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."
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.
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 Employees. If 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.