Wooing Potential Customers with Options: Unregulated "technical advisory boards" are a sweet way for startups to funnel stock to big-company buyers.
Fortune, July 10, 2000 v142 i2 p139+
By Melanie Warner
Right before Jim McManus retired from UUNet last year, he bought a yacht. A big honcho in the telecommunications industry, McManus had always wanted a boat, and now he would finally have the time to enjoy one. He had the money too.
McManus left his job as vice president and lead systems engineer with a personal fortune of more than $20 million. And most of the wealth came not from his compensation but in the form of stock he received from little startups hoping to do business with UUNet, a subsidiary of MCI WorldCom and operator of the world's largest Internet backbone.
At least three networking equipment companies, including Avici Systems, Sycamore Networks, and Redstone Communications, have given McManus valuable stock options because he sat on their so-called technical advisory boards. Sometimes he also bought shares in these companies as a private investor or was granted friends-and-family shares, which are options that a CEO hands out just before a company's initial public offering.
If the share price goes wild after the IPO, holders of friends-and-family shares get a nice windfall.
Welcome to corporate perks in the new economy, where guys like McManus get stock options simply because they hold important jobs at big companies--jobs in which they make buying decisions about new technology.
In the old economy, that deeply dull realm unbrightened by multibillion-dollar IPOs or free-flowing stock options, cozying up to customers might involve treating an executive to a round of golf at the country club or seats in the corporate box for the big game, or perhaps dinner at a swank restaurant.
If you wanted to be really persuasive, you could always make a direct appeal to venality and offer a cash bribe, though unlike golf outings and fancy meals, bribes can get you into legal trouble.
For a fast-growing Internet company, stock options are a much more tantalizing perk to give to people who make buying decisions, and a perfectly legal one too. Startups hand out options to all sorts of people--employees, partners, consultants, even landlords--so it's not at all surprising that they would give them to prospective customers.
The stakes in this game are high; executives on the receiving end can make several million dollars from a single company. And even if it's legal, largesse on such a scale raises questions about the propriety of the practice.
Joseph Badaracco, a professor of business ethics at Harvard Business School, says, "In the old days you could give a ham to the purchasing agent at Christmas. This looks an awful lot like driving up with 16 22-wheel trucks full of ham."
Of all the ways startups have devised to give customers stock, the technical advisory board, or TAB, is the most ingenious. Sitting on such a board sounds like the sort of serious, meaningful endeavor that would justify getting lots of options.
Frequently, though, it's not. The work is usually not at all demanding. Formal meetings are rare, with most of the interaction between a company and the board members conducted on an individual basis via telephone and e-mail.
And unlike regular boards of directors, advisory boards carry no fiduciary responsibility. Rabid shareholder class-action lawyers are never going to sue anyone for being on a TAB.
Though technical advisory boards have been around for years, using them to lure prospective customers is a relatively new custom. Here's how it works: Say you've just launched a startup with the aim of developing an exotic strain of fiber-optic gear.
First you figure out which companies you'd most want to have as customers. You then invite one or two key decision-makers from each of these companies to sit on your advisory board, and you offer them anywhere from 10,000 to 40,000 options.
You develop a relationship with them. You talk, you brainstorm, you have lunch, you send lengthy e-mails. When you manage to produce a finished product and you're ready to start selling it, your TAB members shepherd you into their companies, introducing you to other key decision-makers.
This starts the ball rolling. At the very least, you want to get your product into the customers' labs for testing, which gives you valuable bragging rights. If all goes well, you wind up with a purchase order that leads to revenues.
There's no guarantee that a deal will materialize, but somehow or other, one often does.
Despite the apparent conflicts of interest, most people don't seem to have any scruples about the arrangement, which can be financially life changing for the recipient.
Paul Mockapetris, inventor of the domain-name system and co-founder of Urban Media Communications, a Palo Alto company offering broadband services to businesses, says, "I know people who bought houses with the money from their technical advisory board options. Houses in the Valley."
So prevalent is the practice in the networking equipment industry, says Mockapetris, that two-thirds of all startups have TABs with customers or potential customers as members. (Urban Media is also forming a TAB, and it will likely have customer members.)
These startups are especially eager to make friends at big telecommunications companies, which are spending billions on gear to build or revamp huge networks. Getting such a behemoth to place an order can pay off handsomely on Wall Street too.
Sycamore, for instance, went public last year with a $12 billion valuation even though it had just a single customer--but the customer was a big one, Williams Communications, which is building an ultramodern high-speed data network.
Not surprisingly, other telco executives besides Jim McManus have made killings from their dealings with startups. Matt Bross, CTO of Williams, has made more than $15 million from friends-and-family stock in Juniper Networks and from sitting on various technical advisory boards, including those of Sycamore and Corvis.
