Cypress' Options Largess Extends to Subsidiaries - TheStreet

Cypress Semiconductor

(CY) - Get Report

, a supplier of integrated circuits mostly for the communications industry, is using an esoteric system of equity compensation at several subsidiaries that experts say obscures expenses and could create conflicts of interest.

The system, first articulated in a 1992 book by T.J. Rodgers, Cypress' outspoken CEO, sets aside minority ownership stakes in subsidiaries for employees -- as well as Cypress executives who sit on their boards. The stakes are awarded without a shareholder vote.

Employees and directors of the new Cypress units receive ownership interests via securities that the company labels as either options or shares, although no public market exists for either. Instead, these stakes become valuable when, after time, the parent repurchases the stake or sells them to the public in an IPO. Until then, the cost of the compensation program isn't known or disclosed.

"Our concerns with these plans include the fact they lie outside the scope of the company's corporate options plan, thereby making their true cost difficult to measure," wrote proxy adviser Glass Lewis in a report about Cypress Semiconductor earlier this year. Glass Lewis said the plans are "a risk-free call option on Cypress' future growth opportunities provided to insiders at the expense of shareholders."

The subsidiary stock plans have drawn increased scrutiny amid growing concern about Cypress' heavy use of options in general. In June, Cypress

quietly increased the number of shares available under one of its corporate options plans by 20 million, equal to about 16% of its outstanding stock. The move came days before the company would have been required to take a shareholder vote on the increase, but Cypress didn't disclose it to shareholders until more than six weeks after the fact.

Cypress has two types of subsidiaries. It has launched several start-ups in which it aims to buy back the employee stakes, and has made several acquisitions, which Cypress may choose to take public.

Rodgers argues the equity stakes amount to a bonus program. The company has bought the stakes back in four out of four of its internal start-ups after determining the subsidiaries developed a salable technology. For acquired subsidiaries, Cypress has either not handed out an ownership stake or issued relatively fewer shares to limit the potential payout, Rodgers notes.

Corporate governance experts note two main concerns about the program: Cypress is giving away company ownership without a shareholder vote, and that value is conferred to employees without the company immediately expensing it as an ongoing cost of business.

"I think this is nothing more than a circuitous means of transferring assets from a holding company's owners to that company's employees," said Robert Chapman of hedge fund Chapman Capital. Chapman does not have a stake in Cypress.

Critics are particularly concerned that Cypress executives are getting options in the new units while sitting on their boards, introducing the potential for conflicts of interest between the parent company and its subsidiaries.

"Why is Cypress' board of directors permitting the CEO of the company to be in a conflicted position? We can only assume that they are well aware of these grants and this conflict," said Greg Taxin, chief executive of Glass Lewis. "This causes me great concerns about their fidelity to the public shareholders of Cypress."

Cypress executives are among those holding nominal stakes in Silicon Magnetic Systems, an internal start-up, and other Cypress units. Last year, Cypress awarded Rodgers, for instance, 200,000 shares in Silicon Magnetic Systems. Antonio Alvarez and Christopher Seams, executive vice presidents of Cypress' memory products division and its manufacturing and technology department, respectively, also received 200,000 options in Silicon Magnetic Systems. The company considers the options grants as salary for sitting on the subsidiaries' boards.

Rodgers acknowledges that conflicts between the parent and subsidiary companies can occur. Such a conflict happened with a unit in 1992, when the employees and Cypress disagreed about the unit's direction, Rodgers said.

Rodgers argues that he and other executives derive so little of their overall pay from subsidiary stock that no temptation exists to operate in anything but the parent's interest. The compensation he receives from subsidiary options is like a bonus plan for developing those companies, he said.

A typical grant to a Cypress subsidiary director is 50,000 shares each year over five years. Assuming that the company buys each subsidiary back at $1 a share, Rodgers' net gain will be less than $250,000, or less than $50,000 for each year he received shares. That's a fraction of his overall salary, he noted. And in the case of a less successful subsidiary like Cypress MicroSystems, Rodgers said his potential gain now looks to be only about $27,500 a year.

Aside from his options grants, Rodgers earned $336,065 in salary and bonus last year. He realized another $109,246 in value by exercising 90,100 options, although he ended up holding on to the shares.

Rodgers receives more than 95% of his compensation from parent company Cypress Semiconductor, he said. For that reason, he maintained, "it is not in my interest as a Cypress shareholder to cut too unfavorable a deal."

Indeed, Rodgers' total compensation ranks close to lowest among CEOs of his peer companies.

"My board's choice is to give me tiny pieces of stock worth a few thousand dollars a year in three subsidiary companies and some Cypress options and incentivize me to work on all those things," Rodgers said. "That's the way we run the company and it doesn't lead to excessive compensation."

Cypress generally plans to buy back the minority interest in its internal start-ups for $10 million to $20 million, but currently plans to sell portions of the acquired subsidiaries in public offerings. That opens another avenue of criticism, since Rodgers and other Cypress executives with stakes in the units could theoretically see their holdings balloon in value in a successful offering.

The options grants at Cypress subsidiaries "sound intuitively appealing -- to set up an entrepreneurial culture, etc. Yet, in reality it's a way of getting huge cash compensation to employees in somewhat of a cloaked fashion," said Ken Broad, a fund manager at Transamerica Investment Management. "Is there anything illegal? No. Does it smack of the appearance of impropriety? Absolutely." Broad's fund has no position in Cypress.

