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.

Working for a Startup?  | Clawback Clause, Forfeiture Term & Repurchase Right | Protect Your Equity Stake

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.

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Early Exercise of Startup Stock Options

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Planning for your startup stock options? Consider an early exercise of stock options to protect your equity stake from taxes and forfeiture.

Most people learn the hard way about the complexity of exercising stock options at a startup. If you can spare a few minutes of attention, this post will teach you about early exercise - the easy street of startup stock option exercise strategies.

Early Exercise Stock Options

An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS before the options vest

Early exercise makes you the owner of the shares in the eyes of the company. The shares are still subject to the options’ original vesting schedule, though, as the unvested shares can be repurchased from you if you leave the company prior to your vesting milestones. The repurchase price for unvested shares is usually the lower of your exercise price or the fair market value (“FMV”) on the date of termination. 

Early exercise with an 83(b) election also makes you the owner of the shares in the eyes of the IRS. That means you start your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods, which sets you up for the lowest possible tax rates when you sell your shares. 

Tax Benefits of Early Exercise  of Stock Options

If you early exercise while your exercise price is equal to the FMV of the common shares, the exercise itself is not taxable and therefore defers all taxation until you sell the shares and have cash gains to use to pay the taxes. 

This may seem like overkill on planning, but the tax bill for a later option exercise can snowball surprisingly quickly and make it impossible to exercise vested stock options. More on this here: Startup Stock Options - Early Expiration - The $1M Problem. Early exercise can, therefore, act as a forfeiture-avoidance strategy as it can defer taxes until sale of stock and, therefore, save people from prohibitive pre-liquidity tax bills for exercise.

When to Early Exercise Stock Options

Since options are granted with an exercise price equal to the FMV on the date of grant, it’s a safe bet to early exercise immediately after grant to be sure you can do so without a tax cost.

The most common approach is to negotiate for the right to early exercise in the grant at the offer letter stage, and then join the company and wait a while before early exercising. This allows employees to get some visibility on the company’s possibility of success and their own fit within the company. So long as the early exercise is completed while the FMV is still equal to the strike price, the early exercise is tax free.

If you early exercise (or exercise vested options) after the FMV has increased above the exercise price (such as after a round of funding following your grant date) you will have taxable income on the difference between the FMV and the exercise price in the year of exercise. (The tax rates depend on whether you are early exercising NQSO or making an qualifying early exercise of ISOs.) This might seem unappealing, as you would of course prefer to defer all taxes until sale of stock. However, some people choose to early exercise even if they have to recognize income on that early exercise in order to be taxed at exercise on the current FMV rather than paying higher taxes on a later exercise based on a higher FMV.

Investment Risk of Early Exercise Options

The downside of early exercising startup stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up in the future. That’s why early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. For instance, a first employee might be able to exercise 1% of the company for, say, $5,000. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant. For instance, some startup stock options packages have a $1M+ exercise price.

Some key hires of later stage startups with higher option exercise prices negotiate for the right to early exercise (or exercise vested options) with a promissory note instead of cash. Instead of paying their significant exercise price with cash, they deliver a promissory note to the company. This is a promise to pay the exercise price at some date in the future. There is some complexity to this to address with your advisor if you are considering this path. 

Negotiating the Right to Early Exercise Options

Early exercise is not available at every company. Therefore, if you want to early exercise you will need to negotiate for this right during your offer letter negotiation or after you join the company. 

For example, some early Uber employees negotiated to add the right to early exercise to their existing stock option grants. This allowed them to early exercise their unvested options (and exercise their vested options) before the FMV of the shares skyrocketed, so that the tax bill for the exercise was only in the tens of thousands of dollars. 

Despite the out-of-pocket cost for the exercise price and taxes, this was a wise exercise choice for a few reasons. First, if they had waited and exercised after the FMV skyrocketed they would have had to pay far more in taxes to exercise - in some cases more than $1M. More on that issue here. Second, if they had failed to early exercise and ended up leaving the company prior to the company’s IPO, they would have had to come up with those astronomical tax payments before they had a market to sell the stock. This is because the company had only a 30-day post-termination exercise deadline and an absolute prohibition on sales of stock prior to IPO. Third, many of these employees purchased their shares while the company was QSBS eligible and then held the shares for the 5-year QSBS holding period. This qualified them for 0% federal tax rates on up to $10M in gains on the sale of their shares. 

