The Emergence of “Human Capital Management”

I had dinner a couple of nights ago with two of my favorite executives, the CEO and COO of an enterprise SaaS company in which I invested early stage venture capital. The CEO rose through the sales ranks, and the COO through what used to be called HR and is now being called HCM—human capital management.

I have always liked sales-oriented CEOs because they are focused on customers and measurable results. The good ones spread these orientations throughout the organization, creating a culture attuned to customer service and accountability. This is the first company I have worked with, though, where the number two executive has risen through the HR ranks—and I’m surprised at what a good decision this has turned out to be. We talked a great deal about the shift from HR to HCM and how this reflects on modern personnel practices, especially in technology companies.

When I went to business school, HR was not the choice calling of most of my classmates. It was a backwater focused on administering benefits and avoiding corporate liability—not central to the MBA educational process—or so I thought then.

That is no longer the case.  The functional area has clearly been elevated. Talent acquisition, training, assessment, and retention are no longer backwaters, but are strategic to forward-looking companies.

There are many reasons why HR has become HCM, including better data on what drives strong company performance. Culture is increasingly understood to be important, and this particular company places a big emphasis not just on hiring good people, but on hiring people who fit and quickly weeding out ones who don’t. Yes, top performers are significantly more productive than average ones, but cultural misfits can be disruptive and hinder team productivity, no matter their individual performance. Bad hires are expensive because they have to be replaced, any holes they leave need to be filled, and any damage they have done repaired.

Watching this company, and learning from this team, I have become a convert to modern talent management practices. Apparently, I’m not alone, and am probably behind the curve.

Anybody who has been following the emergence of enterprise SaaS has seen the speed with which the HCM sector has emerged. SuccessFactors pointed the way, growing from startup in 2001 to $330 million in sales before being acquired by SAP for $3.4 billion in December 2011—that’s right, the acquisition price was 10x revenues. Not to be outdone, Oracle followed in February 2012 with a $1.9 billion acquisition of Taleo for 7x revenues. Not content to sit on the sidelines as SAP and Oracle bought their way into the cloud, IBM bought HCM company Kenexa for $1.3 billion in August 2012; the company was on a run rate of about $250 million in revenues—a relatively inexpensive 6x multiple.

HCM SaaS companies also have been well represented in the IPO market. Workday, founded by former executives from PeopleSoft, went public in October of 2012, and is now valued at $12 billion dollars—more than 34 times trailing 12-month revenues of $350 million. CornerstoneOnDemand, another HCM company that went public in May 2011, sports a market cap of $2.6 billion, a multiple of 16 times trailing 12-month revenues of $150 million.

There are also dozens of smaller privately-held HCM companies, many of which are growing at annual rates of 50% or more.

How can there be so many successful companies in this emerging market? There is clearly enough demand to feed them all.

These are all companies that, in one way or another, help businesses to attract, train, motivate, and retain the best people. I haven’t done the math, but it feels to me that if you added up the revenues or market caps of all the HCM companies in the enterprise SaaS industry, it would be the largest sector.

All in all, it was a pleasurable dinner. These two executives have been very intentional about elevating culture in their organization, and that decision—supported by the board—has produced very good results. I’m reminded of this every year at their Christmas party, which feels like a family gathering. Each year they have an artistic contest of some type—most creative door covering, for instance—and it is amazing to see the energy that people in every functional area put into letting their creative sides run free. You can’t predict who will have the most artistic creations based on their job functions. I take this as a sign that people are comfortable being themselves in this environment.

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Why Expensing Stock Options Makes No Sense

In the third of my three posts on stock options, I would like to address the issue of expensing stock options on a company’s income statement. I think that this policy, which was developed by the Financial Standards Accountability Board (FASB) as FAS 123r, is nonsensical.

The decision to expense stock options had its origins in the period following the Enron and WorldCom scandals and the dot.com bust. Congressional hearings were held to uncover the causes of the scandals and one focus of legislator and media outrage was people making money through stock options—though options were clearly not causative of the scandals. You may remember that no less an eminence than Steve Jobs was investigated by the SEC regarding options he was issued by Apple’s board.

What followed the decision to expense stock options was a decade in which fewer stock options were granted to fewer people, which has been documented in at least two studies. That can’t have been the public policy objective.

No Sense, or Nonsense

Here is my analysis of why expensing stock options makes no sense, particularly for the companies that have received early stage venture capital. Let me begin by confirming that I am not an accountant; I don’t want to be an accountant; you don’t want me to be an accountant; the world doesn’t want me to be an accountant; the world probably has enough accountants already; and, my favorite accountant is Bob Newhart, who famously left the profession (involuntarily) because “getting within a few dollars was good enough for me.”

