Cue the background music [link to a streaming music play].

Watching the gyrating reports on the price paid for Apple’s purchase of music streaming service LaLa reminds me that acquisition prices are widely misreported and often misunderstood even when correctly reported.  Some people only want to know one number – the price paid – without caring about the many other numbers that are relevant to understanding who got what:  the company’s cash on hand, outstanding debt, financing history, and other numbers relevant to the capitalization of the company.

Even the best reporting often misses one important element of the analysis:  newly issued options (or other equity) shortly before the deal.  I like to call this the “options icing” – and it’s a very important concept for understanding what really happened.  For company founders, management and especially employees, it can mean the difference between a happy and tragic outcome for their startup.  The “icing” is both icing on the cake for employees, and also a good way to ice a bad cap table.

The options icing doesn’t come into play very often, but it is more common when the acquiror is a large, sophisticated tech company that historically rewards employees with equity incentive.  This kind of acquiror understands that the future success of the acquired product is less about the technology and more about the personnel continuing to prosper in the big company environment.

Let me make up an example.  A big company has got a problem if the market value of a 50-person company they want to acquire is only $20 million, while the investors have already put in $35 million into the company.  Typically, the investors have to be paid back first before anyone else gets paid, which means that employees would get nothing, which means that the big company would spend $20 million and get a bunch of seriously disgruntled employees, who will probably leave the company pretty soon after the deal. Even if the investors agree to restructure their liquidation preference, say by half, you still have very little left over:  $17.5 million to investors, $2.5 million for employees.  Let’s say that 1/2 of the employee stake is owned by 2 founders, and then you’re down to only $1.25 million for 48 other employees.  Nobody is happy with that outcome.

Here’s where the options icing comes in.  The company could issue a huge pool of options to employees who would be critical to carrying the product forward (in any scenario, whether acquired or not).  Say they issue $10 million worth of new options.  The magic here is that a smart acquiror will be willing to pay for some or all of those new options.  Even though the company is still only worth $20 million, the acquiror could be happy to pay $30 million if the options are issued to the right folks with the right terms.

The “right terms” include typical vesting terms, so the employees receiving options are incented to do great work for the acquiror.  From the employee’s perspective, this is fair because it is a whole lot better than the stick in the eye they would have been getting under the $20 million scenario.  From the acquiror’s perspective, this is a good deal because rather than flushing $20 million down the toilet, they are making a rational $20 million purchase, with a nice $10 million compensation package that addresses the compensation disadvantage that big companies face in competing with startups.

One of the key reasons that people work in startups is that you can really move the needle for the company’s value.  In financial terms, if you are part of a startup that creates, say, $100 million in value, then it’s a pretty neat feeling to have made nothing into $100 million, and you can get rewarded handsomely for that.  But if you are in a big company that is worth $100 billion, nobody will really notice, or even be able to tell, that you added $100 million in value – it certainly won’t make much of a difference in the stock price.  And that creates a compensation disadvantage for big companies that are trying to motivate their employees with equity grants.

But in the scenario above, the big company can pay for $10 million in stock grants to motivate a relatively small number of employees to execute on a product they clearly understand.  If these employees can turn that $20 million business into a $100 million business, they will be rewarded for it in a manner comparable to their rewards if they had remained an independent company.  That kind of compensation is generally not possible to award in a big company other than in this scenario because of internal “fairness” issues.

The beauty of all of this is that it is one of the few situations in this rotten ol’ world that deal dynamics favor the rank-and-file employees.  Most corporate dynamics, especially in big deals, have a tendency to screw the little guy.  But in order for this situation to be a good outcome for everybody, the rank-and-file employees have to be rewarded in a fair manner.  Coming back to my example above, the options icing can be win-win-win all around:  The investors can get a little tip for agreeing to the restructuring and the new equity; let’s say they get $18 million, just a bit more than they would have made otherwise.  That leaves $12 million for the employees – say the two founders take $3 million, more than twice as much as they would have made under the $20 million deal.  The other employees get $9 million, more than 7 times as they would have made.  The acquiror paid $10 million more, but as described above, this is money that really makes sense to spend, and it’s more like incentive compensation than it is acquisition consideration.

And this deal gets reported as a $30 million price paid.  But really from the right perspective it should be regarded as a $20 million deal.  Now, I am not saying that anything like this is what happened in the Apple-LaLa deal – actually the discrepancy in the reported numbers is too large to be explained by options icing alone.