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.

Clawbacks for Startup Stock - Can I Keep What I think I Own?

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.

Updated February 23, 2017. Originally published on Jul 19, 2014. Thank you for your enthusiastic feedback on this post. As of February 23, 2017, over 30,000 people have viewed it.  I hope you’ll read it, use it and share it.

Everyone loves a gold rush story about startup hires making millions on startup equity. But not all startup equity is created equal. If a startup adds repurchase rights for vested shares (one example of a "clawback") to its agreements, individuals may lose the value of their vested equity because a company can force them to sell their shares back to the company in certain situations, such as if they leave their jobs or are fired prior to IPO or acquisition. Other examples of clawbacks are forfeiture (rather than repurchase) of vested shares at termination or for violation of IP agreements or non-competes.

Image from  Babak Nivi of Venture Hacks , who warns startup founders and hires to “run screaming from” startup offers with clawbacks or repurchase rights for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”

Image from Babak Nivi of Venture Hacks, who warns startup founders and hires to “run screaming from” startup offers with clawbacks or repurchase rights for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”

How Clawbacks Limit Startup Equity Value

In a true startup equity plan, executives and employees earn shares, which they continue to own when they leave the company. There are special rules about vesting and requirements for exercising options, but once the shares are earned (and options exercised), these stockholders have true ownership rights.

But for startups with clawback rights, individuals earn shares they don’t really own. In the case of repurchase rights for vested shares, the company can purchase the shares upon certain events, most commonly after the individual leaves or is terminated by the company. If the individual is still at the company at the time of an 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 (“FMV”) on the date of termination of employment or other triggering event.

Most hires do not know about these clawbacks when they negotiate an offer, join a company or exercise their stock options. This means they are earning equity and purchasing shares but do not have a true sense of its value or their ownership rights (or lack thereof).

Clawbacks are “Horrible” for Employees -  Sam Altman of Y Combinator

In some cases a stockholder would be happy to sell their shares back to the company. But repurchase rights are not designed with the individual’s interests in mind. They allow the company to buy the shares back against the stockholder’s will and at a discounted price per share known as the “fair market value” or “FMV” of the common stock. As Y Combinator’s Sam Altman wrote, “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 FMV paid by the company for the shares 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 valuation of the startup), but the buyback FMV is far lower than this valuation. Second, the real value of owning startup stock comes at the exit event - IPO or acquisition. This early buyback prevents the stockholder realizing that growth or “pop” in value.

Real Life Example - Skype Shares Worth $0 in $8.5 Billion Acquisition by Microsoft

In 2011, when Microsoft bought Skype for $8.5 billion (that’s a B), some former employees and executives were outraged when they found that their equity was worth $0 because of a clawback in their equity documents. Their shock followed a period of disbelief, during which they insisted that they owned the shares. They couldn’t lose something they owned, right?

One former employee who received $0 in the acquisition said that while the fine print of the legal documents did set forth this company right, he was not aware of it when he joined. “I would have never gone to work there had I known,” he told Bloomberg. According to Bloomberg, “The only mention that the company had the right to buy if he left in less than five years came in a single sentence toward the end of the document that referred him to yet another document, which he never bothered to read.”

Both Skype and the investors who implemented the clawbacks, Silver Lake Partners, were called out in the press as “evil,” the startup community’s indignation did not change the legal status of the employees and executives who were cut out of millions of dollars of value in the deal.

Hypothetical Example #1 - Company Does NOT Have Repurchase Rights for Vested Shares - Share Value: $1.7 Million

Here’s an example of how an individual would earn the value of startup stock without repurchase rights or clawbacks. In the case of an early hire of Ruckus Wireless, Inc., the value would have grown as shown below.

This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million.

This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million. If you want to see the working calculations, see this Google Sheet.

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.

Hypothetical Example #2 - Company Has Clawbacks for Vested Shares - Share Value: $68,916

If the company had the right to repurchase the shares at FMV at the individual’s departure, and they left after four years of service when the shares were fully vested, the forced buyout price would have been $68,916 (estimated). This would have caused the stockholder to forfeit $1,635,054 in value.

In this hypothetical, the individual would have lost $1,635,054 in value if the shares were repurchased at their termination. If you want to see the working calculations, see this Google Sheet.

No Surprises - Identifying Clawbacks During Negotiation

As you can see, clawbacks dramatically affect the value of startup stock. For some clients, this term is a deal breaker when they are negotiating a startup offer. For others, it makes cash compensation more important in their negotiation. Either way, it’s essential to know about this term when evaluating and negotiating an offer, or in considering the value of equity after joining a startup.

Unfortunately this term is not likely to be spelled out in an offer letter. It can appear in any number of documents such as stock option agreements, stockholders agreements, bylaws, IP agreements or non-compete agreements. These are not usually offered to a recruit before they sign the offer letter and joining the company. But they can be requested and reviewed during the negotiation stage to discover and renegotiate clawbacks and other red-flag terms.

My clients who are negotiating offers ask the company for form versions of all relevant documents before agreeing to an equity package. I read the documents, identify red-flags like clawbacks, and propose more favorable terms within market standards. In most cases, clients negotiate the terms on their own behalf. I am available behind the scenes during their negotiation and to review the final versions of the documents. If you would like professional guidance on your startup equity, please see this FAQ or contact me at (650) 326-3412 or info@stockoptioncounsel.com.

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 to Dianne Walker of Stock Option Counsel for edits to this post. 

VIDEO Startup Stock Options: Negotiate the Right Startup Stock Option Offer

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.

 

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.

Negotiation Rhythms #2: Best Alternative to Negotiated Agreement

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.

We know we want to push beyond our limits to capture as much value as possible in a negotiation. But how do we define those limits? It takes a five-word phrase to bring this concept into focus: Best Alternative to Negotiated Agreement (“BATNA”).