But I do know enough about accounting to believe that the accounting treatment of a transaction should follow the substance of the transaction, and that expensing stock options does not follow the substance of the transaction. It attempts to make an income statement item out of what is actually a balance sheet item.

Argument For Expensing Stock Options

The argument for expensing stock options is that they are a form of compensation and should be treated like cash compensation as a current-period expense against income. Warren Buffett made this argument to Berkshire Hathaway shareholders as early as 1998.  (He is not an accountant either.)

If employees didn’t receive stock options, this line of reasoning holds, companies would have to pay them more in cash. This is the main argument buttressing the policy to expense stocks options in the period in which they are awarded.

In large public companies, with which Warren Buffett is mostly concerned, this argument may hold true. Options are closer to cash compensation because there is a liquid market for large company shares and these companies are managed for steady, predictable earnings. Options are granted at market prices and the rise in their value is as predictable as is the rise in company earnings.

The federal mind finds comfort in the orderliness and predictability of steady results at large companies and tries to spread these results throughout the economy by promulgating rules, including for smaller, more volatile public companies and private companies for which the argument doesn’t hold true.

Argument Against Expensing Stock Options

There is little market for private company shares. Stock options in these companies are inherently risky. The value of options is based on a 409A valuation that is highly dependent on assumptions. They will be worthless if the Strike Price* is under water when the options mature. If the private company fails, or is acquired at a price below the option strike price, or is never acquired, the options are worthless and the previous expensing of the options is shown to have been arbitrary.

Smaller public companies are somewhere in between. The market for their shares may be limited. Earnings may be less predictable, and share prices may be more volatile. Options are, therefore, more at risk than is the case in large public companies.

As these three scenarios suggest, the problem lies in a “one size fits all” rule that is best suited for large public companies.

When stock options are issued, they have no cash effect on the company (besides a de minimis transaction cost that we will overlook). Therefore, they don’t affect a company’s income statement or cash flow statement. The options are a contingent claim on the company’s shares, i.e., the company must issue additional shares to the holders when options mature and are exercised.

Make Sense

If the granting of options is not, as I am arguing, an expense, then how should they be accounted for? The substance of the transaction is that issuing stock options has no cash effect on the company. When they mature and if they are exercised, they dilute existing shareholders (whose percent ownership declines predicated on the number of new shares issued). All other things being equal, the value of outstanding shares will fall by the value of options exercised, minus the cash received by the company for the option strike price. Earnings per share (EPS) will also decline by a like amount.

The likeliest effect of  issuing stock options will be to increase the company’s cost of capital—to the extent that the company raises capital by issuing new equity rather than debt.

From an accounting standpoint, it should be possible to calculate a company’s cost of capital considering the cost both before and after options are granted, and providing a footnote to help shareholders understand the consequences of stock options on their ownership interest. And that’s what I think should be done.

I would like to see a return to the day when stock options become a more widespread way for people working in companies to benefit from the share appreciation in those companies.  Changing the accounting treatment of stock option grants to more closely mirror the substance of the transaction would likely reverse the decline in option grants and have the effect, once again, intended for stock options–to spread the wealth more widely.

*The strike price is the price at which a holder of stock options can turn them into actual shares. It is supposed to be Fair Market Value (FMV) at the time of grant. If a public company’s common shares are trading for $10, the FMV for the option at the time of grant is $10. For a private company the math is more complicated because there is not a ready market for trading its shares and there may also be multiple classes of preferred shares with seniority to the common shares into which stock options generally convert. Private companies attempt to establish FMV by using the last round of investment—if within 12 months—or a calculated FMV based on the Black-Scholes model.   Since private companies often have multiple classes of shares, including Preferred Shares, the FMV strike price for an option may be well below the price at which preferred shares were last bought.  “Underwater” means the strike price for the option is below the current price of the shares themselves and there is no incentive to exercise the option; it is worthless.

Stock Options for Overseas Employees?

In the current age, business has gone international and even early stage companies may have employees overseas. Stock options are becoming a part of expected compensation, particularly in technology companies. Stock options are an important component of company culture and of the incentives used to attract, compensate, and retain the best employees. Should an early stage company grant stock options to citizens of other countries?

My knowledge of this subject developed when the first-time founders of a company with employees in an overseas country wanted to grant them stock options. There was a lot of momentum behind the proposal and expectations had already been set. The company and the country don’t matter: it could have been any company with employees in India, China, or a former Soviet republic. The issues are the same.

