Eliminate Negotiation in Startup Compensation???

Ellen Pao, the interim CEO of Reddit, has seen women struggle with salary negotiations. So she’s eliminating money talk from the company’s hiring process.

In her first interview since losing the landmark Silicon Valley trial, Pao told The Wall Street Journal that she has eliminated salary negotiations from the hiring process at Reddit, where she currently serves as interim CEO.
— Mashable http://mashable.com/2015/04/06/ellen-pao-reddit-salary/
Men negotiate harder than women do and sometimes women get penalized when they do negotiate. So as part of our recruiting process, we don’t negotiate with candidates. We come up with an offer that we think is fair. If you want more equity, we’ll let you swap a little bit of your cash salary for equity, but we aren’t going to reward people who are better negotiators with more compensation.
— Ellen Pao, as quoted in the Wall Street Journal
I appreciate ... that it actually puts a substantial burden on Reddit to pay what they think someone is worth, not what they think they can get away with. This is not an easy way out for them - far from it.
— Gayle Laakmann McDowell @gayle via @quora http://qr.ae/LNR0U

Reddit to Share Stock with Users

What’s new and interesting is that the round was led by an individual — Y Combinator president Sam Altman — and that he, along with the other investors, plans to allocate 10 percent of the equity they are buying to Reddit users.

How exactly that’s going to be managed hasn’t yet been figured out (or, more importantly, approved by bankers and lawyers), but Altman said Reddit may dole out shares using a distributed accounting system, a la the bitcoin block chain.
— @LizGannes, Reddit @ http://on.recode.net/1pndO1M

Startup Equity - Ownership - Can the Company Take Back My Vested Shares?

This is a companion piece to the Gold Standard of Startup Equity - A Guide for Employees. It describes why startup employees should ask about Standard #1: Ownership: Can the Company Take Back My Vested Shares?

Image republished with permission of Babak Nivi of Venture Hacks, who warns startup employees to "run screaming from" any startup equity offer that gives the company the right to repurchase vested stock: "Some option plans provide the company the right to repurchase your vested stock upon your departure. The purchase price is 'fair market value.' Guess whether the definition of fair market value is favorable to you or the company... Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully."

Image republished with permission of Babak Nivi of Venture Hacks, who warns startup employees to "run screaming from" any startup equity offer that gives the company the right to repurchase vested stock: "Some option plans provide the company the right to repurchase your vested stock upon your departure. The purchase price is 'fair market value.' Guess whether the definition of fair market value is favorable to you or the company... Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully."

The news loves a gold rush story about a Google chef or a Facebook muralist who made millions on startup employee equity. But not all startup equity is created equal. If a startup adds "repurchase rights for vested shares" to its employee stock agreements, its employees have to keep their jobs all the way until an IPO or acquisition in order to get the full value of their shares.  If you're working at a tech startup with a gold rush dream, make sure you avoid the dreaded:

Repurchase rights for vested shares are "horrible for employees" - YC's Sam Altman

In a true startup equity plan, employees earn shares of common stock which they continue to own when they leave the company. Just as they would own shares of public company stock they bought through a broker, they own their startup stock until they are paid for the shares when they company is acquired or they are able to sell them on the public markets after an IPO. There are special rules about vesting and requirements for exercising options, but once the shares are vested and purchased, the employees of true startups have true ownership rights.

But some startups design their equity plans so that employees earn shares that they don't really own. If the company includes repurchase rights for vested shares, the company can purchase the employees' shares upon certain events, most commonly after an employee leaves the company or is terminated by the company. Most repurchase rights expire after an IPO or acquisition so that if the employee is still there at the IPO or acquisition they get the full value of the shares. If not, the company can buy back the shares at a discounted price, called the "fair market value" of the common stock on the date of the buyback ("FMV").

These repurchase rights are included in stock option plans, stock option agreements or company bylaws, but most employees do not know about these value-limiting terms when they join a company or even when they choose to exercise their stock options. That's why the Gold Standard of Startup Equity - A Guide for Employees - suggests that employees ask before they accept startup equity: Can the Company take back my vested shares?

