPO typically outstrips supply and pushes the price to stunning if perhaps only temporary heights. In this sense, the market for new issues is to some extent a "false" one in that the scarcity of tradable shares in the float is affecting the market's pricing of the business.
This is why the overhang of employee stock options can be so important for newly public companies: The new shares hitting the market change the supply/demand dynamic.
As Browning's Journal article pointed out quite nicely, company insiders typically agree to a "lockup period," or a period of generally 180 days after the IPO (but sometimes longer or shorter) during which they agree not to sell any shares, whether owned outright or via exercisable options. Information about the lockup period is usually detailed in the prospectus. This roughly six-month period should allow the stock to find its natural investors so that when and if insiders decide to cash out, the market can absorb the increased supply. Yet, this becomes increasingly less likely as lower quality companies rush to take advantage of the favorable market for Internet issues. And every wave of "hot" stocks ultimately ends with a spate of second-rate "me too" companies going public.
Investors in a hot sector like the Internet must understand, then, what the end of the lockup period might mean for the stocks they own, particularly during a period when the Internet euphoria wanes. Indeed, short-sellers often enter positions just prior to a lockup's end on the expectation that insider sales will hit the market in a rush and pummel the stock. As a result, this potential overhang of employee and VC shares can alone push a stock down even before a lockup ends since short-sellers are, in effect, providing an added supply of shares even before insiders do. In this way, the end of a lockup can create the very flavor of panic that may cause anxious insiders to cash out now before the stock falls any further.
And it need not be merely insider shares coming out of lockup. As Browning's article indicated, shares of Healtheon (Nasdaq: HLTH) dipped 19% on August 10 because shares used to acquire another company last year finally became freely tradable. Again, the overhang issue is basically one of new supply meeting fixed demand.
As I've noted before, this supply and demand dynamic also plays out on a broader scale. It's simply not coincidence that Internet stocks fell into a funk after April, as more and more new Internet issues hit the market. In light of the massive VC funding of upstarts that will be looking to come public in the next few years, this suggests that the entire Internet sector should remain quite volatile. And in individual cases, the options overhang could lead to an avalanche that you want to avoid.
Correction: Having slammed Gretchen Morgenson last week, now I must slam myself. In accounting for Cisco's outstanding stock options as of July 25, 1998, I adjusted for the recent 2-for-1 stock split (which Gretchen missed) but failed to account for the 3-for-2 split that occurred in September 1998. Adjusting for both splits, Cisco would have had 646.96 million options outstanding, options that could be exercised at an average price of $8.51. Of these options, 233.1 million were then exercisable at an average price of $4.85.