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Markkula Center for Applied Ethics

The Case of Underwater Options

Miriam Schulman

An acquisition raises questions about fairness and an employee’s right to know in this fictionalized case about a biotech start-up.

A salary of $85,000 plus options to buy 30,000 shares of common stock it sounded like a reasonable deal to Leanne Gallagher.

It was April 1999, and Gallagher was being recruited to join a start-up venture, MoniMed. The company, which had already been in operation for two years, made medical monitoring devices. Marc Cornwall, the director of engineering, who interviewed Gallagher, said the company was expected to go public within the year.

If Gallagher took the job, she would be joining the 30-person firm as a senior software engineer. She had been working at an established corporation for 15 years and had recently completed her master’s degree. Now she felt ready for a more demanding challenge.

Of course, she was currently making $105,000 a year, but she was willing to risk the salary differential on stock in what looked like a viable concern. MoniMed had a good strategy that would take advantage of imminent changes in flat panel display technology. But the company had to get its product to market within the next 12 months to exploit this niche. Gallagher thought she was just the person to kick the manufacturing arm of the company into high gear.

As far as the stock went, 30,000 options at 30 cents a share seemed like a good offer though she had no way of knowing for sure. She had asked what percentage of the total outstanding shares her options represented, but Cornwall didn’t have that information. None of the employees, he said, really knew what percentage of the stock they owned, but all the IPOs had been doing so well recently that everyone assumed they would come out ahead.

Although Gallagher knew from other engineers that a failure to share financial information was not uncommon at Silicon Valley start-ups, she hoped to be a little better informed before she accepted the offer. She learned from a friend with an MBA that all corporations in California had to file certain information about their boards of directors and stock plans with the secretary of state’s office. She decided to contact that office and request information on MoniMed.

She got a phone number for the secretary of state’s corporate status office, which she assumed was the correct department, but when she called, she learned that it was not possible to speak to an actual human being at that number. Instead, a recorded message gave a list of documents (with fees) that could be ordered. Since Gallagher didn’t know which one would have the information she needed, and since any document wouldn’t arrive for two weeks, she decided to abandon that route.

Instead, she decided to do some general research on the Web, reading articles about options. She saw that, as a rule of thumb, $10 was the typical target price for the initial offering. If MoniMed followed that pattern, even after purchasing the options for the $9,000 in her salary package, she would make $291,000 on the stock.

That should more than make up for the salary differential. Assuming she got no raises for the four years before she was completely vested, Gallagher would lose $80,000 in salary from the job change. But she should still come out ahead unless the stock fell below the option costs combined with her salary losses, or $89,000. That came out to about $3 a share, which seemed unlikely. Medical device companies often came out at $20 a share. Besides, IPOs had been going through the roof all year. On March 30, rose 331 percent on its first day of trading.

Of course, MoniMed might fail: The team might not produce their initial product within the window created by the advent of the new flat panel display. They might not be able to bring the costs down enough to make it attractive. Agilent or some other competitor might even now be coming up with a better product. Those were all risks Gallagher was prepared to take because she fully believed she had the right skills and ideas to help make the company a success. She decided to take the job.

What Gallagher didn’t know because Cornwall didn’t know it when he interviewed her was that MoniMed was at a critical juncture. Barry Grantz, the founder/CEO, had enough capital left from an original investment by his father and some venture investors two years earlier to keep the company going another three months. If MoniMed could not attract some new funding soon, it was going to have to close up shop. Grantz had decided not to share this information with anyone other than the CFO because he did not want to provoke a mass exodus, and besides, he firmly believed the company would eventually succeed especially with the help of his new, more experienced hires.

When Gallagher came to work the first day, she was struck at once by the youth of her colleagues. She was one of 20 engineers. Most were newly minted bachelors of science, and MoniMed was their first foray into the business world. She was a little nervous about whether such an untried crew could bring the project in on time.

But soon Gallagher realized that what they lacked in experience, they made up in enthusiasm and diligence. Eighty-hour work weeks were common. Gallagher herself went directly from graduation ceremonies to the office and stayed past midnight. Pretty soon, she lost count of the all-nighters. During the industry tradeshow, some of her colleagues actually slept on the convention premises. They did not leave the show for a week–not even for meals.