How Repurchase Rights Take away Employee Equity Value

One might think that an employee might be happy to sell their shares to the company. But repurchase rights are not designed with the employee's interests in mind. They allow the company to buy the shares back against the employees will and at a discounted price per share. As Y Combinator head Sam Altman wrote, "Some companies now write in a repurchase right on vested shares at the current common price when an employee leaves.  It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this."

The  common price at the date of repurchase is not the true value for two reasons. First, the true value of common stock is close to the preferred stock price per share (the price that is paid by investors for stock and which is used to define the value of the startup). Second, the real value of owning startup stock comes at the exit event - IPO or acquisition. This early buyback prevents the employee realizing that value.

Example - Company Does NOT Have Repurchase Rights for Vested Shares - Employee Value: $1.7 Million

Here's an example of how an employee in a true startup earns the value of startup stock. The company cannot buy his or her shares at departure, so he or she holds them until IPO. In the case of an early employee of Ruckus Wireless, Inc., the value would have grown as shown below.

This is an example of a hypothetical early employee of Ruckus Wireless, which went public in 2012. It assumes that the company did not offer equity with the "horrible" repurchase rights for vested shares. Therefore, the employee was able to hold his or her shares until IPO and earn $1.7 million. These calculations were estimated from company public filings with the State of California, the State of Delaware, and the Securities and Exchange Commission. For more on these calculations, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO. 

This is an example of a hypothetical early employee of Ruckus Wireless, which went public in 2012. It assumes that the company did not offer equity with the "horrible" repurchase rights for vested shares. Therefore, the employee was able to hold his or her shares until IPO and earn $1.7 million. These calculations were estimated from company public filings with the State of California, the State of Delaware, and the Securities and Exchange Commission. For more on these calculations, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO. 

If you want to see the working calculations, visit the document on GoogleDocs.

Example - Company DOES Have Repurchase Rights for Vested Shares - Employee Value: $68,916

If the company had the right to repurchase the shares at the fair market value of the common stock at the employee's departure, and the employee left after four years of service when his shares were fully vested, the buyout price would have been $68,916 (estimated). This would have taken away a value of $1,635,054 by the time of the IPO:

Hypothetical - If the company could have repurchased the vested shares at departure, the employee would have lost $1,635,054 in value. When you are evaluating an equity offer, always ask: Can the company take back my vested shares? For more, see Gold Standard of Startup Equity - A Guide for EmployeesIf you want to see the working calculations, visit the document on GoogleDocs.

If you want to see the working calculations, visit the document on GoogleDocs.

Here's the point:

When you are evaluating your startup equity, find out if the company has the right to repurchase your vested shares. If they can do so, you don't really own them. That changes their value significantly. If you have the power to negotiate this term out of your documents, do so. If not, incorporate this value-limiting term into your evaluation of your equity. Not all equity is created equal. 

For more, see Stock Option Counsel's Gold Standard of Startup Equity - A Guide for Employees. If you would like professional guidance in evaluating your startup equity,  contact Stock Option Counsel - Legal Services for Individuals.

Attorney Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. She is available through Stock Option Counsel to guide individual employees and founders in negotiating and evaluating startup equity, negotiating post-acquisition employment agreements, making stock option exercise and tax decisions and selling startup stock.

In the News: Startup Employees in the Dark on Equity

Mary Russell, an attorney who founded Stock Option Counsel to help employees evaluate their equity compensation, says the first step is for employees to make sure any equity is theirs to keep. Some companies have repurchase rights in their equity agreements that give them a right to buy back shares and options from any employee who leaves; and some give founders or investors broad latitude to change the terms.

“If the company can take back employee shares it dramatically limits the value of those shares,” says Ms. Russell. “It’s the sort of thing an employee needs to know about when they go into a job.” She says it’s as simple as asking whether the company can take back vested shares.
— Katie Benner, The Information

See Katie Benner's full article, Startup Employees in the Dark on Equity. The Information is a subscription publication for professionals who need the inside scoop on technology news and trends. 

Repurchase Rights are "Horrible" for Employees

As an aside, some companies now write in a repurchase right on vested shares at the current common price when an employee leaves. It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this.
— Sam Altman, YC

What can you do about it? Ask before you join:

Can the company take back my vested shares?
— Mary Russell, Stock Option Counsel

For more from Sam Altman, see his post, Employee Equity. For more on questions to ask to make sure you have true startup equity, see our post, Startup Equity Standards - A Guide for Employees.

