Change of Control Terms for Startup Stock Options, Restricted Stock and RSUs

June 5, 2018 Mary Russell

Stock Option Counsel, P.C. - Legal Services for Individuals. Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsels founders on their personal interests at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or info@stockoptioncounsel.com.

I counsel individuals evaluating startup job offers with stock options, restricted stock or RSUs. Here’s a key question I suggest as part of that evaluation:

“What happens to any unvested shares if the company is acquired?”

Since startup employees and executives earn, or vest, their equity over time, a company may be acquired before they are fully vested. The treatment of unvested shares in an acquisition affects the risk calculus of joining a startup, as the right to earn 100% of the shares gives the equity a much higher potential upside than the right to earn only a portion of the shares.

Founders, executives and key hires, including employee-level hires at early stage startups, can negotiate for Double Trigger Acceleration to protect their unvested shares in the event that the individual is terminated after an acquisition. Advisors and some founders and executives may negotiate for Single Trigger Acceleration so that their shares immediately vest at acquisition. However, protective terms for unvested shares are not negotiable for most employee-level hires. Their equity will be governed by the general terms of the Plan, which will likely be either an unfavorable Cancellation Plan or a more favorable Continuation Plan.

Cancellation Plan

Some equity incentive plans allow the company to cancel unvested shares without payment in an acquisition. In fact, in recent years I’ve noticed that this is the most common treatment in Silicon Valley-style startup employee equity plans. We’ll call this type of plan a Cancellation Plan. Under a Cancellation Plan, unvested equity can be cancelled and replaced with $0, even if the unvested shares had significant value at the time of the acquisition. For example, if an employee's total number of shares was worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 at closing. The unvested value of $100,000 could be cancelled without payment even if the employee stayed on as an employee after the acquisition. In another example, if the employee was within the first year of service and had a one-year cliff vesting schedule, 100% of the grant could be cancelled without payment.

As noted above, the distinction between a Cancellation Plan and the more protective Continuation Plan is not usually a negotiable term. The exception to this would be at a startup with employee-friendly founders and executives who are willing to advocate for changes to their plan with the board and stockholders.

Continuation Plan

Other startup equity plans prohibit cancellation of valuable unvested equity without payment. We’ll call this style of plan a Continuation Plan. Although unvested equity that is worthless based on the acquisition price could be cancelled, valuable unvested equity must be continued or substituted for cash or equity awards with the same value as the deal consideration for the shares being cancelled. If the deal does not provide for such continuation or substitution, unvested equity will be accelerated so that it becomes 100% vested and paid at closing.

In the same example as above, if an employee's total number of shares was worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 at closing. But the unvested shares would be replaced with a substitution or continuation award in exchange for the $100,000 in unvested value. That might be in the form of cash to vest over time, continuing awards in the original company, or new equity in the acquiring company's equity.

Under a Continuation Plan, the payment for unvested shares still must be earned over the original vesting schedule. So without the Double or Single Trigger Acceleration protections described below, the individual could be terminated for any reason, at any time, and lose the unvested shares. However, those who stay at the acquiring company under a Continuation Plan will continue to earn the deal consideration for their shares. (But beware. Those with unvested equity under a Continuation Plan may also be asked to sign new employment agreements forfeiting these rights as part of the acquisition, since the company’s leverage of termination is significant).

Double Trigger Acceleration

Founders, executives and key hires, including employee-level hires at early stage startups, negotiate special vesting schedules to protect themselves from losing unvested shares. With Double Trigger Acceleration rights, if an individual is terminated without cause after an acquisition, unvested equity immediately vests. It’s called Double Trigger Acceleration because vesting occurs immediately (faster than the original schedule) when two triggers have occurred - first, the acquisition and, second, the termination.

One key argument for this term is based on risk. If an individual at any level of the organization is taking a significant risk to join the company, such as sacrificing significant cash or other compensation for the equity, they advocate for Double Trigger Acceleration to protect their upside in the event that the equity becomes valuable. A second key argument for this term is based on “aligning incentives.” If the team could lose valuable unvested equity by achieving a prompt acquisition, their incentives would not be aligned with the company’s goals. Double Trigger Acceleration rights bring the individuals' incentives in alignment with the company's goals.