The BATNA for a car buyer might be the same car at a nearby dealership for $20,000. The BATNA for a home seller might be an offer from another party for $1 million. The BATNA for a child trading baseball cards might be to hold onto his favorite cards and enjoy looking at them rather than to trade them away.

 

BATNA Slide.jpg

Any agreement below (or, for a maximum limit, above) a BATNA would leave the negotiator worse off than in the absence of that particular agreement. Said another way, the negotiator would be better off with some other option – their BATNA – than accepting an agreement on those terms.

 

BATNAexamples.jpg

To properly identify a BATNA, we must do a lot of calculating, daydreaming, and going out in the world to test alternatives. But this creative process is necessary. When we believe that the only alternative is the one at hand, our negotiation position is dangerously weak. It is also dangerously ineffective because it leads to an arrangement that does not, in fact, make the negotiator better off than without it. And any deal that is not in both parties’ best interests is unstable and likely to collapse after it is made.

Countless factors go into naming and ranking one’s alternatives to arrive at a BATNA, and even then it is impossible to do so clearly as those factors cannot all be outlined in numerical format. A better offer might be less certain of being completed, so it might be more advantageous to make an agreement on less favorable terms today. For example, the other job offer might not be certain even though it appears it would be more advantageous if it were finalized. This is the old saying that a bird in the hand is better than two in the bush, and this can be dangerous for those who optimistically negotiate as if their imaginary alternatives are already in the hand. In the other extreme, this is very limiting for those who are very fearful of uncertainty, as they will accept disadvantageous terms for the simple purpose of having certain terms when a bit of risk in pursuit of a better alternative could have led to greater results.

Timing is important in other ways as well, as a negotiator with more time to come to an agreement will have more chances to find alternatives to the agreement at hand. "Wait and see" becomes a BATNA in itself. The opposite of this would be a party who must have resolution today, which would, of course, limit the alternatives.

Beyond hard limits on time, some people do not enjoy the back and forth process of negotiating. They might prefer to take this deal, and even to accept much less of the middle than is possible to capture, than to continue to seek alternatives or negotiate deals. For these people, the process itself inhibits the growth of BATNAs.

We’ll see in the next post – Negotiation Rhythms #3: Sales & Threats – how brainstorming or eliminating BATNAs changes the ZOPA and improves or weakens our force in negotiation.

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.

Negotiation Rhythms

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.

We’ve all heard plenty of advice about negotiating.

The business world directs us to stay rationally focused, rely on exhaustive preparation, think through alternatives, spend less time talking and more time listening and asking questions, and let the other side make the first offer.[1]

The psych world counsels us to listen first, sit down, find common ground, move in, keep cool, be brief, forget neutrality, avoid empty threats, and don’t yield.[2]

These tips don’t have much meaning without knowing the underlying principles of negotiations, and studying tips alone is about as meaningful as learning dance steps without ever hearing the music.

The following three-part series presents the rhythm of negotiations as described in the Harvard Negotiation Project’s Getting to Yes: Negotiating Agreement Without Giving In.[3] It should be useful for those first learning to hear this rhythm and for those who have been dancing since the bazaars of their youth who may need to go back to basics to learn some tricky new steps.

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 welcome to contact Stock Option Counsel at info@stockoptioncounsel or (650) 326-3412.

Read on!

#1: Zone of Possible Agreement

#2: Best Alternatives to Negotiated Agreement

#3: Sales & Threats

[1] Take It Or Leave It: The Only Guide to Negotiating You Will Ever Need http://www.inc.com/magazine/20030801/negotiation.html via @Inc

[2] The Art of Negotiation | Psychology Today http://www.psychologytoday.com/articles/200701/the-art-negotiation

[3] Roger Fisher, William Ury and Bruce Patton, Getting to Yes: Negotiating Agreement Without Giving In

 

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.

Startup Negotiation: Know the Game

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.

Craps is the best game in a casino. The house odds are very low at around 0.6%. When you’re rolling and you’re hot you can make big money for everyone at the table. And when you’re cold it doesn’t take long for your turn to end and the dice to move to someone who might get hot!

The same is true for Silicon Valley. It is arguably the only place where employees can strike it rich. Employees become rollers here, making the enterprise happen and enjoying some of the upside of the business through employee equity.

But the odds in craps can be even worse than double zero roulette if you don’t choose the right bets. There are about 120 to choose from, and the people who win know the game and know the risks they’re taking with each bet.

This is a list of casino-style descriptions of a bet on stock options, RSUs or ESPPs. We’ll give each a more thorough look (and pay attention to the great casino king Uncle Sam’s take) in later posts. To keep it simple, these presume that the vesting time/terms have been met by the player.

Stock Options: Player wins cash if (1) player pays cash exercise price to company before/when leaving the company and before the expiration date of the option; (2) company gives permission for or requires player to sell shares (on secondary market, at IPO, at sale of company, etc.); and (3) player sells shares at a price greater than the exercise price. Player loses the exercise price cash if (2) and (3) are not met.

RSUs (“Restricted Stock Units”): Player wins cash when (1) company settles the RSUs in shares of common stock (aka company gives player common stock) and (2) player sells the shares.

ESPPs (“Employee Stock Purchase Plans”): Player wins cash if (1) player makes cash payroll contribution; (2) company converts player’s cash to shares on purchase date (# of shares = cash/conversion price); (3) player sells shares at a price greater than the conversion price. Player loses cash if player sells shares below the conversion price.

Of course, this post does not include the 1000 disclaimers that would be necessary to cover every possible Stock Option/RSU/ESPP plan or equity compensation bet. But it should be a good place to start for employees trying to know the game.

 

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.