Attorney Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock. 

The Gold Standard of Startup Equity - A Guide for Employees

Learn the three standards that define Startup Equity and three questions to ask to know if you have the real thing. 

1. Ownership - “Can the company take back my vested shares?”

2. Risk/Reward - “What information can you provide to help me evaluate the offer?”

3. Tax Benefits - “Is this equity designed for capital gains tax rates and tax deferral?”

Attorney Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock. 

Links - Best web content on startup employee stock

Here's links to the best web content on startup employee stock:

1.  Risk/Reward

Calculating percentage ownership and understanding fully diluted capital, #1-2 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog

How to value an offer, Right to Value How-To, Stock Option Counsel Blog

How to use the company's VC valuation to evaluate your equity offer, Video, Stock Option Counsel Blog

How to calculate the future value of your equity by estimating dilution and valuation, John Greathouse's Blog

How to ask about valuation, #11-13 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog

How preferred stock rights make common stock less valuable, Stock Option Counsel Blog

Knowing your market rate with regards to startup equity, #3-4 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog

How to know how much is enough equity for a pre-Series A startup, Stock Option Counsel Blog

Four factors of how startups decide your salary and equity Mary Russell & Boris Esptein on the Stock Option Counsel Blog

Four factors of how startup decide your equity offer VIDEO Mary Russell & Boris Esptein on the Stock Option Counsel Blog

Negotiating Compensation An Engineer's Guide to Silicon Valley Startups

2. Vesting

Acceleration upon change of control, Gil Silberman on Quora

When acceleration upon change of control does not make sense, Gil Silberman on Quora

What is vesting; what is acceleration upon change of control? #5 & #8 of 14 Crucial Questions about Stock Options, Andy Rachleff, Wealthfront Blog

Does my vesting make sense? Stock Option Counsel Blog

3. Ownership

Can the company take back my vested shares if I leave?, #6 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog

How Skype's repurchase rights gave certain employees $0 of $8.5 billion acquisition payouts, Felix Salmon on Reuters Blog

4. Tax Benefits

Three Ways to Avoid Tax Problems When You Exercise Options, Bob Guenley, Wealthfront Blog

Ensuring company compliance with tax rules - and your tax rights - when negotiating an offer, #9-10 of 14 Crucial Questions About Stock Options, Andy Rachleff on the Wealthfront Blog

Incentive stock options, Michael Gray, CPA

Non-qualified employee stock options Michael Gray, CPA

5. Overview

The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog

Risk/Reward of Startup Employee Stock

Startup employee equity should reward the risk you take in joining the company. Here's some ways to understand equity value so you can decide if your equity meets this standard.

 

Attorney Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock. 

For more information on joining an early stage startup before there is a VC valuation, see Joining An Early Stage Startup? Negotiate Your Salary and Equity with Stock Option Counsel Tips.

March 14 Event: Bill of Rights Discussion

Thanks to the 300 people who joined Chris Zaharias, @SearchQuant, and Mary Russell, Attorney Counsel to Individuals @StockOptionCnsl, for this event in Palo Alto on March 14, 2014! 

We had a great discussion of how to define and improve startup equity. For Mary Russell's current suggestions on the topic, please see Startup Equity Standards: A Guide for Employees.

Here's what we discussed at the event:

Right to Know. Company information on capitalization and valuation, being necessary to the employee’s negotiation of a fair compensation package, shall be provided to the employee with his or her equity offer and after each dilution and valuation event.

Right to Value. The right of the employee to earn the full value of his or her grant shall not be limited by unreasonable vesting terms.

Right to Hold Earned Equity. The right of the employee to hold vested equity up to an acquisition or public offering shall not be violated, and no forfeiture, repurchase or other provisions shall allow the company to seize vested equity of current or former employees.

Right to Tax Benefits. The employee shall enjoy the right to all tax benefits available from state and federal governments, and shall not be subjected to tax penalties due to company negligence, at grant, at vesting or settlement and at company acquisition or sale of stock.