ISOs v. NSOs and Early Exercise Stock Options

If you are early exercising stock options, it is more favorable to have the options granted as NQSO rather than ISOs. If you early exercise ISOs, you have to hold the shares for two years before sale for long-term capital gains tax rates on your gains. If you early exercise NSOs, you only have to hold the shares for one year for capital gains treatment. Therefore, if you are planning to early exercise immediately after the grant, you will want to ask the company to make the grant as a NQSO rather than an ISO. 

If you are not planning to early exercise, you may not want to include the right to early exercise in your documents. That’s because of the $100K limitation on ISOs. ISOs are a tax-favored stock option that are subject to certain limits under the tax code. Only $100K in exercise price of stock options can become exercisable in any given year and qualify as ISOs. So if you have a $400K exercise price grant that is intended to be ISOs, all $400K of the options will be ISOs if you do not include the right to early exercise. If you do include the right to early exercise, all $400K will become exercisable in the first year and so only $100K of the options will be ISOs. The remainder will be NSOs which are less tax favored. 

Don’t Forget the Section 83(b) Election

If you early exercise unvested stock options, you file a Section 83(b) election with the IRS within 30 days of the exercise. The consequences of a missed 83(b) election can be very, very unappealing. If you don’t have the attention necessary to follow through on that, don’t early exercise.

When to Exercise Stock Options

As you can see, early exercise of stock options is not the best choice in every situation. To learn about the best structures for a variety of cases, see Examples of Good Startup Equity Design by Company Stage. For a comprehensive analysis of when to exercise stock options, see this three-part series:

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Silicon Valley Wins Big With Tax Break Aimed at Small Businesses: An eight-figure IPO windfall can mean a zero-digit tax bill

"If you planned well, you ended up with a phenomenal result," says Mary Russell, an attorney at Stock Option Counsel in Palo Alto, Calif., who advises tech employees on their compensation. "If you didn’t, you were in a really tight, messy spot."

"If you planned well, you ended up with a phenomenal result," says Mary Russell, an attorney at Stock Option Counsel in Palo Alto, Calif., who advises tech employees on their compensation. "If you didn’t, you were in a really tight, messy spot." Photo by Mikhail Nilov.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Startup equity and Stock Option Counsel, P.C. in Bloomberg Business this week:

While venture investors and founders, who can afford top-notch tax advice, are using [the Qualified Small Business Stock tax provision to take advantage of 0% tax rates on startup gains], tech workers might not be as lucky. The rules are complicated, and it can be easy to miss out. For example, early employees needed to have exercised options at a time when their startup was still under $50 million in assets. ‘If you planned well, you ended up with a phenomenal result,’ says Mary Russell, an attorney at Stock Option Counsel in Palo Alto, Calif., who advises tech employees on their compensation. ‘If you didn’t, you were in a really tight, messy spot.’
— Silicon Valley Wins Big With Tax Break Aimed at Small Businesses: An eight-figure IPO windfall can mean a zero-digit tax bill - By Ben Steverman

For more information about planning for option exercises, see The Menu of Stock Option Exercise Strategies. Happy strategizing!

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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.

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Seed Stage Startup Job Offer - Equity Negotiation Checklist

Here’s the Stock Option Counsel negotiation checklist for seed stage startup offer negotiations. Plan ahead to protect your equity stake.

Working for a Startup? Seed Stage Startup Job Offer Equity Compensation Negotiation Checklist. Image from rawpixel.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.

Have a job offer from a seed stage startup? Individuals work for equity at seed stage startups (otherwise known as early stage startups) with the expectation that they will have great financial success if the company itself is successful. That dream can come true, but it depends on taking care of a few key details of the option or restricted stock at the offer negotiation stage. Here’s the Stock Option Counsel negotiation checklist for seed stage startup offer negotiations.

Percentage Ownership. The lore of Silicon Valley is that anyone who joins an early stage startup that is later a huge success will become rich. But if they fail to negotiate a significant number of shares at hire, they cannot expect that the value of their interest at the time of an acquisition or IPO will be impressive. Since being one of the first startup employees is extremely risky, there needs to be enough equity in the offer to balance that risk. I have seen individuals who are disappointed (to say the least) in these situations when they have accepted a below-market equity percentage and assumed that the founders would “take care of them” in the future. With these points  in mind, I recommend taking the following steps before agreeing to join a startup:

  1. Negotiate for enough shares up-front to balance the risk in joining the company. This is based on market norms, so do plenty of research among colleagues and advisors to confidently set market-based expectations.

  2. Insist on time-based, not performance or milestone, vesting.

  3. Expect that the equity interest will be significantly diluted and negotiate for enough shares to cover that expectation.

