Stock Options—Heading Down—Looking up


The growth in new businesses continues to be the engine that drives the American economy. According to the 2008 Kauffman study, The Capital Structure of New Firms, 17 percent of new firms in the longitudinal study have more than three employees and more than 87 percent have a medium or low credit score. That is to say that these enterprises have a leveraged compensation structure and generally highly constrained access to cash, at least during capital-intensive stages such as start up or market entry.

Access to cash secured by assets is and has been exceptionally tight, leaving entrepreneurs with the dilemma of having to either reduce overhead costs and thereby decrease the speed at which the company achieves profitability from operations or sell off its earnings in the venture capital market and thereby hope to capitalize itself adequately for long enough to access the marketplace.


The venture capital marketplace is, however, not currently a likely candidate for most businesses to access liquidity. From June 2001 to June 2011, venture capital funds earned an average of 1.3 percent on their investments. Over this same period, the DJIA returned 4.2 percent, the S&P delivered 2.7 percent and the NASDAQ provided a 2.5 percent return. The “barbell” strategy of most venture funds has left early and mid-stage companies with stagnant capital plans.


The inevitable valuation discount based on asymmetric information imposed by outside equity investors, combined with the ubiquitous distaste by company founders for diluting their ownership proportions, renders debt a much more attractive source for capital than is outside equity. As a result, founders initially tend to prefer internal financing methods, followed by the issuance of debt until the anticipated service of that debt appears no longer reasonable to service (a decision as often as not reached without qualified analysis), and finally by selling equity in the company.


As debt increases and equity stays level during early stage and even mid-stage enterprise development, founders are incentivized to take on increasingly risky projects, often in the hopes of windfall revenue that will liquidate the dent burden. All too often, once the debt to equity ratio of the firm approaches unity, the founders have increased risk appetite because the return from the increased risk flows exclusively to the equity owners, whereas the debt holders retain all the increased risk of loss. This mismatch in incentives, called the asset substitution effect, becomes increasingly more dramatic once the D/E is below one and the founders have, in effect, nothing to lose by taking on larger risks. Obviously, temporal information asymmetries underlie the difficulties in managing this problem and can be overcome with diligent, even aggressive, transparency protocols, such as real time financial disclosure and debt-holder monitoring of all financial activity. While burdensome on all parties, these time-tested mechanisms operationally align the interests of the equity –constrained enterprise and its creditors.


But what of the company struggling to bring its innovation to the market or to grow in a competitive environment?


Enterprises seeking to retain or attract talent should be aware that, since, 2004, the use of stock options has generally decreased in the U.S., with a notable exception for full time employees in New England, where the use of stock options has rebounded measurably in the last few years. Interestingly, the tightening of credit and cash has not appeared to have shifted a substantial emphasis to options. Rather, companies have become, across the entire country, less willing to dilute the equity of their founders in order to remain competitive. In short, in the last couple of years, business owners have been becoming more optimistic about the future.



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Vox Clamantis in Deserto

The idea of the American philanthropic institution began on its present course in 1769 when
Dr. Eleazar Wheelock obtained from the British Crown, with the intercession of John Wentworth, the British Colonial Governor (and friend and classmate of John Adams at Harvard), a charter for the new Dartmouth College. That Charter auspiciously provided that the College be established , among other things:

for the education & instruction of Youth of  the Indian Tribes in this Land in reading, writing & all parts of Learning which shall appear necessary and expedient for civilizing & christianizing Children of Pagans as well as in all liberal Arts and Sciences; and also of English Youth and any others

Like many institutions of higher education of the time, religion held a galvanizing role in the college’s purpose. In 1779, Eleazar’s son, succeeded him and became America’s first lay college president. With the arrival of the new decade, Dartmouth would find itself as the very crucible of American charity.

Through the 1780s, New Hampshire increased its support for Dartmouth, partly in response to Vermont’s overtures to the college. In the late 1780s and early ‘90s, New Hampshire made repeated land grants to Dartmouth. The national trend of legislatures demanding increased secularism in the curricula of the schools they supported found its way to Dartmouth’s door and the inevitable counter-revolution swept the college up in its candescence.