In addition, Bross sits on the main corporate board of optical networking company ONI Systems, for which he received 180,000 options. He was also allowed to buy 142,460 shares in ONI at $6.32 apiece, for a total layout of about $900,000; the stash is now worth $34 million.
Vab Goel, former VP of emerging technologies at Qwest and now a VC at Norwest Ventures in Palo Alto, has made more than $20 million from stock he got from Juniper and from sitting on the TABs of such companies as CoSine, Corvis, and Siara (sold to Redback Networks).
Another popular guy among the startup crowd is McManus' colleague Mike O'Dell, UUNet's chief scientist. He has served on the advisory boards of both Avici and Xedia, an Acton, Mass., startup that Lucent bought last August and that sells routers to UUNet.
Not all managers of networking equipment startups are happy about the TABs' influence on buying decisions. "I call them bribery boards," says the CEO of a startup company that makes equipment for IP networks.
This entrepreneur, who is still deciding whether to establish an advisory board, argues that startup companies use them to buy customers and that refusing to play the game would put a new company at a disadvantage. When he was running a previous startup, he claims, it was nearly impossible to cut deals with certain companies because the decision-makers there were already sitting on the TABs of several of his competitors.
He remembers once talking to an executive at a large telecommunications services operator, trying to get his product into the telco's lab for testing. The entrepreneur was rebuffed for not having shares to offer. "What do I get out of it?" the big-company executive wanted to know.
Executives at large equipment makers like Lucent, Nortel, Cisco, and Ciena also decry the way startups are using TABs to curry favor with customers. Several of these executives who spoke to FORTUNE, all on condition of anonymity, believe that they have lost deals because of TAB relationships.
"We were in a strange situation recently where a startup competitor was winning the deal against us," recalls an executive at one of the big equipment companies. "We thought it was because of price, so we went in with a better offer. But we still weren't winning the deal. We got to the point where we were practically giving it [our product] away, but we didn't get the business. We later found out that there were guys at the purchasing company on the TAB of the startup."
True, the big boys have a vested interest in finding fault with these upstarts' mores. Nor is this to imply that high-level executives at prominent companies like Williams, Qwest, and UUNet are wantonly running around on personal-wealth-creation sprees, ordering products simply because they have investments in the companies that make them.
In interviews with FORTUNE, these executives deny that there's anything wrong with sitting on a TAB. They say that they join TABs with the best of intentions--to represent the interests of their companies and find innovative technology for their networks. "I sat on TABs because it's a way to gain insight into fast-moving technology and to beat out the competition," explains Vab Goel, who just turned 30.
Matt Bross says he fields lots of requests from startups that want him on their advisory board but that he says yes only to companies he thinks Williams might ideally want to buy products from.
Mike O'Dell of UUNet says that he too sits on TABs to get involved in the development of new technology. "About four years ago, UUNet decided that we couldn't sit around and hope people would build the right product for us," says O'Dell. "We started to take a more proactive approach."
A lifelong technologist, O'Dell says that when he joins a TAB he makes it very clear that he isn't for sale. "In the beginning, we have a full-disclosure conversation with the company," he explains. "We tell them that there's no guarantee we are going to become a customer.
Some things take off, and some things don't." Jim McManus didn't want to comment for this story, except to say, "I don't think there's anything wrong with technical advisory boards, as long as you have ethics. And I've played things very clean."
However pure the intentions of people like McManus, advisory boards do help give no-name startups priceless visibility. Take Corvis, of Columbia, Md., a maker of optical networking equipment. In April, Corvis, a company that has thus far produced no sales, signed a deal with Williams that will bring in $200 million in revenues over the next two years.
The agreement has cast the developing-stage startup as a real superstar, because people expect such deals to go to 800-pound gorillas like Nortel and Lucent, companies that actually have lots of real revenue. Winning the deal suggests that Corvis, which is in the process of attempting an IPO, has a stellar product and management team.
Maybe it does; then again the fact that Williams' Matt Bross was sitting on Corvis' TAB couldn't have hurt.
Williams' general counsel Bob McCoy acknowledges that Bross' membership on Corvis' TAB represents a conflict of interest. But he maintains that Williams can manage this sort of conflict internally so that it doesn't compromise the interests of the company.
Bross, he says, is not the only one involved in making purchasing decisions at Williams, and everyone responsible for evaluating new technology knows which executives may have relationships with suppliers. McCoy says, "Just because there's a conflict doesn't mean Matt shouldn't be on the technical advisory board or that we shouldn't be buying from the company."
Corvis, citing restrictions on talking to the press during its IPO process, had no comment.
Corvis isn't the only startup to make a sale with some help from TAB members. In February, CoSine of Palo Alto signed a multimillion-dollar deal to sell IP networking gear to Qwest. And guess who's on CoSine's advisory board. Yup, Vab Goel, the former Qwest executive who went on CoSine's TAB after Qwest invested in the company last spring.