This Double Trigger Acceleration protection is negotiated at the offer letter stage and included in the final equity grant documents. The key negotiable terms in this clause are (1) full acceleration so that a termination of the individual without cause at any time after acquisition accelerates 100% of unvested shares; (2) application to a constructive termination in the event the individual resigns for good reason; (3) a narrow definition of “cause” and a broad definition of “good reason”; (4) a broad definition of acceleration (known as “change of control”) including a sale of substantially all the company’s assets; (5) application in the event that unvested shares would otherwise be cancelled under a Cancellation Plan; and, perhaps, (6) application to termination in anticipation of, or for a certain protective period of time prior to, an acquisition.

Single Trigger Acceleration

Advisors and some founders and executives may negotiate for Single Trigger Acceleration to immediately vest at acquisition. This is usually rejected by investors and companies as they argue that the company is an unappealing acquisition target if its talent will not be incentivized to stay after closing. This is especially true for technical talent at a technology company.

The key argument for this term is based on the need, or lack of need, for the individual’s role after acquisition. For example, advisors naturally negotiate for Single Trigger Acceleration because their primary role is to advise a company at the startup stage. They would not be necessary after an acquisition as they’ve fulfilled their purpose by that time. Others may make similar arguments as above under Double Trigger Acceleration along the lines of aligning incentives. For example, I’ve worked with a CFO who negotiated for 50% Single Trigger Acceleration because he was hired with the express purpose of improving the company’s financial position to achieve an acquisition. Those with similar arguments may even negotiate for Single Trigger Acceleration to apply at IPO, which would be a very unusual term but a logical incentive for certain hires.

Negotiating Change of Control Terms

As noted above, acceleration terms are not “on the table” in most startup equity offer negotiations. However, the availability of acceleration protection and/or the distinction between a Cancellation Plan and a Continuation Plan is a factor in assessing the risk of joining a startup. Without these protections, it may make sense to negotiate for a higher cash package or number of shares to balance risk. Check out more on my blog about considerations in defining the right startup job offer and other key terms that affect the risk of startup equity including clawbacks and tax structuring.

Stock Option Counsel, P.C. - Legal Services for Individuals. Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsels founders on their personal interests at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or info@stockoptioncounsel.com.

The Good Stuff - Continuation Plans - How To Avoid the Juno Drivers' Fate of Cancelled RSUs in a $200 Million Acquisition

April 27, 2017 Mary Russell

Josh Brustein @joshuabrustein of Bloomberg reported this week on the rescission of potentially valuable RSUs in Juno's $200 acquisition by Gett. He reported that Juno promised 50% of founders shares to drivers, but that it appears that the maximum portion of the acquisition price they could have received was 1.5%.

This highlights a type of startup equity plan - a Cancellation Plan - that can dramatically limit the value of employee equity grants.

Some startup stock plans allow companies to cancel unvested equity in an acquisition. We'll call these Cancellation Plans.

The standard for startup stock plans has been that unvested employee equity must be continued or substituted in an acquisition rather than cancelled without payment. We'll call these Continuation Plans. This means they must be replaced with either cash or equity awards with the same value as the deal consideration for the shares being cancelled. If they are not replaced for the deal value, their vesting will be immediately accelerated at the acquisition and paid the entire deal price for the vested and unvested shares. The replacement still must be earned over the original vesting schedule, so there's no guarantee of earning the unvested shares without also having single or double acceleration upon change of control protections. However, this traditional requirement offered protection of value for employees. Those who stay at the acquiring company under a Continuation Plan will continue to earn the deal consideration for their shares in some other form.

The Cancellation Plans that allow cancellation of in-the-money unvested equity without payment are grabbing value from employee shares. Unvested equity - RSUs, options, etc. - can be cancelled and replaced with $0. For example, if an employee's total number of RSUs were worth $200,000 at the acquisition price, and only 50% had vested at the acquisition, the employee would be paid $100,000 and the remaining $100,000 in value of RSUs would be cancelled without payment, continuation or substitution even if the employee stays as an employee after the acquisition.

In a Continuation Plan, an employee would receive the $100,000 deal consideration for the vested shares and a substitution or continuation award in exchange for the $100,000 in unvested value. That might be in the form of cash to vest over time, continuing awards in the acquired company if it survives the merger, or substitute value of the acquiring company's equity, such as RSUs worth $100,000 in value of the acquiring company. Any such replacements would continue to vest over the original remaining vesting schedule.