Making it Official. At the earliest stage startups, employees and founders often work for promises of future equity without signing the necessary paperwork to ensure that they have the legal right to that equity. They often start working with vague promises of future grants and “trust” that their business partners will “take care of them” in the future. This is misguided, as the purpose of a stock option grant or any written agreement is to not have to rely solely on the trust you have in any individual person. Since changes in leadership, investors, direction, etc. are guaranteed to happen at some point in time, you need protection from the company not promises from the current leaders. Before signing an Offer Letter or beginning work, I suggest to first:

  1. Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein. Review the terms and negotiate any issues.

  2. Ask the company to confirm that the board will officially make the equity grant promptly after hire.

Board Approval Timing. Early stage startup companies often delay officially making grants to the detriment of their employees. This is due to administrative disorganization, a desire to delay the legal and valuation expenses of making the grant, or even a disagreement among executives and investors about how much equity should be allocated for employee grants. After starting in the role, take the following steps:

  1. Follow up to be sure the grant is made by the board promptly. This should not take more than a couple of months.

  2. Compare the terms of the grant to be sure they are as-agreed during the offer negotiation stage.

Tax Planning. The potential tax benefits to receiving equity in an early stage startup are unparallelled. The structure may allow for tax deferral until sale of stock - which avoids the problem of paying taxes on option exercise before liquidity - and lower capital gains tax rates or even 0% QSBS tax rates on gains. Achieving these tax benefits requires precise design by the company - such as restricted stock or early exercised stock options - and effective execution by the individual - such as the timely delivery of  the purchase price and filing of the Section 83(b) election with the IRS. Early tax planning action items are:

  1. Negotiate the tax structure during the offer negotiation stage. The right structure will depend on the stage of the company, so work with advisors if necessary to determine the most desirable structure for your grant.

  2. Take care of the required follow-through to take advantage of the most desirable tax structures.

Legal Terms. Startup employees are sometimes very surprised by the legal terms in their grant years after they have accepted its terms. They might have assumed that they have the right to hold the shares that they have purchased and vested and find out that the company can forcibly repurchase the shares at their termination. Or they might assume that they have the right to earn their unvested shares following an acquisition but find out that they can be cancelled as part of the deal without payment. To avoid these and other unpleasant surprises regarding the legal terms of a grant, take the following steps during negotiation:

  1. Ask for a copy of the Form of Stock Option Grant or Restricted Stock Purchase Agreement, along with any other documents referenced therein.

  2. Review the terms and negotiate any issues before committing to joining.

  3. If the legal terms have unexpected risks, negotiate for more shares or more cash compensation to balance the risk.

Have an offer from a seed stage startup? Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Stock Options, startups, Working for a startup Mary Russell Stock Options, startups, Working for a startup Mary Russell

VIDEO Startup Stock Options: Exercise Price Basics

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Negotiating your startup stock option offer? Use this video to understand the exercise price/strike price, valuation, 409A valuation, etc.


 Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Tax Changes for Startup Executives and Employees - Tax Cuts and Jobs Act of 2017 - Q1 2018 Newsletter - Stock Option Counsel, P.C.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Here's our Q1 2018 Newsletter.  Sign up for our mailing list to receive these quarterly updates!

Hello Startup Community!

The final Tax Cuts and Jobs Act of 2017 is already affecting startup equity holders. Check out my recent blog posts on Tax-Deferred Option Exercises Under the New Section 83(i) and Incentive Stock Options & Changes to the Alternative Minimum Tax. Here's the short version.

Tax Deferral for Option Exercise - New Section 83(i) Election. The new Section 83(i) was designed to defer taxation from a stock option exercise until the shares become liquid. Unfortunately, the details of the new Section 83(i) make it unlikely to work for most startup option holders. But where it does apply it will defer taxation for up to five years from the date of option exercise with the use of the new Section 83(i) Election. These are the key details of the new Section 83(i).

Tax Relief for ISO Exercise - New AMT Limits. Dramatic increases to the exemption amounts and phase out thresholds of the Alternative Minimum Tax (AMT) will allow many more startup employees to exercise Incentive Stock Options (ISOs) tax-free. This allows for more planning opportunities to take advantage of the potential ISO tax benefits of capital gains tax rates on all gains. These are the key details of the AMT changes as they relate to ISO exercise.

Startup Offer Negotiation Tips. What does this mean for our clients negotiating new stock option offers? First, the new Section 83(i) will not provide wide relief from pre-liquidity tax burdens for stock option exercise. So it still makes sense to negotiate for a tax-deferred structure such as early exercise or an extended post-termination exercise period. Second, since the revised AMT limits make the ISO benefits even more appealing than ever, ISOs are far more appealing than NSOs for most people (unless the options will be early exercised.)