By 1804 the orthodox wave had swept up  a majority of the college trustees and they named Roswell Shurtleff as professor of divinity. Mr. Shurtleff had been a student at Dartmouth and had witnessed first had the events of years earlier when the young new president had struggled for campus power by taking his one faculty ally, the campus pastor, away from the college church and thence to the chapel, leaving the church with an empty pulpit and the (in those days) paid seats unpaid for and unfilled.

Pastor John Smith had been a long time and unwavering ally of Dr. Wheelock and Wheelock knew that Smith was not favored as pastor of the church. Accordingly, when he interviewed Shurtleff for the professor of divinity position, he made Shurtleff vow to support him as condition of getting the job. Shurtleff, however, never sought nor obtained Smith’s resignation as pastor. The die was cast for Dartmouth College to make history.

Immediately after Shurtleff’s appointment, the local church induced him to accept a call to its pulpit. Smith, although having earlier announced his resignation, held to the campus church pulpit at Wheelock’s insistence and the split between Wheelock and the Trustees became irreparable.

Smith’s star waned, Shurtleff’s rose, and in 1809 the students rioted. The elimination of “treating” parties (ritualized drinking at major campus events-some things never change) and the imposition of a more conservative curriculum did not sit well with them. Four new orthodox trustees were appointed and Wheelock publicly accused them of turning Dartmouth into a “sectarian school.” Shurtleff responded with accusations that Wheelock was a “liberal” and was turning Dartmouth into a “seminary of Socinianism.” The 19th century American epithet of Socinianism was a general reference to a dissension from the common view, named after the 16th century religious thinker, Laelius Socinus, who, among others, repudiated large parts of orthodox Christian theology including the trinity, the divinity of Christ and soteriology. It was not unlike the broad brush tactics of accusing the opposition of being Communists in the 1950s or being unpatriotic for failing to support warrantless wiretaps after 9/11. The accusation alone was enough to threaten the credibility of the target. The Trustees proceeded to fire Wheelock and Wheelock appealed to the New Hampshire legislature to revise the school’s charter and make it into a public institution.

The Legislature, embracing the argument that, insofar as Dartmouth accepted public funds and land grants, it owed a duty to the state to carry out the affairs of the state, dissolved the college charter, created a new Dartmouth University, and appointed a new board of directors. The previous Board refused to acknowledge the new board and sued William Woodward, the state approved secretary, to force him to turn over the records and seal of the institution. The Supreme Court overturned the action of the legislature and the reasoning of the Court built the foundation upon which modern American charitable theory is built.

Mark D. McGarvie provides a superb analysis of the Court’s opinion in his essay The Dartmouth College Case and the Legal Design of Civil Society appearing in Charity, Philanthropy and Civility in American Society (Cambridge University Press 2002).  He observes, quite differently than most other commentators, that the Supreme Court’s decision was not based on the conclusion that, insofar as the charter of the college constituted a contract, the legislature was prohibited by Article I, Section 10 of the Constitution from interfering with it. Indeed, that reasoning had already been laid down in the earlier cases of Fletcher v. Peck and Terrett v. Taylor. Rather, Chief Justice Marshall first disposes of the legislature’s argument that the College was bound to the interests of the state. The people of the state, in making donations to the College, Marshall observes, are disposing in the interest of that institution, as articulated in its charter, not in the interest of the state. Hence, The Court concludes that the charter, as a contract between the people and the state, and the chartered enterprise and the state, must be held inviolate.

With this opinion was born the assurance to donors that the objects of their bounty would be honored and the promise to charitable enterprises that their existence would remain perpetual. The “long term” was invented with the same breath that blew volatility out of the charitable donative transaction. The voice in the wilderness would cry out to posterity forever.

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Corporate Demand for Money–Some Background


 First, a little background as to what got me thinking about corporate philanthropic behavior in the first place. Corporations, like the rest of us, have a choice in what they do with their money and they will, like the rest of us, seek to maximize the utility they derive from each dollar spent. Corporations have a predictable and measurable demand for money that William Baumol modeled in 1952.

Corporate demand for money can be measured with this relationship:

 C =- bT/M + iM/2


T is a known stream of expenditures that must be paid for in cash

This cash is obtained from a withdrawal from assets bearing a constant known interest rate i

b is the fixed cost per withdrawal

So, if the company withdraws from cash each time its balance reaches zero, it will have an average money balance of M/2  and brokerage costs of bT/M.

