High-tech lifeblood at risk

Here, in the windowless office of Michael Sears's start-up, is Silicon Valley in miniature.

On the table, a computer runs a program that Mr. Sears thinks will be the next big thing. Employees flit in and out on their own schedules, sometimes arriving at lunchtime, sometimes staying past midnight – and each of them has stock options.

It's a scenario that's been repeated countless times here in Silicon Valley: A company gives its employees the ultimate incentive – stock options – to turn a bright new idea into business success. Even in this most bearish of markets they remain a central capitalist tool, bringing the best workers to the best ideas and keeping them motivated.

Yet Sears leaves no doubt: If he has to start counting his employees' stock options as company expenses, fewer people will get them and things will change: "Those guys will be here at 8 a.m.!"

As momentum builds to tally stock options as expenses on financial reports, this bare-walled room buried in an office park offers a unique perspective on how the practice could change the cradle of American innovation.

For 20 years, the promise of stock options has fueled innovation in Silicon Valley, encouraging everyone from secretaries to CEOs to work into the wee hours for start-ups conceived on placemats and offering barely enough salary to pay rent.

Some say that even with fewer stock options, the valley's ever-ingenious start-ups would find a new way to reward workers. To many here, though, any such move would chip away at the planet's most successful capitalist experiment, dampening a culture of risk and reward with dubious reforms.

"They're talking about killing the golden goose," says Bruce Maxwell, a consultant and venture capitalist here.

It's an argument tech-industry lobbyists have used – so far successfully – to ward off attempts to mandate the expensing of stock options. One study showed that would cause a 70 percent drop in tech companies' earnings.

But pressure for change is mounting. Federal Reserve Chairman Alan Greenspan recently saidstock options are a factor in the corporate crisis, encouraging executives to lie in order to drive stock prices higher. The national accounting standards board has expressed interest in making businesses expense stock options, and Coca-Cola recently decided to do it voluntarily. At least one major high-tech company, EMC, has followed suit.

The trend "is on the side of something happening," says Carol Bowie of the Investor Responsibility Research Center in Washington. "There is a groundswell of feelings that options are a part of the problem."

But from this side of the Sierra Nevadas, it seems that expensing might only make matters worse.

Options rely on rising stock prices – now hard to find on Wall Street. They give holders the right to buy shares in the future, at a specified price. If a stock's market price rises in the meantime, this can mean a big discount.

Basing expenses on estimates of a stock's future value invites scandal, says Richard Barrett of RW3, a software company in San Ramon, Calif.: "If we thought what Arthur Andersen did with Enron was bad, wait until we ask them to guess the price of stock three years into the future."

Executive Frank Levinson, of Finisar, agrees it's a dodgy prospect. His company was trading at $21 two years ago. Now it's trading at $2. Had he had to expense the stock options he gave out at $21, it would have affected his reported earnings. Yet no one will be cashing in those options, given that they have lost 90 percent of their value. "So it's not a real expense," says Mr. Levinson.

But for entrepreneurs like Sears, the change could mean something more profound than questions over number-crunching. It would be a challenge to how Silicon Valley does business.

Sears is a CEO, but he sits at a metal desk with faux wood that looks as if it came from a rummage sale. He and his six coworkers hold stock options. But unless he can convince the world that his Chronadio – designed to record any radio program, anywhere in the country, and play it back whenever you want – is the next Napster, all his options will be worthless.

At companies like his, stock options are no perk designed to supplement fat salaries. Rather, they offer the scent of obscene wealth, tempered by the prospect of utter failure. They are, almost all here in Silicon Valley agree, the most effective incentive available.

More than half of tech com- panies in the US give stock options to all of their employees.

By contrast, in other industries, fewer than 20 percent distribute broad-based options.

"For people here, stock options are still driving how they make their choices about where they work and how hard they work," says Sears. "It's the way we've been thinking for the past 15 to 20 years."

But if he has to expense his company's stock options, Sears will start thinking differently. As companies like his move toward going public, their stock price generally rises. That means companies with deep pools of stock options would see their expenses grow just as they were hoping to show strong balance sheets.

"Every time the stock price rose, earnings would collapse," says Mr. Maxwell. "It becomes a self-fulfilling prophecy – the stock wouldn't rise."

It's a scenario that, some say, would undermine America's greatest economic engine. Some companies simply would not go public, and venture capitalists would tighten their purse strings for fear of not getting their money back. "It raises the cost of capital to young emerging companies," says Bill Tai of Charles River Ventures in Menlo Park, Calif.

Perhaps Wall Street would get wise to the cause of the low earnings and learn how to gauge bad reports. More likely, though, tech companies would simply pare their lists of people with options.