Hearing about the plan for the first time at a board meeting, I innocently asked, “do they have a telephone book there?” (This was a few years ago, when telephone books still mattered.)

Following a moment of stunned silence, the company founder looked at me and asked, “what do you mean?”

“Do they have a telephone book with people’s names and addresses and phone numbers? If an employee exercises vested options and becomes a shareholder, and then quits, you’ll need to track that employee down every time you need shareholder signatures: when you want to increase the stock option pool, or do a financing, or sell the company. Investors or acquirers may want 100% shareholder approval, so they’ll know they won’t have any problems with disgruntled minority shareholders. How will you find ex-employees?”

“I don’t know. We’ll have to check on that,” said the entrepreneur, acknowledging that the infrastructure in this particular country was rudimentary compared to U.S. standards.

For good measure, I added, “is there even a consistent approach to translating employee names from (Hindi, Mandarin, Cyrillic) to English?” I had seen the names of several employees spelled more than one way in various documents. “ When you issue option agreements and share certificates, they’ll have employee names on them. They’ll have to be valid and consistent. The last thing you want is vagueness about ownership when you’re doing a financing or selling the company.”

To be complete, I also asked “what do we know about laws regarding stock options and taxation in this country? It’s just emerging from decades of socialist rule. Do they have the legal infrastructure to enable individuals to own stock, or will the state confiscate them and become a company shareholder? If we grant options, will employees owe tax immediately? If they do, they’ll turn to us for the cash.”

It took over a year to resolve this issue. We hired legal and tax experts with knowledge of the country in question and answered all of the questions that it is a board’s fiduciary duty to ask. Ultimately, we decided to issue employees in those countries stock appreciation rights (SARs) instead of options. We had to amend the company’s Stock Incentive Plan—with shareholder approval—to do so.

SARs separate the financial rights of shares from the ownership and voting rights. They enable employees to benefit from appreciation in the equity value of the company, without granting them ownership and voting rights. This reduces the company’s burden in obtaining shareholder signatures in crucial moments.

Circumstances may differ from company to company and country to country but, for companies with overseas employees, SARs can be an appealing alternative to stock options. Since the time of this story, nearly a decade ago, many countries have improved their legal, regulatory, and tax regulations to conform to international standards, but the search for talent continues to bring new countries on-line. Each time a country becomes integrated into the global economy for the first time, issues like this have to be addressed.

Stock Options for Everybody?

I have been thinking about stock options today, and I had three subjects I wanted to cover, which I’ll separate into three posts:

One of the central questions every entrepreneurial company asks itself is: do we believe in stock options for all employees, or just key ones?

I have seen both approaches and heard justifications for either:

  • “We believe in everybody having ownership incentives,” or
  • “Some jobs are mundane and options won’t change the behavior of people filling them.”

I guess I don’t have a fixed position on which approach to follow. A company should choose how widely to spread options based on its culture and whether the leadership team and board think that options provide a true motivation for employees to behave like owners.

In the first dot.com wave, I was living in Silicon Valley and it seemed like the model was “stock options for all.” I knew secretaries who became millionaires—literally—when their companies were acquired or IPO’d. They were nice enough people and put in their time, but did they really add equivalent value to the company, or were they just in the right place at the right time? Come the dot.com bust, some of the companies didn’t do well and their previously generous stock option policies looked like a wealth transfer from shareholders to low-level employees of non-performing companies.

The dot.com bust, and Enron and WorldCom scandals were followed by Congressional hearings and media outrage that people in business were making money. Sarbanes-Oxley and less formal pressure on private sector compensation led to tighter regulation of stock option grant prices. Even though Sarbanes-Oxley was sold to us as being intended only for public companies, even early stage companies now pay to have annual 409A analyses performed to establish a fair market value (FMV) for a company’s options. There is even a new profession—Valuation Specialist—and a training and certification industry to support it.

Another important change to stock options was an opinion by the Financial Accounting Standards Board (FASB) that companies should expense stock options, as if they are cash outlays. I’ll write about the wisdom of this in a separate post.

As a result of these policies, it seems—anecdotally—that companies became less generous in their option grants. Fewer options were given and they were given to fewer employees.  (If ever I retire to academia I may study this subject to see if the data support the anecdotes. If anybody knows of such a study, please let me know and I’ll publicize it. Found one: here.)

For a decade, these policies had the perverse effect of reducing the sharing of wealth and class mobility–the opposite of what policymakers say they want. Now that these policies have been absorbed into the private economy it appears that companies are returning to more generous option granting policies. Businesses and markets do eventually adjust to whatever the rules are and companies can now go back to spreading the wealth, if they so choose.

New Style Accelerators: Fad or Fixture?