Right to Ask. The right to evaluate equity shall not be violated by company limits on access to information or legal counsel.

Chris Zaharias, SearchQuant LLC

Chris is a startup veteran and advocate for startup employee equity rights. chris@searchquant.net (415) 832-0089.

Q: How much acceleration of vesting upon a change in control do Series-A startups typically offer?

Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. She is an attorney and the founder of Stock Option Counsel.

A: Startup would not likely offer accelerated vesting upon change of control without you asking for it. But acceleration is usually a negotiable term for anyone in mid to senior roles. 

If you frame this negotiation as a discussion of your role and what you are being brought on to accomplish, it will get to the truth of the matter - What vesting makes sense for your position in the enterprise's future? All compensation - and especially vesting schedules - should make sense for what you are there to do. But startups might not take the time to look at it in that way. 

For example, a senior engineer was brought into a Series A startup to make a big push toward efficient operations. He was so successful at his job that the startup was "finished" with him after 6 months when the operations could be managed by junior engineers. He was on a four year vesting schedule with a one year cliff. Did it make sense that he would receive zero equity for doing an amazing job at exactly the job he was hired to do? No.

If the comapny wont agree to acceleration, ask for more shares to make up for the fact that you don't expect to earn the full number of shares in your grant.

Good luck. And watch out for the precise terms of your acceleration language to be sure they make sense as well.

Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. She is an attorney and the founder of Stock Option Counsel.

Tax Deduction Reminder & Stock Option Counsel Updates

 

Stock Option Counsel

Legal Services for Individuals

Thanks for a great year with Stock Option Counsel.

Reminder - Tax Deduction for Legal Fees

Your legal fees may be deductible on your tax return. Check with your tax advisor for more information. 

Update - Stock Option Counsel Services for Employees & Founders

Please keep us in mind as a resource for yourself and your friends and colleagues for guidance on:

  • Job offers, equity grants and employment agreements
  • Stock option exercise and tax choices
  • Sales of employee stock on the secondary market
  • Post-acquisition employment agreements
  • Founders' interests at incorporation, financings, and exits
  • Dispute resolution among founders and employees on startup equity

Our Blog - Articles and Videos on Employee Equity

We use the Stock Option Counsel Blog to share information on negotiating job offers and selling startup stock. Please send us any requests for additions to the blog. Here's some links to our most popular posts:

Joining An Early Stage Startup? Equity Tips

Bull's Eye - Negotiating the Right Job Offer

RSUs - Startup Restricted Stock Units

MARY RUSSELL • ATTORNEY-AT-LAW 

125 UNIVERSITY AVENUE, SUITE 220 • PALO ALTO, CALIFORNIA 94301

INFO@STOCKOPTIONCOUNSEL.COM • (650) 326-3412

©2014 STOCK OPTION COUNSEL • DISCLAIMER

Startup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable

Mary Russell counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. She is an attorney and the founder of Stock Option Counsel.

If you have a job offer from a startup with an option to purchase shares representing 1% of the company, you may want to consider the Preferred Stock "Liquidation Preference" to see if your 1% would really be 1% if the company is acquired. If the Liquidation Preference is high, you might want to negotiate for more shares to make up for the loss in value you can expect when the company is acquired.

Common Stock v. Preferred Stock

As a startup employee, you'll be getting Common Stock (as options, RSUs or restricted stock). When venture capitalists invest in startups, they receive Preferred Stock. Preferred Stock comes with the right to preferential treatment in merger payouts, voting rights, and dividends. If the company / founders have caved and given venture capitalists a lot of preferred rights - like a 3X Liquidation Preference or Participating Preferred Stock , those rights will dramatically reduce your payouts in an acquisition.

Liquidation Preference & How It Makes Employee Stock Less Valuable

One Preferred Stock right is a "Liquidation Preference." Without a Liquidation Preference, each stockholder – preferred or common – would receive a percentage of the acquisition price equal to the stockholder's percentage ownership in the company. If the company were acquired for $15 million, and an employee owned 1% of the company, the employee would be paid out $150,000.

With a Liquidation Preference, preferred stockholders are guaranteed to be paid a set dollar amount of the acquisition price, even if that guaranteed payout is greater than their percentage ownership in the company.

