Uber IPO - Lessons for Negotiating Startup Equity Offers - Spring 2019 Newsletter - Stock Option Counsel, P.C. - Legal Services for Individuals

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 by email.

Hello Startup Community!

Uber's IPO is a great lesson for startup employees on negotiating their startup equity. Unicorn startup recruiters have been telling hires for the past few years to value the offered RSUs at many multiples, even 10X, of the most recent investor valuation in negotiating their compensation offers. Since Uber's value has not risen even 2X in that time, any hires who accepted offers based on this calculus have lost significant value compared to their opportunity cost.

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Individuals need negotiate for enough shares in a startup to balance their risk. The calculation for the right number of RSUs at a late-stage startup with a public-company-size valuation is the current investor value per share, not the potentialfuture value. 

Shira Ovide explored this issue in Bloomberg Opinion last week with input from Stock Option Counsel:

Uber's example shows that employees at startups – particularly those who come aboard when the company is more mature – often don't get rich, even when the companies are successful. Many workers are at the bottom rung of stock holders and tend to have less information about their company's value and prospects than just about anyone else who holds shares. ... Mary Russell of Stock Option Counsel, which advises employees on compensation at startups, said people evaluating job offers at more mature startups should analyze only what the proposed equity is worth at the time of negotiation, not what it could possibly be worth in a dreamy future. That’s not always easy, because Russell said startup recruiters sometimes suggest that a 10-fold increase in valuation in the past is an indication of what prospective employees can expect from their wealth.

For more on using current value to evaluate startup equity offers, see this video from the Stock Option Counsel blog

Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and for the Stock Option Counsel Blog! I will continue to send quarterly updates on important topics in the market for startup equity for individual founders, executives and employees. Please keep in touch. 

Best,

Mary

Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals

You are welcome to contact Stock Option Counsel, P.C. - Legal Services for Individuals for guidance on your startup equity, including:

  • Founder interests at incorporation, financings and exits

  • Job offers, equity grants and employment agreements

  • Executive compensation design

  • Acquisition terms and post-acquisition employment agreements

Or check out our blog and social media for great posts on startup equity for founders, executives and employees. 

Winter 2019 Newsletter - Stock Option Counsel® - Startup Offer Letter? The Equity Issues Hidden Between the Lines

Hello Startup Community!

If you have an Offer Letter from a startup, you may notice that it’s light on information about stock options or other equity. See this new post on the Stock Option Counsel Blog to learn the key issues hidden between the lines. It covers:

Grant Timing. The exercise price is not negotiable, but you will want to follow up after your start date to be sure that the board grants the options promptly. Delays are common and can increase the exercise price dramatically and reduce the value of your stock options.

Protection for Unvested Shares. The standard vesting schedule will not protect unvested shares in an acquisition. Consider negotiating for double trigger acceleration upon change of control.

Clawbacks and Other Red Flags. The equity incentive plan and stock option agreement are usually not provided with the Offer Letter. However, it makes sense to request and review those documents before signing the Offer Letter to identify clawbacks for vested shares or any other red flag terms

Tax Structure. The right tax structure will balance your interests in total value, low tax rates, tax deferral, limited tax risks and investment deferral. 

You can see the full post on the Stock Option Counsel Blog, along with other great information on startup equity negotiations. Happy reading. 

Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and for the Stock Option Counsel Blog! I will continue to send quarterly updates on important topics in the market for startup equity for individual founders, executives and employees. Please keep in touch. 

Best,

Mary

Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals

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 by email.

Have an Offer Letter from a Startup? The Equity Issues are Between the Lines

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 by email.

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If you have an Offer Letter from a startup, you may notice that it’s light on information about stock options. You may see a few sentences noting that (1) the company will recommend to the board that the grant be made at the first market value on the date of grant; (2) the option will vest monthly over four years with a one-year cliff; and (3) the option will be governed by the company’s equity incentive plan and your stock option agreement. It sounds simple. But the key issues are hidden between the lines.

CHANGE OF CONTROL PROTECTION FOR UNVESTED SHARES

A standard vesting schedule does not provide protection for unvested shares in the event the company is acquired. If you are joining in a senior position or as an early stage employee, consider negotiating for a double trigger acceleration upon change of control to protect the right to earn unvested shares. The most robust double trigger language would provide that 100% of unvested shares will accelerate if you are terminated or constructively terminated as part of or at any time following a change of control. See this blog post for more information on change of control terms for startup equity offers.

CLAWBACKS OR OTHER RED FLAGS

The equity incentive plan and stock option agreement are usually not provided with the Offer Letter unless requested, as the official equity grant is not made until after the start date. 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 incentive plan and stock option agreement may give the company the right to forcibly repurchase shares from the employee after termination of employment, even if they are vested shares of restricted stock or vested shares issued upon exercise of options. See this post for some examples of how those clawbacks may be drafted. Clawbacks dramatically limit the value of the equity, as the most significant increase in the value of startups has historically been at the time of an exit event. If this term, or any other red flag term, appears in the form documents, it makes sense to negotiate these out of the deal or provide for alternative compensation to make up for the potential loss in value before signing the Offer Letter.