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
 

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Tax-Deferred Option Exercises Under The New Section 83(i) - Tax Cuts and Jobs Act of 2017

Update 2023: I still have not seen anyone take advantage of Section 83(i). Sigh. It’s just not drafted in a way that can be helpful. Mostly I just see people confusing it with 83(b).

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

The final Tax Cuts and Jobs Act of 2017 added a new Section 83(i) to the Code intending to allow holders of RSUs and options to defer tax on those benefits until they are able to sell the shares to cover their tax bills. Its drafting makes it unlikely to apply in practice at most startups, but where it applies it can defer taxation for up to five years from the date of option exercise or RSU vesting.

Many issues related to the Section 83(i) Election are unclear from the legislation and will need to be clarified by IRS guidance. So this is the best of my understanding as of today. This is not tax advice for readers, so please consult with your own accountant or CPA.

Update 2023: I still have not seen anyone take advantage of Section 83(i). Sigh. It’s just not drafted in a way that can be helpful. Mostly I just see people confusing it with 83(b).

Option Exercises & Section 83(i) Election

Because well-designed startup RSUs are already structured to defer taxation until liquidity, the benefits of tax deferral under Section 83(i) are most needed for option exercises.

For eligible option exercises, a timely election under Section 83(i) will defer income at exercise until the earlier of the (i) IPO; (ii) the first date the stock becomes transferable (including to the employer), (iii) five years from exercise, (iv) the first date the employee becomes an “excluded employee,” or (v) the date the election is revoked. The 83(i) Election must be made within a 30-day period after exercise.

These are some of the eligibility requirements:

1.   The company must have offered stock options on terms that provide the same rights and privileges (other than the number of shares) in the calendar year of grant to at least 80% of its U.S. employees. Since most startups do not make annual grants of stock options, this would be unlikely to apply except in years of very high growth in staff size, or to the occasional startup that gives broad-based annual refresh grants.

2.   The individual must not be a significant owner or executive of the company. The ownership test is met by 1% ownership. The executive test relates to role, such as CEO and CFO, as well as total compensation, as it applies to the four most highly compensated officers of the company. Both definitions have historical applicability, such as a 10-year look back, as well as future applicability, so that if one of the definitions is met after the Section 83(i) Election, the individual becomes an “excluded employee” and the tax deferral ends.

Section 83(i) Notice

Companies are required to provide a Section 83(i) Notice to eligible employees at the time (or a reasonable period before) they become eligible to make the Section 83(i) Election. However, not all eligible employees will be aware of their eligibility, as some companies may still be in the process of assessing eligibility. Therefore, those considering option exercises at private companies may want to inquire as follows:

I understand that the new tax bill created a Section 83(i) Election to allow deferral of taxation at option exercise until the earlier of 5 years from exercise or liquidity. But there are certain rules that have to be met for an option to be eligible, including related to the company’s option grant practices, my own ownership percentage and other requirements. Can you please confirm whether, if I exercise this option, I will be eligible to make a Section 83(i) Election on the stock I purchase?

Making the Section 83(i) Election Decision

Individuals who are eligible to make the Section 83(i) Election will want to consider the pros and cons based on the tax consequences and their investment plans. For example, exercising options and filing the Section 83(i) Election will not solve the pre-liquidity taxation problem if there is not a liquidity event before the five-year (or earlier) deadline. And the Section 83(i) Election converts ISOs into NQSO, so any favorable tax treatment associated with ISOs would be lost. Since the alternative minimum tax exemptions have increased so dramatically, ISOs are more likely to be AMT-free at exercise. Such an ISO exercise may ultimately result in more favorable tax treatment than the Section 83(i) Election, if the shares are held for the full ISO holding periods. And, as in any option exercise, paying the exercise price itself is an investment risk and having a tax-deferred exercise does not make the exercise risk-free.

Negotiating New Offers

All well-negotiated startup equity offers include planning for investment timing, tax timing and tax rates. While the Section 83(i) Election is a new tool in that toolbox, it is not likely to be the most advantageous planning method for new grants. See this post for some examples of my favorite structures for equity offer negotiations.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

 

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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:

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.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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

If you're negotiating a startup equity offer, ask for the good stuff - a Continuation Plan - or even more favorable single or double trigger acceleration upon change of control terms.

