February 18, 1996
Silicon Valley Finds Quick Ways
To Make Cash From Paper Fortunes
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By MICHAEL S. MALONE
SUNNYVALE, Calif. -- In August, the Netscape Communications Corp. held one of the most successful initial public stock offerings in Silicon Valley history. In a single day, the year-old company, with just $17 million in sales, was valued at more than $3 billion. And the stock kept climbing.
It was an exciting moment for Netscape employees, many of whom had instant personal fortunes -- on paper, at least. But almost as exciting was the day three months later when the underwriter, Morgan Stanley, decided Netscape's stock was strong enough to release the lock-out on its sale by non-officers. That's when the payoff became real.
"We wanted to let our employees get a little bit of liquidity," said Mike Homer, Netscape vice president for marketing.
Tales about the bosses are all too familiar -- the new multi-multi-millionaires so obsessed with their work that they still drive their '87 Chevys and haven't bothered to move uphill from their humble lodgings.
But below them are the midlevel employees suddenly worth a million or two on paper -- and still struggling to buy groceries. They're itching to live better -- a lot better.
At Netscape, Homer said, some employees didn't wait for Morgan Stanley to fire the starting gun. Instead, they found financial institutions and brokers willing to lend them money using their newly valuable stock as collateral or otherwise turn their paper wealth into cash.
Most ways of doing this are legal, but some seem to subvert the reason the rules are there in the first place -- to keep insiders from bailing out too soon after the public is invited in.
Any attempt by the Securities and Exchange Commission to categorize and control this type of activity doesn't work, said Robert Gabele, president of CDA/Investnet Inc. in Fort Lauderdale, Fla., which follows the securities industry. "Wall Street quickly finds ways to get around the definition."
As for Homer himself, though he wouldn't say exactly how he got the cash, he did not wait long before he bought a new Mercedes, took a couple of weeks' vacation, started looking for a new house for his family and, for Christmas, bought his mother a new car.
Such spending has been a Silicon Valley phenomenon at least since Apple Computer went public with its first sale of stock in 1981. Within days, even hours of stock offerings, the parking lots full of rusted heaps start to be transformed into a veritable auto show of new Ferraris and Porsches. And within weeks, many of these cars are driven to expensive new homes in the hills.
Where do these people get the cash?
"I sometimes wonder about that myself," laughed E. Michael Begovich, regional vice president for the technology industries group of Bank of the West in San Jose. "But I'll tell you this: If a client worth, say, $200 million on paper came to me and wanted to borrow $100,000 on an unsecured loan and pay it back in six months, I'd do it.
"I want his company's business, I want his business -- and, eventually, he'll probably move on and start some other business, and I want a shot at dealing with that company, too," he said.
Begovich's remarks are a reminder that just because your stock makes you rich doesn't mean you can spend your new wealth, at least not right away. The SEC has regulations tying up big employee stock sales for months after an initial offering.
The underwriters add their restrictions, typically lock-outs to the stocks for as long as six months. Then there are stock options, which employees may not be able to cash in for years. And key executives must be careful about unloading shares or risk damaging the company's image and putting the stock in free fall.
Still, there is a powerful desire to reward yourself for long hours and financial sacrifices. According to Jean W. Blomberg, senior vice president of Silicon Valley Bank in Palo Alto, top managers usually do not have much trouble. "Most of these people have started several companies in the past," she said, "so they typically borrow against some other asset, like a residence, then pay it off when they exercise the stock."
Companies can help employees improve their lot, too. Apple, for example, around the time of its offering, began rewarding top executives with expensive cars, helping prompt the sudden change in the complexion of its parking lot.
More difficult are the first-time entrepreneurial successes, who typically have few assets and have burned up what little credit they had trying to keep the company alive.
For them, the biggest challenge may be just getting through the car dealer's door. Since the days of Steve Jobs and Steve Wozniak, it has been a valley cliche that the scruffy guy in torn clothes looking in the showroom window is either a burglar casing the place or next week's Time magazine cover.
"You talk to everyone who comes in," said Bart Hood, vice president and general manager of Park Avenue Motors Inc., a Mercedes-Benz dealership in Palo Alto. "Not long ago, I had a young kid come in with a ponytail, T-shirt and jeans. Turned out he was a software designer. He'd gone to another dealer and nobody would even talk to him. We sold him a Mercedes roadster."
When these T-shirt tycoons want to turn stock into cash, Ms. Blomberg said, it is important to develop a relationship with the bank, usually through the company, well in advance. It is also important, she added, for the bank to have a good understanding of the industry.
Most banks have their own rules barring lending against restricted stock, she said. "But if you know the company and its business, you can sometimes take that extra risk."
In the housing market, the wave of stock offerings has put increasing pressure on prices, particularly in the best neighborhoods.
Multiple offers on homes have become the rule in communities like Palo Alto, Menlo Park, Los Gatos, Woodside and Portola, and some home seekers complain they are being driven from the market by all-cash offers from employees of newly public companies.
In Santa Clara County, the heart of Silicon Valley, prices in some communities have skyrocketed. From 1994 to 1995 the median value of a home in Los Altos Hills rose from $825,000 to $1 million, or 21 percent; in Palo Alto, it went from $416,000 to $450,000, an 8 percent increase.
One factor in favor of the new Silicon Valley millionaires is that they are the latest in a long line of high-tech grandees. Technology employees burning money on expensive playthings after an initial offering have been around since the 1960s. Apple, for example, created about 100 millionaires when it went public, some of them engineers and secretaries. At Microsoft, it may have been 10 times that.
