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."

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.

Joining an Early Stage Startup? Negotiate Your Equity and Salary with Stock Option Counsel Tips

Attorney Mary Russell, Stock Option Counsel, 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. 

"Hey baby, what's your employee number?" A low employee number at a famous startup is a sign of great riches. But you can't start today and be Employee #1 at Square, Pinterest, or one of the other most valuable startups on Earth. Instead you'll have to join an early-stage startup and negotiate a great equity package. This post walks through the negotiation issues in joining a pre-Series A / seed-funded / very-early-stage startup. 

Q: Isn't it a sure thing? They have funding!

No. Raising small amounts from seed stage investors or friends and family is not the same sign of success and value as a multi-million dollar Series A funding by venture capitalists. According to Josh Lerner, Harvard Business School’s VC expert, 90 percent of new businesses don’t make it from the seed stage to a true VC funding and end up shutting down because of it. So an equity investment in a seed-stage startup is an even riskier game than the very risky game of an equity investment in a VC-funded startup.

Q: How many shares should I get?

Don't think in terms of number of shares or the valuation of shares when you join an early-stage startup. Think of yourself as a late-stage founder and negotiate for a specific percentage ownership in the company. You should base this percentage on your anticipated contribution to the company's growth in value.

Early-stage companies expect to dramatically increase in value between founding and Series A. For example, a common pre-money valuation at a VC financing is $8 million. And no company can become an $8 million company without a great team. So think about your contribution in this way:

Q: How should early-stage startups calculate my percentage ownership?

You'll be negotiating your equity as a percentage of the company's "Fully Diluted Capital." Fully Diluted Capital = the number of shares issued to founders ("Founder Stock") + the number of shares reserved for employees ("Employee Pool") + the number of shares issued or promised to other investors ("Convertible Notes"). There may also be warrants outstanding, which should also be included. Your Number of Shares / Fully Diluted Capital = Your Percentage Ownership.

Be aware that many early-stage startups will ignore Convertible Notes when they give you the Fully Diluted Capital number to calculate your ownership percentage. Convertible Notes are issued to angel or seed investors before a full VC financing. The seed stage investors give the company money a year or so before the VC financing is expected, and the company "converts" the Convertible Notes into preferred stock during the VC financing at a discount from the price per share paid by VCs.

Since the Convertible Notes are a promise to issue stock, you'll want to ask the company to include some estimate for conversion of Convertible Notes in the Fully Diluted Capital to help you more accurately estimate your Percentage Ownership. 

Q: Is 1% the standard equity offer?

1% may make sense for an employee joining after a Series A financing, but do not make the mistake of thinking that an early-stage employee is the same as a post-Series A employee.

First, your ownership percentage will be significantly diluted at the Series A financing. When the Series A VC buys approximately 20% of the company, you will own approximately 20% less of the company.

Second, there is a huge risk that the company will never raise a VC financing.  According to CB Insights, about 39.4% of companies with legitimate seed funding go on to raise follow-on financing. And the number is far lower for seed deals in which legitimate VCs are not participating. 

Don't be fooled by promises that the company is "raising money" or "about to close a financing." Founders are notoriously delusional about these matters. If they haven't closed the deal and put millions of dollars in the bank, the risk is high that the company will run out of money and no longer be able to pay you a salary. Since your risk is higher than a post-Series A employee, your equity percentage should be higher as well.

Q: Is there anything tricky I should look out for in my stock documents?

Yes. Look for repurchase rights for vested shares or termination of stock options for violations of non-compete or bad-leaver clauses. Have your attorney read your documents them as soon as you have access to them. If you don't have access to the documents before you accept your offer, ask the company this question:

Does the company maintain any repurchase rights over my vested shares or any other rights that prevent me from owning what I have vested? 

If the company answers "yes" to this question, you may forfeit your equity when you leave the company or are fired. In other words, you have infinite vesting as you don't really own the shares even after they vest. This can be called "vested share repurchase rights," "clawbacks," "non-competition restrictions on equity," or even "evil" or "vampire capitalism."

Most employees who will be subject to this don't know about it until they are leaving the company (either willingly or after being fired) or waiting to get paid out in a merger that is never going to pay them out. That means they have been working to earn equity that does not have the value they think it does while they could have been working somewhere else for real equity.

Q: What is fair for vesting? For acceleration upon change of control?

The standard vesting is monthly vesting over four years with a one year cliff. This means that you earn 1/4 of the shares after one year and 1/48 of the shares every month thereafter. But vesting should make sense. If your role at the company is not expected to extend for four years, negotiate for an vesting schedule that matches that expectation.