I spent a couple of hours today at FlashStarts, one of the new style accelerators for technology companies to raise early stage venture capital. They had asked a couple of VCs to come and hear company presentations—not pitches—and give some feedback. The presentations, as should be expected early in the process, had strengths and weaknesses. Driving home led me to musing about whether these new style accelerators are destined to be a fad or a permanent fixture in the start-up scene.

Accelerators like FlashStarts are popping up across the country, including in places not traditionally known for entrepreneurship—at least on the scale of Silicon Valley: Launchhouse; 10xelerator; The Brandery; 1871; Healthbox. Why is this?

Successful innovations are copied in an economy, like a successful mutation that sweeps through a population. Early versions of accelerators, such as Y Combinator and TechStars, have spawned imitators because they generated some great companies in a model for investors that seemingly reduced risk, lowered start-up costs, and brought together potential deal syndicates.

Will the followers be as successful as the innovators? It’s probably too early to tell. Does a mutation become a permanent fixture in the gene pool, like the ability to digest milk into adulthood, or fade away like some mutation none of us has ever heard of? Or will accelerators, like mortgage-backed securities (initially a valuable financial innovation) be adopted too widely and become a money-losing debacle?

There is a lot to like about the approach to accelerating start-ups. Entrepreneurs are encouraged to quickly (and inexpensively) build a minimally viable product (MVP) and get it out to customers for fast feedback and iterative enhancements. They receive mentoring from experienced, successful entrepreneurs like Charles Stack (the founder of FlashStarts) and experienced VCs like myself and Mike Stubler. They hang out in a cool space where they can share ideas and receive peer support from other entrepreneurs who are tackling similar challenges. Investors can come and interact with entrepreneurs without the pressure of having to “take a pitch” and make a Yes/No investment decision.

The main concern I have heard expressed about the proliferation of accelerators is whether deal quality will be diluted. Some companies serially apply to every accelerator program in the country until one accepts them. The process for each accelerator is supposed to be selective, but if there are many accelerators seeking deal flow, does this dilute overall quality? For the newer ones, that haven’t yet developed a track record and name brand, the answer is probably “yes,” at least in the short term. Established accelerators like Y Combinator and TechStars will probably continue to attract quality companies. Programs which aren’t able to demonstrate success will either adjust their models or go away. That’s how evolution works.

On balance, I think that these new style accelerators are positive and will become a permanent fixture of the entrepreneurial economy that the U.S. so desperately needs to drive economic growth and wealth creation. I’m spending more and more time with these programs, and I’m probably learning as much as I’m contributing. That’s evolution, too.

Why I Hate Pitches

Over my years in VC, I have had many entrepreneurs call me or e-mail me who were convinced that if they could just schedule time to “pitch” me that I would quickly see the merit in what they were doing and immediately decide to invest.

Early in my career I took a lot of these meetings and, on the urging of partners and trusted sources of referrals, I still take a few. More often than not, though, I find myself leaving pitch sessions dissatisfied—enough so that I have spent considerable time reflecting on the source of my dismay.

My conclusion is that pitch meetings are so unsatisfactory because there is a 99% chance that I will have to tell the entrepreneur “No.”  The venture capital industry funds only 1% of what it sees. Who likes those odds? I don’t enjoy delivering the message, and entrepreneurs don’t like receiving it.

The pitch session is structured like a sales call. The entrepreneur is “selling” and is often certain that conviction or passion or vision will sell me. I react to being pressured like most people do—defensively—activating instincts that interfere with my ability to listen to what the entrepreneur is saying or to get beyond the packaged pitch to the essence of the company’s value proposition. How can this be good for anyone?

My standard response now is to ask for something to read so that I can think about the company before being confronted with a “Yes/No” investment decision. Then I try to talk the entrepreneur out of putting a big stack of chips (to use a roulette metaphor) on the single number of depending on a pitch. Instead, why don’t we have coffee, sit on the same side of the table, and just talk about the business? Let me provide perspective and advice about how to increase the odds of receiving a “yes” from a VC; or thoughts about whether venture capital is the right financial product for this particular company and what other choices are available. Let me get to know you better and to see how you react to advice and suggestions.  Who knows, the freer I am to understand the business and the people, without the pressure of an investment decision, the more I may be willing to put time into developing an investment thesis.

For an impatient entrepreneur, spending the time to develop a relationship with a VC may be frustrating. But fund-raising is a process, not an event. You’re going to be in a relationship for five years, or maybe ten. Don’t put all your chips on a pitch. As Congreve wrote “marry in haste; repent in leisure.”