If we set the derivative of this equation with respect to M equal to zero, we find that the optimal withdrawal size is:


M* = SQRT [2bT/i]

Clearly, the prevailing interest rate will affect the utility function of the corporate decision to withdraw cash, no matter what that cash is for. Thus, I decided to explore what the effect of the interest rate is on corporate philanthropy. It turns out that it has a larger effect than I expected.

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Give It Away


I have been advising and sitting on the boards of charitable organizations for most of my career and, in the last few years, charities have struggled mightily. Most attribute the struggle to a falloff in donations; others observe a decline in operating revenues such as ticket sales.

One thing I have noticed the many charitable organizations in the communities I serve have in common is that each identifies the cause, and the appropriate response set, differently. I have no doubt that each organization should, and does, view its market space differently. Another is that they all miss what is really going on in the marketplace and, more importantly, what they need to do to thrive in a volatile economy.

The next five entries in this blog will be about some of my own research and some classic studies on how charities can make the most of this economy and how they can understand and respond to the economic conditions they find themselves in.

Philanthropy has five roles in society. Each of those roles has a market position and each should be addressed separately in evaluating a charity’s strategy for growing (or remaining) in its business. None of them should be ignored.

Robert Payton and Michael Moody have produced an excellent book called Understanding Philanthropy   Payton and Moody distill a number of studies of the roles of tax exempt organizations to five principal purposes:

  • Service Role – Providing services  and meeting needs, especially in the gaps that other services leave;
  • Advocacy – advocating for particular interests or goals;
  • Cultural role – Providing a vehicle for expressing shared values, traditions and identities ;
  • Civic Role – Building community; Generating social capital; and Promoting an increase in civic engagement;
  • Vanguard Role – Serving as a locus for social innovation, experimentation and entrepreneurism.

As a general rule, philanthropic and charitable organizations do more than merely express the agendas of their organizers. They are tax exempt and are, thereby, supported at the public fisc. As well, donations to these organizations are typically encouraged by the government through the availability of tax deductions. The combined cost to the tax rolls, then, is substantial.

The next four posts here will consider, in turn, the following issues:

  1. Do and should charities do the work of government?
  2. What motivates individuals to donate money to charity (hint- it’s not the tax deduction)
  3. What motivates corporations to donate to charity (see above hint)
  4. Some of my own research over the last couple of decades considering how charities can better anticipate and manage their resources and goals in various  economic conditions.


Individuals and corporations give away to charity about 2.2% of the total U.S. GDP every year. This is an enormous economic force. We’ll make some effort here to understand it a little better.

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Bernanke’s Press Conference


Ben Bernanke, Chairman of the Federal Reserve, gave a speech on April 27, a press conference really. This was the first scheduled press conference ever given by the Chairman. He meant for it to contain no news at all but merely to put a human and more credible face on the Federal Reserve, on whose, variously, inaction, over reaction, and wrong action is blamed the stagnant state of the American economy.

Hidden in Mr. Bernanke’s message, however, was an alarming notice of a departure from established economic theory. He stated both that “a strong and stable dollar is in America’s best interest” and that inflation is expected to be between 2.1 and 2.8 percent this year. Interest rates, he said, would be kept low for “a couple of FOMC meetings.” The FOMC meets in June, August, September, November and December this year.

Why is this interesting, even baffling? The answer lies in the notion of Keynesian equilibrium. This is achieved when aggregate expenditures equal aggregate production in an economy and is represented by the equation:























AE is the Aggregate Expenditure in the economy

C is the expense for consumption

 I is investment expenditures

G is government expenditures and

(X-M) is the difference between exports, goods and services produced by the domestic economy and purchased by the foreign sector, and imports, goods and services produced by the foreign sector and purchased by the domestic economy. While exports and imports important unto themselves, when combined into a single measure net exports captures the overall interaction between the foreign sector and the domestic economy. Arithmetically speaking, if exports exceed imports, then net exports are positive, and if imports exceed exports, the net exports are negative.

It follows that if inflation is pushing prices up, and the dollar is simultaneously remaining strong, then  aggregate expenditures will have to go up, in order for the economy to remain in equilibrium.