When you negotiate for an equity package in anticipation of a valuable exit, you would hope that you would have the opportunity to earn the full value of the package. However, if you are terminated before the end of your vesting schedule, even after a valuable acquisition, you may not earn the full value of your shares. For example, if your entire grant is worth $1 million dollars at the time of an acquisition, and you have only vested half of your shares, you would only be entitled to half of that value. The remainder would be treated however the company agrees it will be treated in the acquisition negotiation. You may continue to earn that value over the next half of your vesting schedule, but not if you are terminated after the acquisition.

Some employees negotiate for “double trigger acceleration upon change of control.” This protects the right to earn the full block of shares, as the shares would immediately become vested if both of the following are met: (1st trigger) after an acquisition which occurs before the award is fully vested (2nd trigger) the employee is terminated (as defined in the stock option agreement).

Q: The company says they will decide the exercise price of my stock options. Can I negotiate that? 

The company will set the exercise price at the fair market value ("FMV") on the date the board grants the options to you. This price is not negotiable, but to protect your interests you want to be sure that they grant you the options ASAP.

Let the company know that this is important to you and follow up on it after you start. If they delay granting you the options until after a financing or other important event, the FMV and the exercise price will go up. This would reduce the value of your stock options by the increase in value of the company.

Early-stage startups very commonly delay making grants. They shrug this off as due to "bandwidth" or other nonsense. But it is really just carelessness about giving their employees what they have been promised.

The timing and, therefore, price of grants does not matter much if the company is a failure. But if the company has great success within its first years, it is a huge problem for individual employees. I have seen individuals stuck with exercise prices in the hundreds of thousands of dollars when they were promised exercise prices in the hundreds of dollars. 

Q: What salary can I negotiate as an early-stage employee?

When you join an early-stage startup, you may have to accept a below market salary. But a startup is not a non-profit. You should be up to market salary as soon as the company raises real money. And you should be rewarded for any loss of salary (and the risk that you will be earning $0 salary in a few months if the company does not raise money) in a significant equity award when you join the company.

When you join the company, you may want to come to agreement on your market rate and agree that you will receive a raise to that amount at the time of the financing. You can also ask when you join for the company to grant you a bonus at the time of the financing to make up for your work at below-market rates in the early stages. This is a gamble, of course, because only a small percent of seed-stage startups would ever make it to Series A and be able to pay that bonus.

Q: What form of equity should I receive? What are the tax consequences of the form?

[Please do not rely on these as tax advice to your particular situation, as they are based on many, many assumptions about an individual's tax situation and the company's compliance with the law. For example, if the company incorrectly designs the structure or the details of your grants, you can be faced with penalty taxes of up to 70%. Or if there are price fluctuations in the year of sale, your tax treatment may be different. Or if the company makes certain choices at acquisition, your tax treatment may be different. Or ... you get the idea that this is complicated.]

These are the most tax advantaged forms of equity compensation for an early-stage employee in order of best to worst.:

1. [Tie] Restricted Stock. You buy the shares for their fair market value at the date of grant and file an 83(b) election with the IRS within 30 days. Since you own the shares, your capital gains holding period begins immediately. You avoid being taxed when you receive the stock and avoid ordinary income tax rates at sale of stock. But you take the risk that the stock will become worthless or will be worth less than the price you paid to buy it.

1. [Tie] Non-Qualified Stock Options (Immediately Early Exercised). You early exercise the stock options immediately and file an 83(b) election with the IRS within 30 days. There is no spread between the fair market value of the stock and the exercise price of the options, so you avoid any taxes (even AMT) at exercise. You immediately own the shares (subject to vesting), so you avoid ordinary income tax rates at sale of stock and your capital gains holding period begins immediately. But you take the investment risk that the stock will become worthless or will be worth less than the price you paid to exercise it.

3. Incentive Stock Options ("ISOs"): You will not be taxed when the options are granted, and you will not have ordinary income when you exercise your options. However, you may have to pay Alternative Minimum Tax ("AMT") when you exercise your options on the spread between the fair market value ("FMV") on the date of exercise and the exercise price. You will also get capital gains treatment when you sell the stock so long as you sell your stock at least (1) one year after exercise AND (2) two years after the ISOs are granted.

4. Restricted Stock Units ("RSUs"). You are not taxed at grant. You do not have to pay an exercise price. But you pay ordinary income tax and FICA taxes on the value of the shares on the vesting date or at a later date (depending on the company's plan and when the RSUs are "settled"). You probably will not have a choice between RSUs and stock options (ISOs or NQSO) unless you are a very early employee or serious executive and you have the power to drive the company's capital structure. So if you are joining at an early stage and are willing to lay out some cash to buy common stock, ask for Restricted Stock instead.