Several other Qwest executives also own stock in CoSine, having been invited last fall by CoSine's CEO and CFO to become private investors in the company. CoSine also has a friend in Qwest Chairman Phil Anschutz, whose Anschutz Family Investment Co. bought 1.4 million shares in several financing rounds last year.
So anyone thinking of investing in a startup ought to find out which executives are sitting on its TAB and what they got for their services, right? Well, good luck. Most companies don't publish the names of their TAB members and don't wish to talk about the subject when journalists call.
"We have a corporate policy not to disclose participants of our technical advisory boards," wrote Brett Van Sledright, CoSine's public relations manager, in an e-mail.
Companies can be secretive about their TABs because the SEC requires very little in the way of disclosure. Public companies must report grants of stock to any corporation that accounts for more than 10% of their revenues. But strangely, they don't have to report awards of stock to individuals at these companies, as long as the grant is for less than 5% of shares outstanding.
In other words, as far as the SEC is concerned, Company X can hand over $15 million of stock to an executive at Customer Company Y without having to say a word about it. The SEC does not seem to be focusing on this gaping hole in its rules. "We haven't really given the matter much thought," says SEC commissioner Isaac Hunt Jr.
One concession that TABs may not be 100% kosher came recently from Williams. When FORTUNE first contacted the company in January about employees' accepting stock in startups, Williams said the practice was okay as long as the person's supervisor knew about it. In March, Williams decided to change its policy.
Now the party line is that no Williams employee can accept stock in companies it could have business dealings with, meaning that when Bross sits on technical advisory boards in the future he'll have to say "No, thanks" to the stock.
Gill Broyles, head of communications at Williams, says, "The valuations [of the startup companies] were leading to perceptions we weren't comfortable with." Qwest and UUNet continue to let employees accept stock as long as they tell their supervisors. By contrast, AT&T has a firm policy against employees' accepting stock from companies AT&T does business with.
But FORTUNE has learned that AT&T is investigating some executives who found their way around these rules and own stock in a number of such companies, including Avici, whose gear AT&T is currently testing in field trials and may eventually buy. (AT&T would not comment.)
If any change in attitude is to stanch the flow of options, chances are it will come from the uneasiness of companies whose employees receive them, not from disquiet among the givers. Many startup CEOs, eager to advance their businesses, see nothing wrong with giving stock to TAB members.
Their view is that if startups buy anything with TAB stock options, it's not special access but invaluable guidance on product development, technology, and markets. If by assimilating all this information a startup ends up selling $100 million of gear to its mentor's corporation, then that's just great.
"Having early large customers on the technical advisory board helps with writing product specs," says Urban Media's Mockapetris. "You establish an early relationship and really see what companies need."
As helpful as their advice may be, though, the amount of money TAB members get does seem a little out of whack. Not that anyone really knows how much the options are going to be worth at the time they are granted, but given the recent inflated valuations of networking equipment companies, people can form a pretty good idea.
Yet Goel and O'Dell argue that the money they have made from TABs is just an interesting footnote to their quest for new technology. "The idea of the stock having great value is the last thing on your mind," insists O'Dell.
If this is true, then something startling has happened to our perception of wealth. For, in effect, O'Dell is saying not only that $2 million or $3 million is a perfectly reasonable amount to receive for minimal work but that such a payout is almost a trivial sum. Kind of makes you long for the simple days of Christmas hams, doesn't it?
FEEDBACK: mwarner@fortunemail.com
ALL ABOARD the GRAVY TRAIN
Startups appoint customers to their technical advisory boards...and then make out.
STARTUP CUSTOMER
Avici Jim McManus, UUNet
PRIZE WON BY STARTUP
Terabit switch routers in the lab for testing
Corvis Matt Bross, Williams
Vab Goel, Qwest Communications
[PRIZE WON BY STARTUP]
$200 million over two years for optical networking equipment Multiyear agreement for OC-192 routers
CoSine Vab Goel, Qwest[1] [PRIZE WON BY STARTUP] Multimillion-dollar agreement for IP hardware and software
ONI Matt Bross[2], Williams [PRIZE WON BY STARTUP] Purchase and licensing agreement for Online9000 router
Sycamore Matt Bross, Williams [PRIZE WON BY STARTUP] $400 million over two years for optical networking equipment
Xedia Mike O'Dell, UUNet [PRIZE WON BY STARTUP] Multimillion-dollar deal for Internet access routers
[1]Qwest Chairman Phil Anschutz is also an investor. [2]Sits on board of directors.
-QUOT-
"In the old days you could give a ham to the purchasing agent at Christmas. This looks like 16 trucks of ham." |
