Three years ago, top executives at cash-hungry West Coast companies thought they had found the perfect device for luring and locking up key employees without draining precious cash resources: an innovative form of equity called "junior stock." At the time, it seemed like a brilliant idea. "Junior common stock came blazing out of the West, and suddenly everybody had to have it," says Robert Frome, a senior partner with Olshan, Grundman & Frome, a New York City law firm. Lately, however, a phalanx of regulators has launched an assault on junior stock -- and sent executives scurrying to find a new compensation gimmick.
The attack on junior stock has been led by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission, which, late last year, set about reclassifying the full, converted stock value as compensation. Such a change would wind up draining cash from capital-starved companies. Meanwhile, the Internal Revenue Service began taking a careful look at a possible reclassification that would treat junior stock benefits as ordinary income, removing the employee's tax break.
Pioneered by Genetech Inc. in 1980, junior stock is a class of common stock with sharply limited dividends and voting rights. It is issued at a fraction of the going price for regular common, but it can be converted into regular common if the company meets specified performance goals -- usually sales and profit levels -- by a set date. The idea was that key employees would be able to invest in their own companies with little cash up front. If the company prospered and met the sales and profit targets, the employees would reap substantial rewards by converting the stock, but that compensation would be taxed at the lower capital-gains rates, not the ordinary income-tax rates. In addition, the company would be able to entice employees without having to recognize the full compensation as a current expense and reduce the all-important cash flow. As an incentive vehicle, junior stock is simple, elegant, and, it appears, too good to be true.
"Silicon Valley gave us junior common," says attorney Frome. "We'll just have to sit back and wait for Silicon Valley to come up with another hot new idea." Ed Schwesinger, a partner in the New York City office of Coopers & Lybrand, the accounting firm, has a more revolutionary thought. "In the final analysis," he says, only half-kiddingly, "the best incentive might turn out to be a simple one: Offer more money."
That, however, is not always an option for young companies. "Cash is very dear out here," says Terry Duryea, national industry director for Deloitte Haskins & Sells's high-technology industry group in San Jose, Calif. "I know one CEO who values his cash more highly than he does his mother." Instead, small companies are returning to some of the safer, if stodgier, stock-participation alternatives that prevailed before the junior stock phenomenon.
Synapse Computer Corp., a high-tech start-up in Milpitas, Calif., had been actively considering a junior stock plan before the FASB and the SEC got into the act. "Luckily, we found out about the pitfalls before we had a chance to get too excited about juniot," Stan Meresman, Synapse's vice-president of finance and administration, says -- but not without a regretful backward glance. "Junior really looked ideal for a while," he recalls. "Here we are, in a very high-risk area, trying to attract employees away from secure positions with big companies; we have to be able to offer them something substantial."
Synapse has opted to stay with an incentive stock option (ISO) plan, an established compensation device that offers benefits that are similar to junior stock's, but far more limited.
Compensation experts likewise advise a return to basics. "There are no well-defined plans to come up with a vehicle to replace junior common," says Deliotte's Duryea. "What we see as the best answer for a lot of companies is a kind of menu plan, with a variety of incentives -- ISOs, restricted stock, combinations, alternatives . . ."
Just such a cafeteria approach is favored by John McMillan, vice-president and director of compensation services at A. S. Hansen Inc., the Lake Bluff, Ill., compensation and benefits consulting firm. "Junior stock was really a gimmick that depended on a loophole," he says. "We were always leery of junior stock -- when something looks too good to be true, it usually is."
Meanwhile, for those who took junior stock while the taking was good, the word from Washington seems reassuring. "We are highly sensitive to the grandfathering issue," says Larry Jones, Professional Accounting Fellow with the SEC, "because in part it was our previous position, with regard to Genetech, that led people to believe that this was a safe way to go."