Exercising an Incentive Stock Option (ISO)? Should You Hold the Stock?

This is a guest post from Michael Gray CPA. He counsels individuals on their employee stock option tax questions. For more employee stock option tax resources, see Michael Gray, CPA's Option Alert at StockOptionAdvisors.com.  

When you have decided to exercise an incentive stock option (ISO) and consider the federal alternative minimum tax (AMT) and the net investment income tax, the benefits of holding stock after exercising an incentive stock option are reduced. The "brass ring" of having the gain from the sale of the stock eligible for long-term capital gains rates (15% or 20%) seems attractive, but the 28% alternative minimum tax rate applies
for the excess of the fair market value of the stock at exercise over the option price ("spread") when the option is exercised.  (California also has a 7% alternative minimum tax. Find out the rules for your state.)  The minimum tax credit for this tax "prepayment" is hard for many taxpayers to recover, because they are already subject to the AMT, due to deductions disallowed for the AMT computation, including state income taxes, real estate taxes and miscellaneous itemized deductions.  That means the "spread" at exercise is probably
going to be taxed at a 28% federal tax rate when the dust settles.

In addition, long-term capital gains are subject to the 3.8% net investment income tax when the taxpayer has high adjusted gross income.  That means the total federal tax rate for the initial spread would be 31.8%, versus a maximum federal tax rate of 39.6%.  Is an 8% tax benefit worth the risk of exposure to market volatility of the stock?  It could fall much more than that.

The main time it makes sense to hold the stock is when the "spread" is low and the option price is low.  Then you can probably afford to pay for the stock and AMT (if any) and to take the risk that the value of the stock could fall.  When you do this, you forgo the "time value premium" for the option.  If you have the alternative of just buying the stock for about the same price without exercising the option, you will probably be in a better position by doing that, because you will still have the options to exercise if the value of the stock increases with no downside risk for the options.

An alternative is to exercise the option and immediately sell the stock, provided the stock is publicly traded or there is a "liquidity event" such as a sale of the employer company.  In that case, the gain will be taxed as additional wages, subject to federal tax rates up to 39.6%, but exempt from employment
taxes such as social security and medicare taxes.

These are general comments.  You really should meet with a tax professional familiar with incentive stock options (that's our business!) to discuss your individual situation and have tax planning computations done.  To make an appointment with Michael Gray, call Dawn Siemer at (408)918-3162 on Mondays,
Wednesdays, Thursdays or Fridays.

This article was published in the September 24, 2014 Option Advisor Alert. Republished with permission. 

Source: http://www.stockoptionadvisors.com/optiona...

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 - "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 current 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 also prevents the employee from holding onto the shares until that jump in valuation at exit.

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

Four years after his or her departure, when the company filed for its IPO, the employee would hold $1.7 million worth of shares. This example was estimated from the public filings. For more on this example, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 Million at IPO.

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 been forced to sacrifice $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, you are welcome to 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.

Netflix: How to Recruit People Who Already Have Great Jobs

According to [former Netflix Chief Talent Officer] Patty McCord, a major factor in prying [great talent] away [from competitors] was the company’s compensation philosophy. It didn’t pay performance bonuses, for example.

”If your employees are fully formed adults who put the company first, an annual bonus won’t make them work harder or smarter,” McCord writes.

It also encouraged talent to talk to recruiters and interview with competitors to get a sense of the market rate for their talent.

Equity was also vastly different. Employees could pick how much of their compensation would be in equity versus salary.

”We believed that they were sophisticated enough to understand the trade-offs, judge their personal tolerance for risk, and decide what was best for them and their families,” she says.

Additionally, there were no “golden handcuffs,” the sort of four-year vesting schedule for options often used to aid retention.

”We never thought that made sense,” McCord says. “If you see a better opportunity elsewhere, you should be allowed to take what you’ve earned and leave. If you no longer want to work with us, we don’t want to hold you hostage.”
— Read more: http://www.businessinsider.com/netflix-corporate-culture-hr-policy-2013-12#ixzz34HROHAzY

Check out the Stock Option Counsel blog for negotiating employment compensation offers and equity compensation.

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. 

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.

Company Valuation Facts

If the startup has sold preferred stock, you may be able to calculate the most recent investor valuation of your percentage ownership in the company ($X) for a rough understanding of the value of your percentage ownership in the company. For example: 

1.      You could ask the company to provide the number of shares in your grant (“Your Number of Shares”), the company’s post-money valuation in a recent financing (“Post-Money Valuation”) and the current number of shares outstanding on a fully diluted basis (“Fully Diluted Capital”) to calculate: $X = (Your Number of Shares/Fully Diluted Capital) * Post-Money Valuation                                                                                                   

2.    Or you could ask the company to provide Your Number of Shares and ask a professional to research the most recent price paid by investors for shares of the company’s stock (“Preferred Stock Price Per Share”). $X  =  My Number of Shares   *  Preferred Stock Price Per Share

3.    If you want to go further, you could estimate a discount on the recent valuation of your ownership percentage because your common stock is less valuable than the Preferred Stock Price Per Share. To understand liquidation preferences and participation rights and how they reduce the value of common stock, seeStartup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable. You can also follow the how-to below on company estimates. The difference in your payout between a company exit at 1X the current VC valuation v. your payout between a company exit at 2X or 10X the current VC valuation will show you how the liquidation preference affects the value of your shares in an acquisition. [Note I: Preferences do not affect your value if there is an IPO and you can sell your shares on the public market.] [Note 2: The most recent “fair market value of common stock” from the company is not a good way to estimate the value of startup stock. It’s created for tax purposes, not for valuation purposes.]

Internal Equity - Personal Valuation

If the startup has not sold preferred stock, you may be able to compare your percentage ownership in the company to the founders’ and other employee’s percentage ownership to determine if you are being compensated appropriately for your relative contribution to the team. You could calculate your percentage ownership (Your Number of Shares / Fully Diluted Capital) by asking the company to provide:

  1. Your Number of Shares; and
  2. The current number of shares outstanding on a fully diluted basis (“Fully Diluted Capital”), including the details of:                                             
  • Founders’ shares outstanding (vested and unvested shares)
  • Investor shares outstanding; 
  • Employee equity pool (reserved and issued); and
  • Estimated shares to be issued upon conversion of convertible notes and exercise of warrants.

Exit Value Guessing

You could also ask the company to provide calculations of your equity value in possible exit scenarios, such as:

a. What would the shares to be worth at an acquisition or IPO at the most recent Post-Money Valuation? At 2X the most recent Post-Money Valuation? At 10X the most recent Post-Money Valuation?

b. What would the shares to be worth in the company’s estimations of the three most likely exit scenarios? 

You could also make your own estimations of future dilution and future valuation to calculate your potential exit payout. The calculations could follow this logic, provided by John Greathouse on his blog [Click to look at colored image with calculation. I haven't gotten his permission to use it here, and it's great.]

Risk/Reward Going Forward

After you join the company, you can continually reevaluate your equity based on changes in company progress, valuation, liquidation preferences and your percentage ownership in the company on a fully diluted basis.

These equity evaluations are designed to help you negotiate for the right number of shares when you accept an offer and after you have joined the company. As time passes, you can continually reevaluate your equity comp based on changes to the company’s capitalization and valuation, your performance and your competitive scenarios on the market. 

 

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.

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. 

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.