The hours were hard on her marriage, but she considered herself one of the lucky ones. Her husband was also an engineer, and he understood the time demands. And they had no children. Many colleagues had a tougher time, with at least two divorces and one serious stress-related illness as the employees struggled to get the company ready for a public offering.

They did not receive much help from Grantz. It didn’t take Gallagher long to realize that her CEO knew a lot less about biomedical devices than his staff. Of course, that wouldn’t necessarily have been a problem if he had been good on the business side. His contribution, however, seemed to be primarily a rich father, who had put MoniMed together as a sort of toy for his son.

At the same time, Gallagher liked the intellectual challenges of her job, liked figuring out successful compromises between optimal solutions, time pressures and costs. As senior engineer, she was responsible for refining the dynamic physiological monitoring capabilities. She worked closely with the director of manufacturing, who had been able to reduce the unit cost while simultaneously making it more reliable. They were able to bring the project in on time, and the improvements helped the sales manager (who had been practically starving on his commission wages) to attract a large customer Acme Biosystems.

Grantz could not have been more encouraging, calling an all-hands meeting to congratulate the staff and predict a Mercedes in all of their futures. Gallagher and her colleagues were justifiably proud when, soon after Acme signed a contract to buy 400 cardiovascular monitoring devices, the IPO was announced for January.

They were jubilant for a few weeks. Soon scuttlebutt began circulating that the IPO was on hold. It was impossible to get reliable information, but water cooler gossip said an acquisition was in the works. Two companies had expressed an interest, CV Diagnostix and Fenton Health Group. At first, Gallagher thought this wouldn’t be a bad fate for the company. After all, both rumored buyers were solid companies with distribution systems and marketing infrastructure unavailable to a start-up.

Gallagher asked to talk to Grantz about the proposed deals, but she was told that he would have nothing to say while negotiations were ongoing. Still, details began to leak out. Employees heard that Fenton was offering the sweeter deal, but it came with a proviso: MoniMed would have to install a new CEO. Gallagher was equally sure that such a move would be good for the company and that Grantz would never accept it. She was right. Within days, Grantz called employees together to announce that MoniMed was being acquired by CV Diagnostix–at 27 cents a share for common stock.

When the financials became public as part of the deal, Gallagher was shocked to discover that the company had not done nearly as well as the employees had been led to believe. MoniMed had raised and spent over $14 million. It had also lost another $12.7 million, so that when CV Diagnostix acquired the company for $10.5 million, investors were down about $2 million.

Any options granted prior to June 1999 (including those owned by Gallagher and all the other employees) had strike prices of at least 30 cents. That meant Gallagher and the other engineers’ shares were what is colorfully described as "underwater." It would cost more to exercise them than they were worth.

Oh, there were some people who made out OK. Grantz received about $2.5 million from the sale.

Gallagher submitted her resignation the next day. In her letter to Grantz she wrote, "When I went to work for MoniMed, I knew I was taking a risk. If we hadn’t been able to produce the device or if there had been no market for it, I would have accepted my losses. But we beat the odds we made a good product and attracted a large customer.

"You led us to believe that the firm was doing well, but when we were acquired, you were the only person to profit. Why were the people responsible for the firm’s success the biggest losers?

"I went to work for you at less than my normal salary with the understanding that my stock options represented some significant ownership in the company. This deal made me a de facto investor. Beyond the monetary investment, I also put my family and health at risk through the long, demanding hours.

"Didn’t this at least entitle me to the basic information and protections other investors received? Shouldn’t I have been told what percentage of the total stock my options represented? Didn’t I have a right to know that the company was nearly out of money when I was hired? Was it fair to string me along with tales of a new Mercedes when you knew the rate at which MoniMed was burning money? Shouldn’t I have been given a voice in the deal you accepted, which made my investment worthless?"

How would you answer Leanne Gallagher?

Miriam Schulman is the director of publications for the Markkula Center for Applied Ethics at Santa Clara University.

Spring 2001

Apr 1, 2001