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.

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.

 

Will this Seed Stage Company Become a Unicorn?

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.

Wondering if your seed stage startup will become a unicorn? Here's a great illustration of your chances from Dustin Moskovitz's presentation, Why to Start a Startup from Y Combinator's Startup School

Startup Value

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

Advice for startup employees in bill gurley's "on the road to recap"

Startup employees have been curious lately about how economics at their companies and in the broader VC world are affecting the value of their shares.  Benchmark partner Bill Gurley has published a popular post on the wider topic, and he includes some advice specific to employees at unicorn startups. I won't bother with a summary here, as a read of the full article is necessary for a comprehensive view of his advice. So I'll simply suggest Bill Gurley's On the Road to Recap: Why the Unicorn Financing Market Just Became Dangerous...For All Involved.

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.

 

Is the battle for talent delaying unicorn ipos?

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.

Frederic Kerrest, Chief Operating Officer and Co-Founder of Okta lists recruitment as one of a few factors that influenced their choice to delay their IPO. 

There’s a few reasons specifically that we thought about when we went through the calculation [of taking another private financing rather than having an IPO]. Five or ten years ago, companies like us would have gone public at this point instead of doing this financing round, because it’s about the same amount of money you would raise in a typical IPO.

First of all, it’s interesting for potential employees who want to come join the company. The opportunity to join a pre-IPO company is something that’s interesting to them, even if it’s just 6 or 9 months before.
— Frederic Kerrest, Chief Operating Officer & Co-Founder, Okta
Do you think it’s harder to hire certain folks if you were public as opposed to being pre-public?
— Dan Primack, Fortune
I think it’s a slightly different kind of person who wants to join a pre-public versus a ... public company. They have different profiles, they’re looking for different things. They’re looking for different things in terms of the company, in terms of the job, in terms of other things.
— Frederic Kerrest, Chief Operating Officer & Co-Founder, Okta

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.

Tax Deduction Reminder & Stock Option Counsel Updates

 

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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.

Thanks for a great year with Stock Option Counsel.

Reminder - Tax Deduction for Legal Fees

Your legal fees may be deductible on your tax return. Check with your tax advisor for more information. 

Update - Stock Option Counsel Services for Employees & Founders

Please keep us in mind as a resource for yourself and your friends and colleagues for guidance on:

  • Job offers, equity grants and employment agreements
  • Stock option exercise and tax choices
  • Sales of employee stock on the secondary market
  • Post-acquisition employment agreements
  • Founders' interests at incorporation, financings, and exits
  • Dispute resolution among founders and employees on startup equity

Our Blog - Articles and Videos on Employee Equity

We use the Stock Option Counsel Blog to share information on negotiating job offers and selling startup stock. Please send us any requests for additions to the blog. Here's some links to our most popular posts:

Joining An Early Stage Startup? Equity Tips

Bull's Eye - Negotiating the Right Job Offer

RSUs - Startup Restricted Stock Units

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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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.

Who is Mark Zuckerberg's Daddy?

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.

Who is Mark Zuckerberg’s daddy? In a traditional public company, the CEO’s daddy is the board of directors who hire him, and the board’s daddy is the stockholder who can vote out the board. But Mr. Zuckerberg has voting control over the board and the power to define his own priorities.

So, who IS Mr. Zuckerberg’s daddy? He answered that question in yesterday’s interview with TechCrunch founder Mike Arrington with a subtle message to employees: The employee equity we grant you today, at today’s low prices/strike price with a four-year vesting schedule, will “pop” at the end of the vesting schedule.

Well, he didn’t say that exactly. But he led with that very clear (and obviously carefully crafted) message to employees by defining a remarkably specific timeline for stock price increase (remember, he always references vague future goals such as “build value over the long term” and “making the world more open and connected”):

“Over the next three to five years, I think the biggest question that is on everyone’s minds that will determine at least our performance over that period, is really going to be how well we do with mobile. … I think it’s easy for a lot of folks, without us being out there talking about the stuff we’re doing, to really underestimate how fundamentally good mobile is for us.”

Did someone ask him about the next three to five years? Not the interviewer. Not the public markets. Who cares about three to five yearsEmployees care about three to five years because they will receive grants of options or RSUs that will become fully vested in three to five years.

So Mr. Zuckerberg’s message to employees is this:

1. I know you care about the Facebook stock price in three to five years, because its delta over that time is your chance to build a fortune in compensation. If you’re not expecting a delta, you’ll place your bets (work) elsewhere.

2. I am thinking about the stock price in three to five years, because that is what you care about. I care about you. I have a plan, and it is going to benefit you directly.

3. The plan is mobile. Facebook is going to have a higher stock price in three to five years because of mobile.

4. Your employee equity is not worthless. It is going to gain value in the exact time frame in which you want it to gain value. And you will be rich.

So, Mr. Zuckerberg has declared what employees are betting on if they bet their workdays on Facebook employee equity. Will the best and brightest take the bet?

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.