TAX STRUCTURE

The Offer Letter may not include the terms of the tax structure, but if you have any leverage on those terms the Offer Letter negotiation is the time to address them. The right tax structure will balance your interests in total value, low tax rates, tax deferral, limited tax risks and investment deferral. This balance is different at each company stage. For example, at the earliest stage startups you may be able to meet all those goals with the purchase of Restricted Stock for a de minimis purchase price. At mid-stage startups you might prefer to have Incentive Stock Options with an extended post-termination exercise period to defer the investment until a liquidity event. At late-stage startups you might prefer Restricted Stock Units for a full value grant. See this blog post on Examples of Good Startup Equity Design by Company Stage.

GRANT TIMING

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 follow up after your start date to be sure that the board makes the grant of the options soon after your start date. 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’s common stock during that time.

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 by email.

VIDEO Startup Stock Options: Exercise Price Basics

Negotiating your startup stock option offer? Use this video to understand the exercise price. 
 

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 by email.

Incentive Stock Options and the Alternative Minimum Tax - Changes under the Tax Cuts and Jobs Act of 2017

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 by email.

The final Tax Cuts and Jobs Act of 2017 will reduce Alternative Minimum Tax ("AMT") bills for many who exercise Incentive Stock Options ("ISOs") in two ways - one direct and one indirect.

First, the bill increased exemption amounts and phase-out thresholds for the AMT as follows:

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The increased AMT exemption decreases the likelihood of triggering AMT at exercise of ISOs. For those ISO exercises that do trigger AMT, the increased AMT phase-out threshold may reduce the amount of AMT due. The result of these changes is a maximum savings of $18,000 for an individual exercising ISOs.

Second, the bill reduced or repealed several triggers of the prior AMT, such as state and local tax deductions. This reduces the number of taxpayers who will need to use their AMT exemption amount for non-ISO AMT items. According to Joe Rosenberg of the Tax Policy Center, as quoted in the Wall Street Journal, only about 200,000 returns will be subject to AMT in 2018 down from approximately five million in 2017. So starting in 2018 most taxpayers will not have “used up” the AMT exemption amount on non-ISO related items and therefore will be able to use the entire AMT exemption amount to offset gains at exercise of options. In addition, these new thresholds may trigger the release of AMT credit carryovers. 

These changes are somewhat anticlimactic after legislators almost repealed the entire Alternative Minimum Tax, which would have made all ISO exercises tax-free. But they may result in savings of up to approximately $18,000 in AMT for a ISO exercise.
— Mary Russell, Attorney Counsel to Individuals at Stock Option Counsel

What does this mean for existing ISO grants?

These changes are somewhat anticlimactic after legislators almost repealed the entire Alternative Minimum Tax, which would have made all ISO exercises tax-free. But they may result in savings of up to approximately $18,000 in AMT for a ISO exercise. So it makes sense to work with your tax advisor and/or financial planner to decide if/when to exercise to take advantage of the benefits of the new rules. Here are some choices on ISO exercise:

1. Early exercise some ISOs prior to vesting (if allowed under grant documents);

This is a tax planning maneuver to start your capital gains holding period and avoid paying taxes at exercise. (If you have ISOs you are considering for early exercise, you might prefer to have them converted into NSOs before early exercising. See more on this issue here.)

2. Exercise some ISOs after vesting and prior to liquidity; or

Precisely planning your ISO exercises can allow you to take advantage of the ISO benefits, which will be more favorable under the revised AMT limits. Work with your accountant or financial advisor to determine precisely how many ISOs can be exercised per year to fall within the AMT exemption amount for your phase-out threshold status.

3. Wait to exercise all ISOs until the shares will be sold to pay the taxes due at liquidity and the exercise price.

This is likely to have the highest tax rates but the lowest investment risk. However, if the ISOs expire early at employment termination, leaving your job may make this impossible. More on this issue here.

WHAT DOES THIS MEAN FOR NEGOTIATING A NEW STOCK OPTION OFFER?

ISOs are more favorable than NSOs (unless you are early exercising while the exercise price is equal to the FMV). The revised AMT limits make their benefits even more appealing. So, if you are negotiating a stock option offer, make sure the grant will qualify as ISOs up to the limits under the law.

I would be happy to hear from you if you are navigating an existing option grant or negotiating a new offer. For more information, please see this FAQ or contact me at (650) 326-3412 or by email.

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 by email.

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

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 by email.

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.

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 by email.

 

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

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 by email.

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.

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 by email.

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

Early Expiration of Startup Stock Options - Part 1 - A $1 Million Problem

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 by email.

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 1 of a 3-part series. See Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage

EARLY EXPIRATION PERIOD

The standard in the past has been that startup stock options are designed with this early expiration period. They must be exercised by whichever comes first:

1. 10 years after the date of grant or

2. 3 months after the last date of employment.  (We’ll call this an “early expiration period.")