Here’s an example of the difference. An investor buys 5 million shares of Preferred Stock for $1 per share for a total of $5 million. After the financing, there are 20 million shares of common stock and 5 million shares of Preferred Stock outstanding. The company is then acquired for $15 million.                                                                                                                           

Without a Liquidation Preference, each stockholder (common or preferred) would receive $0.60 per share. That’s $15 million / 25 million shares. A hypothetical employee who held 1% of the company or 250000 shares) would receive $150,000 (that’s 1% of $15 million).

If the preferred stockholders had a 1X Liquidation Preference and Non-Participating Preferred Stock, they would receive 1X their investment ($5 million) before any Common Stock is paid in an acquisition. They would receive the first $5 million of the acquisition price, and the remaining $10 million would be divided among the 20 million shares of common stock outstanding ($10 million / 20 million shares of common stock). Each common stockholder would be paid $0.50 per share, and hypothetical employee who held 1% of the company would receive $125,000.

Ugly, Non-Standard Rights That Diminish Employee Stock Value

The standard Liquidation Preference is 1X. This makes sense, as the investors expect to receive their investment dollars back before employees and founders are rewarded for creating value. But some company founders give preferred stockholders multiple Liquidation Preferences or Participation Rights that cut more dramatically into employee stock payouts in an acquisition.

If preferred stockholders had a 3X Liquidation Preference, they would be paid 3X their original investment before common stock was paid out. In this example, preferred would be paid 3X their $5 million investment for a total of $15 million, and the common stockholders would receive $0. ($15 million acquisition price – $15 million Liquidation Preference = $0 paid to common stockholders)

Preferred stock may also have "Participation Rights," which would change our first example above to give preferred stockholders an even larger portion of the acquisition price.

Without Participation Rights, Preferred Stockholders must choose to either receive their Liquidation Preference or participate in the division of the full acquisition price among the all stockholders. In the first example above, the preferred stockholders held 20% of the company and had a $5 million Liquidation Preference. When the company was acquired for $15 million, the preferred stockholders had the choice to receive their $5 million liquidation preference or to participate in an equal distribution of the proceeds to all stockholders. The equal distribution would have given them $3 million (20% of $15 million acquisition price), so they chose to take their $5 million liquidation preference, and the remaining $10 million was divided among 20 million shares of common stock.

If the Preferred Stock also had Participation Rights, (which is called Participating Preferred Stock), they would receive their Liquidation Preference and participate in the distribution of the remaining proceeds.

In our example with a 1X Liquidation Preference but adding a Participation Right, the Participating Preferred Stock would receive their $5 million Liquidation Preference AND a portion of the remaining $10 million of the acquisition price equal to their % ownership in the company.

$5 million Liquidation Preference + ((5 million shares / 25 million shares outstanding) * $10 million) = $7 million

Common stockholders would receive (20 million shares common stock / 25 million shares outstanding) * $10 million = $8 million.

Our hypothetical employee who held 1% of the company would receive $100,000 (.01 * $10 million) or 0.67% of the acquisition price.

Employee Focus – Calculating Your Payout

If you are an employee of a startup, you can use Liquidation Preference as shorthand for the minimum price the company would have to be acquired for before any employees would be paid out. 

If the acquisition price is less than the Liquidation Preference, common stockholders will get $0 in the acquisition.

If you want to go further and understand what you would be paid out if the acquisition price is more than the Liquidation Preference, consider these three scenarios:

If the preferred stockholders have Participating Preferred Stock, Your Payout = (Acquisition Price – Liquidation Preference) * Your % of All Outstanding Stock

If the preferred stockholders have Non-Participating Preferred Stock, you will receive the lower of:

Your Payout = (Acquisition Price – Liquidation Preference) * Your % of Common Stock OR

Your Payout = Acquisition Price * Your % Ownership

Employee Focus – What to Ask the Company

These calculations are complicated, so if you are evaluating a job offer you might want to stay out of these details leave it up to the company to tell you how the Liquidation Preference would affect you in an acquisition. Use these questions to understand how the Liquidation Preference would reduce the value of your common stock in an acquisition. Simply ask the CFO these questions:

1. What is the total Liquidation Preference? Do the investors have Participation Rights?

2. If the company were purchased today at the most recent VC valuation, what would my shares be worth?

3. If the company were purchased today at 2X the most recent VC valuation, what would my shares be worth? 

3. If the company were purchased today at 10X the most recent VC valuation, what would my shares be worth?

This will give you a good feel for how heavy the VC Liquidation Preferences are and how they would weigh down the growth in value of the common stock.