5. Non-Qualified Stock Option (Not Early Exercised): You owe ordinary income tax and FICA taxes on the date of exercise on the spread between the exercise price and the FMV on the date of exercise. When you sell the stock, you have capital gain or loss on the spread between the FMV on the date of exercise and the sale price.

Q: Who will guide me if I have more questions?

Attorney Mary Russell is available to guide individual employees and founders in negotiating and monetizing 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. 

Bull’s Eye: Negotiating the Right Job 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.

Boris Epstein is the founder of BINC Search, a next-generation recruiting startup that helps Silicon Valley companies hire technical talent at the scale they need.

You’re negotiating your salary and equity. You know there is a right answer – a bull’s eye where the final offer should land. But where is it?

The company is deciding what to offer you. They know there is a right answer, and they’ll get there using these four factors:

1.     Past Comp – your salary and equity in current and past jobs

2.     Peer Comp – the salary and equity of others in your peer group within this company

3.     Desired Comp – what you want to get paid, regardless of other indicators

4.     Market Comp – your competitive offers in the market

The right offer for you is the bull’s eye at the center of these possible offers. You can maximize your final offer by thoughtfully using these factors in your negotiation.

Past Comp

The company may ask you to disclose your compensation in your previous positions – your Past Comp.

If you disclose these numbers, be sure to include detail or “color” on the numbers to show the true value of your Past Comp. Do you believe your salary was lower than it should have been because of difficult financial circumstance at the company? Are you overdue for a review and raise? Does your company have valuable equity or a bonus structure that should be included to accurately describe your Past Comp? Are you expecting to continue vesting or receive additional stock option grants that you would forfeit by leaving your company?

A thoughtful discussion of your Past Comp may be more effective than following the lore that you should never disclose this information. You can use your answer to the question to guide the company to the right offer.

Peer Comp

The company also considers your Peer Comp – the range this company is already paying employees in similar positions. You start shaping this number during your interview as you discuss roles, levels and opportunities and present information to help the company understand where you fit to add the most value to the team.

For a company with a thoughtful system of leveling, there will be names or labels for each position and a range of salaries and equity packages they offer within each level. Your negotiation work is to distinguish yourself and show that you are a peer of those being paid at the highest end of the range for your level based on your unique skill set or experience.

The more unique your position, the less experience a startup will have in defining your Peer Comp. If you are a first-hire designer, physician or other leadership or expert role, you may have to help the company understand who your peers will be.  This is especially important in early-stage startups, where the hiring team might not understand that your new role should be considered a peer of, for example, vice presidents rather than junior engineers.

Desired Comp

The company also considers your Desired Comp – what you want to get paid. This is highly relevant to the right offer.

Desired Comp is especially important in equity packages, where your evaluation of the company’s equity may vary greatly from another candidate’s evaluation of that package. If you’ve been hoping for a home run exit during your career, you’ll be looking for an equity package that could get you there. If you’re strapped for cash and looking to maximize salary, you will have less desire for an equity-heavy final offer.   

There may be some tradeoffs, of course, but the right offer will be centered on your Desired Comp. So do your self-reflection homework and know what you want.

Market Comp

Companies take into account Market Comp and need to know what they will have to offer to stay competitive. While companies have a general idea of what is “market” for each position, your personal Market Comp is unique and driven by your efforts to identify alternative offers. The only way to use the right Market Comp in your negotiation is to go out to the market, derive that information and communicate it to the company.  

Once you have competitive offers, evaluate the equity packages and make thoughtful comparisons between them. For example, based on your appetite for risk and financial considerations, would you prefer options to purchase 1% of a Series A startup with a company valuation of $5 million or 5,000 RSUs of a public company with a current market price per share of $10? How many more stock options would the Series A startup have to offer you to equate to the public company offer? The company cannot make this estimation for you any more than they can decide which company is the best fit for your personality. When you own this process, you can confidently and effectively communicate to your company what is “market” for your equity offer.

Market Comp is also relevant after hire, as the startup job market can shift dramatically over time and new opportunities are always surfacing. As you continually find new information about opportunities, you can continually communicate with your company about what is “market” in defining the right salary and equity for your position. 

Bull’s Eye: The Right Offer

With thoughtful attention to these four factors, you can use your negotiation to guide the company to the bull’s eye – the right offer for you. If you see the company using the wrong data, you can bring the conversation back to the truth as you see it and work toward the right outcome. 

For more help on these preparations, you are welcome to read the full text of our interview here: The Right Offer – Long Form Q&A Between Stock Option Counsel and BINC Search

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. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers, making stock option exercise and tax decisions and identifying your rights to sell startup stock. 

Boris Epstein is the founder of BINC Search, a next-generation recruiting startup that helps Silicon Valley companies hire technical talent at the scale they need.