The smart companies, typically those led by veterans of past offerings, bring in professionals to help. Netscape's chairman, James L. Clark, who had founded Silicon Graphics, and its president and chief executive, James L. Barksdale, former chief executive of AT&T Wireless, brought in investment bankers from Morgan Stanley, Hambrecht & Quist and Alex Brown to give employees free advice on investing their new riches.
"The issue often becomes how mature these people are," said Tim Bajarin, president of Creative Strategies Inc. of San Jose. "Some people act like a kid in a candy store. Overnight, they suddenly become rich -- and a lot of them don't know how to deal with it."
But turning restricted stock into cash is not as simple as it may sound, especially the higher you go in the company. The SEC places constraints both on selling stock and on borrowing against it -- the most notable being Section 16 of the 1933 Securities Act, which establishes who is an insider, and Rule 144, which sets limits on when and how much restricted stock can be sold by company executives and board members.
Although the commission does not state an official position about any of this for fear of setting precedents, it is known that these controls are intended to give outside investors an equal advantage with insiders, to aim sunlight at what would otherwise be hidden transactions and to keep corporate executives and underwriters from secretly selling their own stock short.
Unfortunately, the controls do not always work. "The touchiest transactions in this area," said Gabele of CDA/Investnet, "are equity swaps in which the stock is being pledged as collateral and the bank or brokerage is shorting the stock to cover that loan. That should prompt an insider filing with the SEC. But it often doesn't."
On the surface, these rules do not seem particularly onerous. For example, under Rule 144, during any 90-day period an insider may sell up to 1 percent of the company's total outstanding shares, or the average number of shares traded in the most recent four weeks, whichever is greater. That is a large hunk of change.
Of course, an insider must hold the stock for two years after getting it even to qualify for a Rule 144 sale. And it takes three years to get past the Rule 144 limits altogether. But the clock starts running as soon as the stock is acquired -- in most cases, well before a company goes public.
Yet such is the hunger of newly rich stockholders either to cash out or to diversify that a small army of Section 16 lawyers and Rule 144 brokers has appeared to guide their corporate charges through and around this process. The SEC is especially wary of any transactions involving insiders selling their own company's stock short, which is essentially betting against the company.
The biggest brokerage houses -- Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Brothers and Smith Barney -- have even formed special departments for restricted-stock trading.
These teams, which dealt with nine billion such shares in the first half of 1994 alone, have come up with several strategies for liquidating restricted stock, each with advantages and disadvantages.
"A lot of companies view compensation to employees as including the selling of shares," said Richard A. Gadbois III, senior vice president for Merrill Lynch in Irvine, Calif., and one of the most successful Rule 144 brokers. "And certainly, the ability to generate wealth through capital accumulation is far more compelling to employees than simply through salaries. So companies face an essential dilemma between doing the right thing in their financial planning or sending the right message to their shareholders."
Prying cash loose from stock -- especially using techniques like "shorting against the box," or selling short the same number of shares you want cash for, is, to Gadbois, "a wonderful technique to liquidate a position and defer your taxes."
"It's amazing to me the IRS has let us do it so long," he said. "In fact, there are new laws in front of Congress" that might restrict it.
In lieu of unsecured loans, which can be hard to get outside of places like Silicon Valley, Gadbois recommends that clients sell a little stock at a time, not a lot all at once, so they do not stretch any rules.
"Many of them want to buy a home, which we find is the most common first big-ticket item. Others are reluctant to part with their stock and end up riding it back down. The next product fails to meet expectations, the stock falls off the table and their wealth evaporates."
For that reason, Timoney added, Bank of America advises its newly stock-rich clients to diversify their wealth as soon as possible. "We work with them to provide liquidity, such as using the stock for a loan, and then investing those proceeds into other securities."
How much can they borrow? Typically 50 percent to 70 percent of the market value of the stock, said Timoney, adding that because the stock is not actually sold, there is no problem with SEC restrictions. Loans with more solid collateral can reach as much as 90 percent of the underlying value of the stock.
The bank is also willing to be creative, Timoney said -- "to look at transactions outside the box." If, say, a newly paper-rich executive wants to buy an expensive house, Bank of America might "customize the transaction to provide a 100 percent loan combining the usual 70 percent loan on the house with a pledge of stock to make up the difference."
The special banking operations quickly become the home base for the new tycoons. At Silicon Valley Bank, Ms. Blomberg said, it's not unusual to get a call from an executive in an airplane who wants $100,000 taken out of his line of credit and put in his account to buy a ranch or another airplane or an exotic car.
In the latest wrinkle, Silicon Valley Bank has opened an office in the heart of the venture capital industry at an office complex in Menlo Park.
According to Don Cvietusa, a senior vice president who runs the venture capital group, the bank offers a special line of credit for junior partners in venture capital firms to provide them with $50,000 or more they might not otherwise be able to get their hands on.
Being there is also a great way to learn about new star companies that may still be years from going public. "The key in this town is to not be merely reactive, but to anticipate what's coming," Cvietusa said. "We shouldn't wait for these people to come to us after an IPO; rather, we should be in touch with them long before."
And no doubt there will be many more overnight tycoons to come. In the story of Silicon Valley, successful initial offerings not only motivate a new generation of entrepreneurs, but also fill the coffers of the venture capitalists that finance them. The valley dream endures.
"It's always fun to watch the transformation," Bajarin of Creative Strategies said. "One day you're with a guy and he has to borrow a couple of bucks to pay for his lunch. The next day, he can buy the restaurant."
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