Clawback Clause for Startup Stock - Can I Keep What I think I Own?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Updated October 19, 2020 for a recent clawback event in the news.
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 a repurchase rights for vested shares (a.k.a. a clawback clause or clawback provision) 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 a clawback clause are forfeiture (rather than repurchase) of vested shares or options at termination of employment 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 a clawback clause for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”
How a Clawback Clause Limits 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 a clawback clause, 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 the clawback clause 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).
Clawback Clause “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 Sam Altman (now CEO of OpenAI) wrote when he was the head of Y Combinator, “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.
What is an Example of a Clawback Clause?
Famous 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.
Recent Example - Tanium, funded by Salesforce Ventures and Andreessen Horowitz, claws back employee shares
More recently, Business Insider reported that Tanium, funded by Salesforce Ventures and Andreessen Horowitz, has forced employees to sell their shares back to the company at FMV after their employment is terminated.
The employees interviewed by Business Insider were not aware of that their contract included this clawback when they accepted their offers. “'Surprised' was my initial reaction," one such employee said. "I had not heard of that happening before. To me it felt like a gut punch. One of the reasons for working for the company is dangling the carrot of eventually going public or eventually getting acquired so employees would monetarily benefit from that.”
How Does a Clawback Provision Work?
Hypothetical Example #1 - Company Does NOT Have Clawback Clause 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 Clawback Clause 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 a Clawback Clause 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.
What is a Typical Clawback Clause?
For examples of typical clawback clause language, see Part 2 - Examples of Clawbacks for Startup Stock.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Founders' Stock Red Flags - Keep Your Law Firm on Your Side
Lately, I’ve seen startup law firms yielding founder rights to future investors by proposing incorporation documents that are detrimental to founder interests. Photo © Aleksvf | Dreamstime.com
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
I help founders protect their personal equity interests, from incorporation through financing and exit events. Lately, I’ve seen startup law firms yielding founder rights to future investors by proposing incorporation documents that are detrimental to founder interests. These choices are being made by company counsel and signed by founders before a company has investors.
Here are some of the red flag terms I call out for my clients:
Requiring board approval for transfer of shares;
Adding Company repurchase rights for vested founder shares upon termination of employment;
Using stock option structure rather than restricted stock at founding;
Setting the purchase price of shares higher than necessary;
Adopting a stock plan for future employee grants that has off-market, anti-employee terms;
Failing to provide for any vesting acceleration related to a change of control, or limiting double trigger acceleration of change of control to apply only if the termination event is within 6 or 12 months of the change of control rather than at any time after it; or
Adding Company rights to terminate unvested shares or options at the time of a change of control.
I’ve seen some of these terms even from classic Big Law startup-focused firms in recent months. Limits on founder shares are often negotiated between founders and investors at the time of financing – not before. This is usually done through a stockholders agreement, such as a ROFR Agreement or Voting Agreement. It is premature for founders to restrict themselves – or for a company’s law firm to restrict founders – by adding pro-investor terms to the incorporation documents.
The founder’s task is to communicate to company counsel that they want standard, pro-founder terms in the incorporation documents and provide feedback if they see that company counsel has added pro-investor terms have been included before negotiation with investors.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
*Thank you to JD McCullough for edits to this post. JD is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.*
Considerations for founder restricted stock purchase agreements.
Repurchase Rights are "Horrible" for Employees
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
“As an aside, 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.”
What can you do about it? Ask before you join:
“Can the company take back my vested shares?”
For more from Sam Altman, see his post, Employee Equity. For more on repurchase rights on vested shares, see Clawbacks for Startup Stock - Can I Keep What I think I Own? For more on questions to ask to make sure you have true startup equity, see our post, Startup Equity Standards - A Guide for Employees.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Skype Repurchase Rights = Vampire Capitalism
I agree that it is unethical as it goes against the expectation of employees as to how their contributions are valued. If they don't know about it before they choose the company, they are making a choice without an essential term of the deal.
And it goes against the most idealistic ethic of Silicon Valley – that capitalism should be used by groups to organize and cultivate their own creative efforts rather than as a tool of vampires.
But it is not illegal. And I've seen worse in my Stock Option Counsel practice (twice this month alone). Congratulations on paying attention.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Quora Question:
What does it say about a company that has a Skype-like repurchase right in their stock option agreement? The company that I work for has a stock option agreement that has a Skype-like repurchase clause (See: Upgrading Skype and Silver Lake to Evil), basically allowing them to buy back exercise stocks at 1.5x FMV within 90days following the employee's end date/exercise date. I have never seen anything like this, is this to protect them/screw ex-employees? It basically mean my vested stocks can be easily bought back at 1.5x? Isn't it unethical?
Stock Option Counsel Answer:
I agree that it is unethical as it goes against the expectation of employees as to how their contributions are valued. If they don't know about it before they choose the company, they are making a choice without an essential term of the deal.
And it goes against the most idealistic ethic of Silicon Valley – that capitalism should be used by groups to organize and cultivate their own creative efforts rather than as a tool of vampires.
But it is not illegal. And I've seen worse in my Stock Option Counsel practice (twice this month alone). Congratulations on paying attention.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.