If you're negotiating a startup equity offer, ask for the good stuff - a Continuation Plan - or even more favorable single or double trigger acceleration terms. Photo by Erik Mclean.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Bloomberg reported on startup Juno's rescission of driver’s RSU awards in its $200 acquisition by Gett. They 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%

What was the disconnect? 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 without payment for the shares, even if the employees holding that unvested equity stay in service after the closing of the deal. We'll call these Cancellation Plans. (You can read more on all the variations of change of control terms in startup equity offers here.)

The standard for startup stock plans has historically 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.

When 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, they cancelled without payment all 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 - or even more favorable single or double trigger acceleration terms. More on those variations here.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com. 

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Will this Seed Stage Company Become a Unicorn?

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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

Working for a Startup? | Will This Seed Stage Startup Become a Unicorn?

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

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Stock Option Counsel's Mary Russell in the New York Times on Liquidity for Private 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.

For start-up employees, the more explicit language around stock prohibitions can create downsides, said Mary Russell, a lawyer based in Palo Alto, Calif., who works with start-up workers to evaluate their equity compensation. When employees leave start-ups, they often have the opportunity to buy stock that has been set aside for them at a low price. But if their start-ups have been successful, they also need money to pay taxes that will be levied on the increased value of the stock.

Ms. Russell said it is not unusual for a client to say their private company stock is worth $3 million, but that they need to come up with $1 million to pay for the shares and cover the tax bill. “In the past, the solution has been to find a third-party buyer and sell enough of the stock to cover all of those costs,” Ms. Russell said.

The use of more explicit language to cover what is and is not allowed could eliminate the option of raising cash from a third party, Ms. Russell said.

She added that employees rarely read their paperwork carefully. “In some cases a company is simply clarifying its terms, but some are making a black-and-white shift to more restrictive terms,” she said.
— Katie Benner, Airbnb and Others Set Terms for Employees to Cash Out, New York Times

See Katie Benner, Airbnb and Others Set Terms for Employees to Cash Out, New York Times

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Quora: Formula for Option Grant Size at a Startup?

Yes, there is a formula for calculating a fair pre-IPO option grant size.

Yes, there is a formula for calculating a fair pre-IPO option grant size. Photo by Nataliya Vaitkevich.

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: Is there a generic formula I can apply to determine fair pre-IPO stock option grants based on the company's size and # of fully diluted shares?

I am a tech worker who has spent all of my career with post-IPO companies and am negotiating an offer with a well-established startup of approximately 250 employees. I am not taking on a senior role.

This is a simplified version of part of the process I follow with my Stock Option Counsel clients who are evaluating private company equity offers. It works best with a mid-stage startup which has had a recent funding round from a well-known VC (a.k.a. someone whose investment decision you would trust).

Recent VC Company Valuation / Fully Diluted Shares = Current "Value" per Share

Current Value per Share - Exercise Price per Option = Intrinsic Value per Option

Intrinsic Value per Option * Number of Options = Intrinsic Value of Equity Offer

Intrinsic Value of Equity Offer / Number of Years of Vesting = Annual Value of Equity Offer

Annual Value of Equity Offer + Value of Benefits + Salary + Bonus/Commission = Total Annual Compensation

Use Total Annual Compensation to evaluate the offer or compare to market opportunities.

Certain legal terms may change the risk and, therefore, the appropriate number of shares. For more on ownership limitations, see Ownership - Can the Company Take Back My Vested Shares? For more on how companies decide the right offer for startup employees, see Bull’s Eye: Negotiating the Right Job Offer.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Underwater Startup Stock Options Due to Lower 409A Valuations After Mutual Fund Markdowns

Photo: Bobby Mikul. Startup employees may find their stock options are underwater as startup valuations decline. - Mary Russell, Stock Option Counsel

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: Do recent markdowns by mutual funds of private tech company valuations impact the strike price for options granted to new employees?

MARY RUSSELL Answer: 

Yes, I am seeing this in my practice. Companies that issue stock options generally set the strike price at the fair market value on the date of grant, with such value determined with an outside valuation performed every year or six months. These are known as "409A valuations." Some companies which have seen markdowns in their stock, and some other companies in the startup world, are showing their 409A valuations decreasing in their most recent outside valuations.

This is relevant for new hires and existing employee optionholders. For new hires, it may make sense to agree to delay an option grant until a new valuation if the company expects the next 409A valuation to come in at a lower price than the current 409A valuation.

For existing employee option holders, a lower 409A valuation may cause outstanding options to be "underwater." An underwater option is an option with a strike price that is higher than the current value of the shares. In the case of underwater options, it may make sense to ask the company to reprice the options so employees can take advantage of the lower valuations.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

 

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