As Cypress' subsidiaries mature, the company (and its auditors) judge their performance by how much time and capital it takes to create a technology Cypress wants. (The company uses outside firms such as Standard & Poor's to help determine the value of the subsidiaries.) If a subsidiary hits that target using a minimum of resources, Cypress deems the unit "fully valued." For internal start-ups, it typically "buys back" the shares held by employees and directors, usually for $1 each.

CEO Rodgers points out that if units underperform, Cypress could pay less than $1 a share -- or nothing at all. Though that's never happened in the past, he maintains that it looks likely now.

Among the two current internal start-ups, one has "more than an even chance" of failing, which would mean there's no payout at all, Rodgers said. Another is likely to succeed but is way behind schedule, which means stakeholders are likely to receive only 55 cents a share.

"Each of the four subsidiaries that we bought out so far did produce a successful technology," Rodgers said. "Why would we invest in a technology, and then for the sake of

not spending the last 10% of the investment, not buy back the product of that investment for our shareholders? It would simply be foolish to sell a successful new technology to others after taking the risk of having developed it."

The company says it must foment an entrepreneurial culture if the start-ups are to be competitive, and needs equity-based incentives tied to the performance of a specific business unit. "We go out and do one of these internal start-ups because it is special, separate and different," Rodgers said. "We believe in a hot area, we've got to compete against real start-ups and therefore, we've got to offer real start-up opportunities."

Rodgers notes that the potential rewards of the subsidiary stock plans are far less than those of real start-up options. Although start-ups are inherently risky, their value is judged by the stock market or outside investors. By contrast, Cypress' valuation formula leaves its "shares" with a very real ceiling.

"We have never paid more than the preagreed amount

determined by the board of directors to buy back one of our subsidiaries," Rodgers said in an email.

The story is different for the two remaining subsidiaries, which Cypress acquired. As part of its agreement to purchase the companies, Cypress promised their employees, who held options, that it would leave open the possibility of an IPO. Cypress has plans to follow through on that promise, Rodgers said.

Unlike with the internal start-ups, there's no cap on the potential value of shares held in the acquired units. But Cypress has attempted to limit potential payouts, Rodgers said. For example, the company has not awarded any stake in SunPower, one of its acquired units, to Cypress executives, he said.

Meanwhile, at its other acquired subsidiary, Silicon Light Machines, the company has set aside about half as many shares for new employee grants as it has done with its recent internal start-ups. And in another way of limiting payouts to employees, the grants Cypress has handed out in Silicon Light Machines carry exercise prices of 50 cents to 65 cents -- several times the nominal strike prices of shares in Cypress' internal subsidiaries.

Employees of the acquired units aren't the only ones with a potential interest in whether they go public. Cypress has granted shares in Silicon Light Machines to Rodgers and two other Cypress executives. Meanwhile, Rodgers personally owns 5.3% of SunPower via an investment that predated Cypress' own.

Despite the potential payouts to executives if the units go public, Rodgers argues there's nothing for investors to be concerned about.

"Any implication that our start-ups are a scheme for a big payday for Cypress executives would be a willful misrepresentation of the facts," Rodgers said.

Yet Cypress' subsidiary stock plans still concern corporate governance experts.

Unlike bonus programs, Cypress' stock plans involve the granting of nominal ownership stakes. Shareholders have no say in how many shares are handed out or how much the programs will cost, governance experts note

Rodgers argues that until recently, very few compensation systems need shareholder approval.

The cost of the programs aren't clarified unless the subsidiary stock is bought back, at which time it is expensed on the parent's income statement. Cypress executives are extremely sensitive on this point: Rodgers insists the timing of the expense is no different than any bonus payout and strongly implies he will sue anyone who implies otherwise.

"Consider what a typical bonus plan contains," Rodgers said. "There is a written promise to pay out money or other considerations in return for achieving some metric of performance. Typically, there is no preannouncement of bonus plans to shareholders.

"Bonus plans do not pay out if the conditions for payment are not met. If those conditions are met, the bonus plan pays out and is recorded as an expense in the quarter

of payout, not in the quarter of announcement. These conditions for the typical bonus plan are precisely identical to our internal equity programs," Rodgers said.

Still, some experts wonder why Cypress doesn't just pay bonuses, if that's its goal.

"All of it may be legal, but it's designed to make sure you couldn't get a true and accurate picture of the financial status of this corporation," said Scott Harshbarger, the former Massachusetts attorney general who now heads up the corporate governance practice of Boston law firm Murphy Hesse Toomey & Lehane.

Rodgers insists the company is forthcoming with shareholders about its system, however complex, and one institutional holder contacted by


Rodgers and Cypress have communicated to shareholders their belief in options as a way to motivate employees, said Marc Klee, fund manager of the John Hancock Technology Fund. (The fund owned 1 million Cypress shares as of April 30, the last date for which data was available.)

As long as the options awarded are kept within "reasonable" levels and are communicated to shareholders, they can be a "valid form of compensation," Klee said. "We certainly believe that to be the case with the subsidiary companies," he said. "That's something, in my opinion, they've been very up front about."