There is a fantastic example of this from today's news. Juno, a ride-sharing app which promised 50% of its founders shares to drivers in the form of RSUs, was acquired by Gett for $200 million. As part of the acquisition, Juno reportedly rescinded the all the RSUs it had awarded and promised to drivers. The merger terms were not made public, but it appears that Juno had a Cancellation Plan allowing the company the right - which they exercised - to cancel unvested RSUs. All RSUs would have been unvested as the drivers reportedly had to work for 30 months to time-vest any of their RSUs and less than a year had passed between the grants and the acquisition.

The drivers instead received a one-time payment, which appears to be dramatically lower than the RSUs would have been valued in the acquisition. It was reported that the maximum portion of the acquisition price they could have received was 1.5%. It's not entirely clear that this is the case, as drivers report that they were never notified of their percentage ownership in the company at the time of the acquisition. But if the paltry payouts - one example was $250 to a driver - were actually at the deal consideration for the deal, it would mean that the original awards were such a low percentage of the company that they would have crossed into absurdity. Therefore, it safe to assume that Juno had a Cancellation Plan and it used it to cut its drivers out of a $200 million acquisition, less than a year after promising its drivers 50% of the company's equity. Ouch.

So if you're negotiating a startup equity offer, ask for the good stuff - a Continuation Plan.

Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution

March 28, 2017 Mary Russell

The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested options or should their rights to exercise expire early if they leave the company before an IPO or acquisition?

This is Part 2 of a 3-part series. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage.

FULL 10-YEAR TERM SOLUTION

Some companies are saving their optionees from the $1 million problem of early expiration stock options by granting stock options that have a full 10 year term and do not expire early at termination. The law does not require an early expiration period for stock options. Ten years from date of grant is usually the maximum exercise period, as the legal landscape for stock options makes anything beyond a 10 year exercise period impractical in most cases. The 10 year exercise window (without an early exercise period) enables employees to wait for a liquidity event (IPO or acquisition) to pay their exercise price and the associated taxes. This extended structure is designed to compensate employees in a way that makes sense for them.

Startups who choose a full 10-year term in place of early expiration may do so because their recruits or founders have faced the problem of early expiration at prior companies and become disillusioned with stock options as a benefit. Or their recruits may have read about the issue and asked for it as part of their negotiation. Or their founders may have designed their equity plan to be as favorable to employees as possible as a matter of principle or as a recruiting tool.

Other companies are extending their early expiration period for existing stock options. One example of this is Pinterest, which extended the term in some cases to 7 years from the date of grant. This move was in response to their valuation and extreme transfer restrictions that made the early expiration period burdensome for option holders.

An exercise more than 90 days after the last date of employment changes tax treatment for options originally granted as Incentive Stock Options (ISOs). Such an exercise will be treated as the exercise of a Non-Qualified Stock Option (NQSO) instead. Most employees would prefer to have the choice that an extended exercise period allows, the choice between exercising within 90 days of termination of employment for ISO treatment or waiting to exercise and being subject to NQSO treatment.

You can see a list of companies that have adopted an extended option exercise period or changed from the short early expiration period to longer periods.

CREATIVE MODIFICATIONS TO THE FULL 10-YEAR TERM SOLUTION

Companies may prefer early expiration of stock options because terminated stock options reduce dilution for other stockholders. Or they may prefer that their employees are bound to the company by the “golden handcuffs” of early expiration stock options as a retention tool.

For companies that are concerned about excessive dilution, it might make sense to eliminate early expiration only if the company’s value has increased since grant. In other words, employees have a full 10-year term only if the FMV of the common stock on the date of their departure is greater than the exercise price of the stock option. This targets the solution (tax deferral) to the problem (owing tax at exercise before liquidity). If the FMV at exercise is equal to the exercise price, then there is no taxable income to report at exercise. Therefore, an extended exercise period is not necessary to defer taxes until liquidity. This solution does not address the problem of high exercise prices; companies with high exercise prices due to high valuations may want to use RSUs instead of stock options to solve the exercise price problem.

Attorney Augie Rakow, a partner at Orrick who advises startups and investors, has another creative modification to the full 10-year term solution. He has advised clients to find a middle ground by extending exercise periods only for longer-term contributors. This addresses the company concern about retention while solving the early expiration problem for longer-term employees. For example, option agreements might allow three years to exercise after departure only if an employee has been with the company for three years. He notes that "it's a good solution for companies that want to let long-term contributors participate in the value they help create, without incentivizing employees to leave prematurely."

