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Why Google's new option plan is a bad idea and a negative precursor

Google did a good job of "spinning" the good aspects of its new plan to create a private market for valuing Google employee's stock options. This blog intends to shed some light on whether it is such a good idea. I think not. The New York times coverage was the most comprehensive of the six papers I read on the topic.

I am writing about this because as a former leading independent investment researcher, I understand conflicts of interest and capital markets intimately. As the first congressional witness explaining what went wrong with Enron, and the first to see through the spin with WorldCom, I can tell you there is a whole lot for Google shareholders and investors to be worried about in Google's latest example of "innovating without permission." It is especially troublesome when people chime in with the inane insight "if Google does it, it validates it as a smart idea." Hold onto your wallets when that kind of idiocy gets quoted and unchallenged.

During the bubble, stock price routinely was correlated to "smarts" and we all know how that ended. I acutely remember being Bernie Ebbers whipping boy and being derided by him as the "idiot washington analyst" for having the audacity to challenge the WorldCom story at its apex when it was owned by more funds than any other telecom stock. When WorldCom was worth $150b, like Google is now, there were tons of people fawning over Ebbers and others who simply rode momentum of the bubble up. They weren't geniuses becuase their stock prices were high, people just assumed that stock market success equated to brilliance.

Well Google is not worth $150b for its innovation and smarts in employee compensation or stock option innovation, its valuable for its fast growth which emanates from an allegedly superior secret search algorithm that discriminates more effectively than any other search engine.

So why is Google's idea such a bad one?

Like the bubble that came before it, Google is riding the momentum phase of its growth which is truly impressive by any measure. We all know that what goes up must come down even if in the short term the market conveniently can ignore it. While I beleive Google certainly has a lot of fast growth ahead of it, it's growth will slow because of the law of large numbers among other reasons. And when the growth story begins to crack, employees and investors will sense the momentum is shifting and will rush for the exits. That's when people will look back at this option innovation and say what were they thinking?

Generally a company wants an employee to be loyal to the company because they believe in the mission, the company and plan to make a career there. That's the justification for options that makes sense for shareholders. In theory, shareholders are willing to allow themselves to be diluted -- because they supposedly will benefit from that loyalty in more value creation.

If however, Google changes the compensation incentive dynamic for all these thousands of employees they are trying to hire, and continues to give them options that have an ATM cash machine feature where folks can easily cash out before the door hits them on the way out, they are creating a nasty "rush-to-the-exit" dynamic when Google tries to transition from high flier, to more normal growth company.

  • If Google switched to granting restricted shares like Microsoft has very wisely done, that would be much smarter and sager for long term value creation and employee retention.
  • Oh I forgot, the Googlers are the geniuses and Microsofties are dummies becuase their stock has been relatively flat for a few years.

This Google compensation novelty also should be viewed as the ominous precursor that it is. Google is telling us several negative things.

  • First that many of their employees have not drunk the "koolaid" because they question the value of their options.
  • Second they are telling us that they are having trouble recruiting the quality of people they want because these smart people understand that those that get in first or early in a momentum play will do well, but the later you come -- the more options' value is questioned.
  • Third, they telling us that they are putting short term recruiting needs ahead of long term retention needs.
    • They are making it much easier for employees to pull the ripcord faster.
    • How is that good for shareholders?
    • Why should shareholders be happy that more of the value of their investment is being transferred to more Google employees who will be able to cash out faster and easier?

Doesn't Google get that what they are doing is making the decision and path for employees to jump ship much much easier?

I also found it interesting that none of the articles connected the dots with Google's other extraordinary employee practice, which is to formally allow all employees to free lance on personal projects 20% of their time.

  • So lets get this straight.
  • Google is telling its shareholders that they should pay more of their ownership to employ people at top dollar for 80% effort, (Googlers get the equivalent of 10 weeks off a year for their personal projects, in addition to vacation and sick leave) and that these employees are now going to get the added perk of a greasier slide to exit the company if the the going gets tough?

Lastly, how do you think the public market will view the precursor of a private market that has employees cashing out?

  • One big question is: will Google make that private market contempraneously transparent so that if Google employees are found to be rushing for the exits and cashing out, public shareholders have the right to know about it immediately and not after some multi-month reporting period?
  • Has anyone at Google thought of that SEC concern? Last time I checked they cared about insider trading reporting requirements.
  • Let me suggest to those with the motto of "innovating without permission" that they should consult with the SEC about whether the SEC would be interested in protecting public shareholders with some special disclosure rules for this compensation novelty?
    • The SEC will also probably want to ensure that their is no option backdating going on.
    • But what do I know? The Google lawyer that was quoted in the NYT said that the plan did not require SEC approval.
    • That may be technically true, but it does not appear to be a very "politic" approach with the SEC, given all the option backdating scandals going around.