Stock options have been central to the demise of the dotcom sector but also show a lack of thought about compensation and pay policies and the greed of the founders.

This is the latest in a series of columns written for HR Zone from management education portal FTdynamo.com.

The management mayhem at Yahoo!, up till now one of the few blue chips of the internet, has been picked over in prurient detail by the press.

But the real story at Yahoo! – not to mention the 26 other dotcoms that lost their CEOs in January, according to Business Week – is not management disagreements or even wildly over optimistic estimation of demand as recession bites. The hidden destroyer gnawing at the fabric of these internet companies is that sine qua non of the new economy: stock options.

Ignored in the bull market, options have a negative as well as a positive charge. Switched on when the stock market goes into reverse, it is the mirror-image of the more familiar positive charge that operates when the share price climbs. ‘Virtually all dotcoms have relied disproportionately on stock options as a form of pay,’ says Vicky Wright of remuneration specialists Hay Management Consultants. ‘This is tantamount to letting the stock market decide your pay policy.’

And not just pay policy. It’s bad enough that when the share price tanks, the best people no longer have any incentive to stay. Less obviously, as is now becoming clear, option addiction gives a false picture of the company’s entire cost base. Take a typical current scenario. The company’s share price – we’ll call it Inflatedvalue.com – plummets, leaving the founders’ options underwater. The following events ensue.

The founders quit, pushing the share price further downward (since the founders were the main, or only, asset). (The company can of course try to keep them by re-basing the options or issuing new ones. But it can only do that so many times – even in the US suffering investors are becoming increasingly resistant to such ploys. And with the whole market at rock bottom it is much easier for the footloose to skip for a better deal at a new company.)

Next, the other ranks demand a large cash pay rise. Now that the equity dream has evaporated, they suddenly realise they have been working absurd hours in miserable conditions for a salary typically 50 per cent below the normal market rate: in short, they are being exploited.

Suppliers also stop taking equity as payment. It’s cash now, please, in full. The snag here is that unlike equity payments cash has to be charged to the income statement. Net result of moving from the option to the real economy: the company’s reported losses are doubled, or at best profits are cut in half.

Compounding the effect, just as options kept costs artificially low, to the extent that a company accepted them as payment for its own services as supplier, they overstated revenues too. This may involve more than peanuts. For instance, Amazon has booked an estimated $450 million in revenues from its corporate partners. Much of this has been taken in the form of stock, current value unknown.

So down goes the share price once again. Theoretically, a fire-sale price might make the company attractive to a potential bidder. Cheapness may not be enough, however. On top of the double whammy to the firm’s revenue and cost accounts, the stock-option culture has deformed the company’s entire decision-making process. In pursuit of the bonanza, Inflatedvalue.com has tied its decisions to signals from the market which were themselves completely divorced from fundamentals. Now that these are reasserting themselves, any claim which the company had to be considered any differently from its offline peers has vanished.

Companies on both sides of the Atlantic have spent much of the last decade arguing fiercely against the proposal (now resurrected) to charge stock options against income, on the grounds that a) it wasn’t a cost, and b) without them the enterprise economy would collapse. Much good it has done them. As the plight of Yahoo! and many other new-economy hopefuls prove, a costless option is as mythical a beast as a free lunch. If company founders and VCs hadn’t been blinded to these costs by their own greed, their options wouldn’t be pulling their companies apart today.

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