If a stock option is not exercised by this deadline, it expires and the individual forfeits all rights to the equity they earned. In some cases, this period is shorter, such as expiration 1 month after or even the day of last employment.

If an employee leaves a startup - by choice or involuntary termination of employment - and has to exercise stock options within an early expiration period, he or she has the following choice:

1. Pay the exercise price and tax bill with savings or a loan;

2. Find liquidity for some of the shares on the secondary market (which is complicated, not widely accessible, and sometimes prohibited by company or law) to pay for the cost of the exercise price and tax bill; or

3. Walk away and lose the vested value.

A $1 MILLION PROBLEM

This can be a $1 million problem for employees at successful companies because the tax bill due at exercise is based on the value of the shares at exercise. Either ordinary income or alternative minimum taxable (AMT) income may be recognized at exercise. This income will equal the difference between the option exercise price and the value of the shares at the time of exercise. The value of the shares is usually called fair market value (FMV) or 409A valuation.  These values are generally set by an outside firm hired by the company. The company may try to set these valuations as low as possible to minimize this problem for employees, but IRS rules generally require that the FMV increases with investor valuations and business successes.

The more successful the company has been between option grant and option exercise, the higher the tax bill will be. For a wildly successful company, the calculation might look like this:

Here’s an example:

Exercise Price = $50,000

FMV at Exercise = $4 million

Gain (either Ordinary Income or AMT Income) Recognized at Exercise = $3,950,000

Hypothetical tax rate = 25%

Taxes Due for Exercise = $1,027,000

Total Exercise Price + Tax Cost to Exercise = $1,077,000

REMEMBER: FMV at exercise is not cash in hand without a liquidity event. Therefore, if the option holder in this example makes the investment of $50,000 plus the tax payment of $1,027,000, they might never realize the $4 million in stock option value they earned, or even reclaim the $1,077,000 exercise price + tax. The shares may never become liquid and could be a total loss. For someone who goes into debt to exercise and pay taxes, that might mean bankruptcy. So, even if they can come up with $1 million to solve the early expiration problem at exercise, they may have wished they had not if the company value later declines.

Investor-types frame this as a simple investment choice - the option holder needs to decide whether or not to bet on the company by the deadline. But many people simply do not have access to funds to cover these amounts. It’s not a realistic choice. The very success of the company they helped create makes it impossible to exercise the stock options they earned.

Although these numbers may seem impossibly large, I regularly see this problem at the $1 million + magnitude for individual option holders. The common demographic for the problem is very early hires of startups that grew to billion-dollar valuations.

WHY NOW? LATER IPOS, HIGHER VALUATIONS, MORE TRANSFER RESTRICTIONS

Early expiration of stock options is a hot issue right now because successful startups are staying private longer and staying private after unprecedented valuations. These successful but still private companies have also been enforcing extreme transfer restrictions.  These longer timelines from founding to IPO, higher valuations between founding and IPO, and transfer restrictions are causing the early expiration of stock options to affect more employees.

1. Later IPOs = more likely early expiration applies before liquidity. The typical tenure of a startup employee is 3-4 years. As companies stay private longer, employees are more likely to leave a company after their shares have vested but before an IPO. If they have to exercise within the early expiration period but before an IPO, they must pay taxes before they have liquidity to pay the taxes.

2. Higher valuations = higher grant prices. Exercise prices for stock option grants must be set at the fair market value (“FMV” or “409A Value”) of common stock on the date of grant. If an individual joins a company that has had some success in raising funds and in business, the FMV at grant will be higher. Therefore, departing employees are more likely to have hefty exercise prices to pay within an early expiration period. With delayed IPOs they are unlikely to have access to liquidity opportunities to cover exercise prices.

3. Higher valuations = higher tax due at exercise. Total tax bills at exercise are more likely to be high as the company valuations are high because taxable income (either ordinary income or alternative minimum taxable income) is generally equal to FMV at Exercise - Exercise Price. With delayed IPOs, employees are unlikely to have access to liquidity opportunities to cover tax bills.

4. Extreme transfer restrictions = no liquidity prior to IPO or acquisition. In the past, private company stock could be transferred to any accredited investor so long as the seller first offered to sell the shares to the company. (This is known as a right of first refusal or ROFR. The market for pre-IPO stock is known as the secondary market.) Some companies are prohibiting such secondary market transfers and similar structures such as forward sales or loans that had historically allowed employees of hot companies to get liquidity for the shares to pay for exercise costs and tax bills at exercise. Some companies add these transfer restrictions after issuing the shares and even push the limits of the law by claiming that they can enforce new restrictions retroactively.

I hope this post has illuminated the problem of an early expiration period for startup stock options. For more on a solution to the problem, see Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution. See also Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage

Thank You

Thank you to JD McCullough for providing research assistance for 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 in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.

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 by email.