Some Lessons From The $66 Million TOA Technologies Financing

News items come and news items go and, for most of Cleveland, Ohio, and the Midwest, news of the recent $66 million Series E financing of TOA Technologies by Technology Crossover Ventures has probably receded into the past. After all, we’re in the age of the immediate, where sustained writing (and thinking) has been replaced by abbreviations, limits on character (the written kind), and attention spans no longer than the flicker of a neuron. We are, as my brother Dave would have it, in the era of “twitterature.”

But the TOA financing deserves a second, deeper look for what it says about the company, Ohio, and the Midwest entrepreneurial ecosystem.

To begin with, this is the largest venture capital financing for a software company in the history of Ohio. Sixty-six million dollars is a lot of money for a company to raise, especially without shareholders being diluted to oblivion. What could so much money be used for? It must be that the company has growth prospects that a tier-one venture capital firm thinks are worth funding. And it must be that the valuation of the company was sufficient that shareholders were willing to take some dilution in exchange for accelerated growth.

How about that Series E thing; what does that mean, anyway? It means that the company has raised five rounds of capital from smart investors, including Early Stage Partners, Draper Triangle Ventures, Intel Capital, Sutter Hill Ventures, and now Technology Crossover Ventures. To raise so much money from so many quality investors, the company must be on to something. Right? What could that be?

The TOA Technologies Web site says that the company “takes a unique approach to scheduling, routing, and managing mobile workforces of any size.” Perhaps that’s it. Employees are no longer tied down by location, but empowered by mobile devices to work anywhere at any time. Yet they still need to be coordinated, scheduled, managed and–above all–connected. They need to communicate with each other, the office and—most importantly—customers. That’s where the TOA platform comes in, and as the trend towards mobile employees accelerates, they are in the sweet spot of the market.

One manifestation of the trend towards mobility is that technology companies are increasingly exploring the Midwest for their investments, operations, and acquisitions. Google has opened offices in Pittsburgh and Ann Arbor. SalesForce bought ExactTarget (another TCV investment) in Indianapolis. The quality of life in the Midwest is good, the cost of living is reasonable, the universities are excellent, the transportation infrastructure is strong, and employee turnover is low. This last one is worth considering: some Silicon Valley companies experience annual turnover as high as 50%; employees get bored, or go off to start their own companies, or are lured away by a company with more money. It’s hard to build a sustainable business with that kind of turnover. Silicon Valley investors are recognizing this, and that is one reason they’re willing to look to the Midwest.

Do these events mean that the Midwest has come of age as a technology center? It’s still early, but the answer is probably “soon.” Today, with vision, passion, and effort, you can build a great technology company anywhere. Yuval Brisker, Co-Founder and CEO of TOA Technologies, is eloquent on this point in this video interview with Bloomberg News: Click here to see the video.

Confessions of A Midwest VC

Follow me on Twitter: @jpmurray5957

Fifteen years ago I was engaged to conduct a study of how to create an entrepreneurial ecosystem in Cleveland, Ohio, with financial support from the Generation Foundation administered through BioEnterprise. It quickly became clear to me that without locally managed early stage venture capital it was impossible to build and sustain an entrepreneurial ecosystem. Perhaps a bit naively, I took the entrepreneurial plunge and decided to start a venture capital fund.

Lacking a couple of requisite skills—namely, any investment experience whatsoever and any relationships with potential Limited Partners—I partnered up with a couple of guys with actual investment experience and access to capital—Jamie Ireland and Jim Petras. That was how Early Stage Partners was formed.

We spent several years building a constituency for a first-time fund in Cleveland to focus on early stage venture capital investing in technology (what an implausible story that now seems) and began raising capital in earnest in 2001—just in time for the dot.com bust to lengthen our odds. We had a first closing on January 3, 2002 and ultimately raised a $44 million first-time fund (1) to make early stage (2) technology (3) investments in Cleveland, Ohio (4) in the middle of the dot.com bust (5). By my counting, we had five strikes against us.

(A few years later, I met a Professor of Finance from Carnegie-Mellon University at a PVCA luncheon. His comment to me on hearing this story was “that has to be one of the great fund-raising success stories of that era. Nobody was raising first-time funds.”)

In the intervening years, Early Stage Partners raised and invested a second, larger fund (predictably, in the middle of the Great Recession) and has invested in over 25 companies, primarily in the Midwest. The recent $66 million Series E financing of TOA Technologies by Technology Crossover Ventures puts a nice bookend on a twelve-year cycle. Though it’s not an exit, it is a capstone event.

I hope the experience I have gained over these years can be of value to other people. I’ll keep the content flowing as time permits.