CAN I REALISTICALLY EXERCISE THE STOCK OPTIONS IF THE COMPANY IS A SUCCESS?

Due to the prevalence of early expiration stock options at startups, this becomes an essential question in evaluating an equity offer: “Can I realistically earn the value of vested equity if the company is a success?” If the option grant has a very high exercise price or could potentially lead to a huge tax bill at exercise, it may not be feasible to exercise during an early expiration period at the end of employment, making the value of vested equity impossible to capture. Clients have negotiated the removal of early expiration or other creative structures to solve this problem if it arises in the employment offer.

I hope this post has illuminated the usefulness of a full 10-year term as a solution to the problem of early expiration of startup stock options. For other alternatives to structuring startup equity, see Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. See also Early Expiration of Startup Stock Options - Part 1 - A $1 Million Problem for more information on the issue.

THANK YOU

Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Thank you to attorney Augie Rakow, a partner at Orrick who advises startups and investors, for sharing his creative solution to this problem

The C-Level View - Fine Print Issues in Startup Executive Equity Grants

February 21, 2017 Mary Russell

For executives trading significant cash compensation for startup equity, the fine print of the equity documents can significantly change the risk/reward profile of the deal. Be on the lookout for value-limiting terms in the Equity Grant Agreements, the Stock Plan and the Certificate of Incorporation.

Equity Grant Agreements

The Equity Grant Agreements and Stock Plan are usually not provided to the executive with the Offer Letter, as the official equity grant is not made until after hire. However, these agreements contain important details about the grant, so it makes sense to review them before agreeing to the number of shares or signing the Offer Letter.

For example, the Equity Grant Agreements may give the company the right to forcibly repurchase shares from the executive after termination of employment, even if they are vested shares of restricted stock or vested shares issued upon exercise of options. This dramatically limits the value of the equity, as the most significant increase in value of startups has historically been at the time of an exit event.

They may also require the executive to agree to future retroactive changes to the terms of the equity. For example, they may include the executive’s agreement to be bound to repurchase rights that might appear in future changes to the bylaws or the executive’s agreement to sign onto exercise agreements or stockholder agreements in the future which may have onerous terms.

If the Equity Grant Agreements have repurchase or other forfeiture rights for vested shares, it makes sense to negotiate these out of the deal or provide for alternative compensation to make up for the potential loss in value. If the Equity Grant Agreements have commitments to be bound by unknown future terms, it makes sense to remove these commitments and have all relevant terms provided up front.

The Stock Plan

The Stock Plan (otherwise known as an Equity Incentive Plan) can have some of the same red flags addressed above under Equity Grant Agreements. They may also have other onerous terms especially relating to treatment of executive shares in a change of control. The company may reserve the right to terminate, for no consideration, all unvested options at change of control. This could be a significant cancellation of value and could seriously decrease the executive’s leverage in negotiation of post-acquisition employment terms. Also, if an executive has negotiated for favorable double trigger vesting acceleration upon change of control rights, this term could invalidate that benefit, as cancelled unvested options would not be available for acceleration in the event of a post-acquisition termination.

If the Stock Plan has this or other onerous terms, it makes sense to negotiate for modifications in the Equity Grant Agreements or for a grant made outside the Stock Plan with terms crafted for the individual executive. If the Stock Plan has a company right to cancel unvested options at change of control, it makes sense to address this directly in the language of the executive’s vesting acceleration upon change of control term so that the cancellation cannot occur without a corresponding acceleration of vesting.

Certificate of Incorporation

The Certificate of Incorporation will outline some key economic rights of investors, including their liquidation preferences. Executives joining established startups can be misled by their percentage ownership if the investors have significant liquidation preferences, either because of significant fundraising or onerous investor terms. For example, in a company with $300 million investment with standard start up investor rights of 1X non-participating liquidation preference, any acquisition below $300 million valuation would provide $0 to common stockholders. Or, in a company with $50 million investment and outsized investor rights of 3X participating liquidation preference, the investors would take the first $150 million in acquisition proceeds and participate with common stockholders in the distribution of the remaining proceeds.

If investor liquidation preferences are high, it makes sense for an executive to negotiate for significantly more shares to balance the risk or negotiate for a management retention bonus to be earned upon acquisition to make up for the loss in equity value due to these preferences.