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BULLS & BEARS: A study in how options can erode shareholder value

September 11, 2006

Business schools use case studies to teach students realworld business decision-making. Likewise, investors can study the historical Securities and Exchange Commission filings of public companies, see how past business decisions played out in the stock market, and perhaps learn a few lessons.

I came across an interesting case the other day, a small company called Intervideo Inc. that had just announced it was being acquired. The more I looked at the Fremont, Calif.-based company, the more it struck me as a glaring example of where public shareholders got the short end, and executives did very well, namely because of stock options.

Intervideo makes software that enables consumers to do their own DVD editing and recording. The company went public three years ago at $14 and the stock doubled right out of the gate. Then, within three months of the offering date, the stock slid from $28 per share down to $10 per share. Since that tumultuous beginning, Intervideo has mostly hovered between $10 per share and $12 per share.

Intervideo's buyer is Canada-based Corel Corp., which is paying $13 a share. Note that an IPO investor in Intervideo's stock, who faithfully held over the past three years, will be cashed out at a $1 per-share loss, resulting in an annual rate of return of -2.5 percent.

This poor result for the public shareholders of Intervideo is somewhat puzzling, since the business actually performed quite well over its three years of public life. Sales more than doubled from $45 million to $109 million. Also, Intervideo has been profitable each year since going public, free cash flow has been strong, and the company has a solid balance sheet.

More curious is that Intervideo's market value at its IPO was $174 million, yet Corel is paying $196 million to acquire the company. If public shareholders did so poorly, where did the $22 million increase in Intervideo's value go?

The answers lie in the stock options issued by Intervideo. Before the IPO, executives held 3 million stock options and have been serial grantors of options ever since. Since taking the company public, executives have been busy cashing in options and granting new ones, including more than 200,000 options issued at $11 just four months ago. With the sale to Corel, Intervideo executives have unexercised options that will net them over $16 million.

On the other hand, the IPO shareholders have seen their interest in the business diluted away. Because of option issuance, Intervideo's shares outstanding have swelled to 15 million from 12.4 million shares at the time of the IPO.

Thus, while the company's business value has increased and executives have profited handsomely, public shareholders have not seen a nickel of it. Adding insult to injury, a large chunk of the financing for Corel's acquisition of Intervideo will come from cash the shareholders provided to the company in the IPO three years ago.

This case study provides a couple of key lessons. First, anyone who says options do not represent a cost to shareholders is sorely mistaken-an argument some vocal Silicon Valley executives finally lost last year. Second, it is vitally important for investors to be able to identify executives who are in their camp as business partners and not out to fleece them.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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