Those expenses are driven by income, of course, which, in turn, is the product of jobs. Nowhere in Dr. Bernanke’s presentation, however, did he so much as acknowledge that his plan for higher than expected inflation and a stronger dollar (hence, lower exports and higher imports) utterly opposes Keynesian equilibrium.  Bernanke has stepped away from the Keynes theories with which he has been associated and seems to be betting on some unstated outside forces coming in to restore equilibrium.

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Walking Into It


In 2008, the IRS Chief Counsel Issued advice dealing with the New York Qualified Enterprise Zone Enterprise (QEZE) tax credit, which provides tax relief to businesses who are located in certain areas and which maintain prescribed employment characteristics.

For federal tax purposes, the IRS Office of Chief Counsel released CCA 200842002 on October 17, 2008 (corporate tax) and CCA 200909032 on February 27, 2009 (flow-through entities) concluding that the refundable portion of the QEZE credit for real property taxes (the amount that may be applied as a credit to another tax year or refunded in cash) may constitute a recovery of property tax previously deducted and therefore, is included in federal taxable income.

Interestingly, the IRS Chief Counsel reached this conclusion despite the fact that the State of New York has no authority to collect or refund property tax. The cities and towns of the state have that authority. The credit is merely measured by the property tax paid by the taxpayer. Notwithstanding this legal obstacle, the Chief Counsel’s office uses some remarkable logical gymnastics in the Advisory Opinion in order to reach its conclusion that the state tax credit is magically converted to taxable income for federal tax purposes because it credits an amount measured by property tax.

New York has attempted to fight back against this money grab by the IRS by reasserting the state’s position with a pronouncement clarifying that the state is, through the QEZE credit, refunding only income or franchise tax, no matter how the amount of the credit is measured. So, while the IRS works to undermine the economic policies of the states by hosting surprise parties for the taxpayers who participate in some tax credit programs and subjecting them to expensive and time consuming audits, penalties and interest, that states are obliged to defend their policies and hope the incentives they created in good faith will survive the federal assault.

This brings us to Connecticut. On April 17, Governor Malloy announced his intent to promote a $300 tax credit on property tax costs. The use of the derivative term “costs” suggests that the governor has become familiar with the IRS strategy of using the states to produce revenue from unsuspecting citizens. It is my hope that he is not merely walking into the trap the IRS has set, though. Indeed, if the tax credit were measured by an algorithm such as “an amount equal to the mil rate of the town where the property is located multiplied by an amount equal to seventy percent of the assessed value of the property” the feds would have a harder time redirecting state money to the federal fisc.

I hope Governor Malloy is being careful.

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First Five? Really?

Governor Malloy is on the right track. The cycle of job creation and business expansion has to begin with government intervention as the instrumentalities of infrastructure and tax are within the state’s control. The First Five initiative, intended to provide large tax incentives to the first five companies that bring at least 200 new jobs to the state in the next couple of years. The attraction of this sort of silver bullet, not to mention the political hay to be made from bringing in a thousand new jobs, has turned the heads of governors for generations. Governor’s Bill 1001 should be read with caution, however.

The initiative addresses only large companies. States are all looking to solve their revenue problems through recruiting strategies. After all, what could be simpler to implement than an existing company arriving in town and hiring residents?

The First Five plan is aimed unashamedly at large corporations and presents some attractive bait to get them to choose (and choose soon!) Connecticut over other states to which to move some part of their operations. But let’s remember that it’s small business that is the major engine of job growth. Look at these data from a few different government sources:


Bringing in large firms promises a big splash, but little resiliency in job creation. These is no escaping the fact that Connecticut, if it is to develop a sustainable recovery, has to attract and create jobs and, if the state wants jobs, the government must create an environment that attracts the engine of job growth-small business. Tax credits, Research and Development incentives, risk transfer facilities and infrastructure improvements (shipping, transportation, storage, data transmission and so forth) should all be developed to create a long term, sustainable environment that raises the confidence and commitment of businesses and improves their willingness to make Connecticut their home. Right now, Connecticut has the 47th worst business tax climate in the country (New York brings up the rear). We need a solution that speaks to the problem, not to the headlines.

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