Founder Focus – Negotiating Your Acquisition Payout

If you are a founder and are negotiating with an acquiror, consider renegotiating your investors’ Liquidation Preference payout. Everything is negotiable in an acquisition, including the division of the acquisition price among founders, investors and employees. Do not get pushed around by your investors here, as their rights in the documents do not have to determine their payout.

If your investors are pushing to receive the full Liquidation Preference and leaving you and/or your employees with a small cut of the payout, address this with your investment bankers. They may be able to help you play your acquiror against the investors so that you are not cut out of the wealth of the deal, as most acquirors want the founders and employees to receive enough of the acquisition price to inspire them to stay with the company after acquisition.

Mary Russell is an attorney and the founder of Stock Option Counsel. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock. 

Thanks to investment banker Michael Barker for his comments on founder merger negotiations. Michael is a Managing Director at Shea & Company, LLC,  a technology-focused investment bank and leading strategic advisor to the software industry.

Would a sale of private company /startup common stock by a former employee trigger a change in 409A / fair market value?

Short answer:

Not in all cases. It comes down to logic. How significant is the market for this company's stock? Is it enough to really show there is a market? Or that there is a clear value? Probably not, unless it is a company-sponsored sale or a Facebook-type frenzy. But companies do use this as an excuse to prohibit secondary sales or drag their feet on allowing their employees to do them.

Lawyer answer:

Based on the tax code rules, the Board needs to change the fair market value price at which they grant options / employee stock any time a major change has occurred that either reduces risk or materially changes company forecasts. Is a secondary sale of private company stock a material change that would have to be seen by the Board as a sign that the risk of investment in common stock has changed?

There are arguments on both sides of this question.

One one side, the secondary sale of shares of common stock shows that common stock is "liquid," or convertible into cash. The lack of liquidity is a big factor in the riskiness of stock and in the logic of discounting common stock value compared to preferred stock value, so liquidity for common stock would raise the "market" price of common stock. Also, the investor who invested has clearly signaled that he/she thinks the stock is less risky than the prior 409A valuation if he/she pays more than that valuation.

However, there are good arguments on the other side as well. The basic argument is that a one-off sale of common stock does not a market make. When you look at the FMV of publicly traded stock, it is based on many sales and the presumption that anyone who holds common stock can trade at any time. Small sales of private company common stock do not mean that any shareholder could find a buyer or that any shareholder could sell at that price. Another argument is that a single buyer or even group of buyers who do not have access to inside company information do not have enough information to know if the stock is more or less risky than the Board has determined it to be in setting the FMV. So one buyer or small group of buyers acting with limited information would not be the appropriate group to define the risk of the stock and, therefore, its fair market value.

Many thanks to Aranca for the following additions to this analysis:

In addition to 2 key points (# of sale points for the price paid, and profile of buyer + seller) that have been mentioned for assessing reasonability of price paid as reflection of FMV, I would like to add 2 more angles that would need to be evaluated while making the determination:

How many different buyers participated at the price that has been paid for the security: If there have been lets say a couple of parties that have transacted, the applicability for the price paid to be considered as reflection of FMV would be weak. However, if there are several buyers who bought from the seller, the applicability of price paid as a FMV can be high.

What has been the valuation range (if any) / bid-ask spread offered by buyers: If the available buyers give a valuation range which is wide and significantly different from the transacted price, then again the applicability of price paid as reflection of FMV becomes questionable. However, if there are sizable number of buyers providing a tight valuation range, then the applicability of price paid as an FMV can be a good indicator.

Mary Russell is an attorney and the founder of Stock Option Counsel. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock. 

Many thanks for the contributions of Dylan Gittleman, Vice-President, ARANCA US and Manpreet Singh, ASA, Manager, Valuation Services, ARANCA US. Aranca is a leading provider of 409A valuation services.