14 posts categorized "Equity Incentives"

Giving up on ISOs - the right thing to do?

An interesting campaign launched this week. The key argument is that 90 day post-termination exercise requirements - typical for stock options granted by startups - are not fair to rank-and-file employees.

The case is well made by Harjeet, in what appeared to be a coordinated brace of posts on Medium, published yesterday:

Those of you familiar with tax law requirements for ISOs (incentive stock options) will be quick to say, "well, that tight exercise window is required by the law; it's part of the tradeoff for the employee getting the favored tax treatment of ISOs."

6108085408_8d79bbe1c2_bBut Harjeet is arguing that the tax benefits of ISOs are outweighed by the impracticalities of the 90 day post-termination exercise window.

And are those tax benefits as significant as many assume? Here's part of his discussion of the tax benefit lost on exercise of the stock option as a non-qualified stock option, which is necessarily what you get when you extend the post termination exercise window and so fall outside ISO requirements:

"ISO: Employee now owes AMT (Alternative Minimum Tax) on the difference between the amount they paid to exercise their options (the exercise price) and the fair market value of that stock today. Calculating exactly AMT can be tricky, most likely you’ll pay 28% on the difference."

"NSO: Employee owes Ordinary Income Tax (38%) on the difference between the exercise price and fair market value of the stock."

So ISO treatment is not as compelling for tax reasons as one might suppose. My friend, the startup lawyer, Joe Wallin, has been pointing this out for years.

There are company-side factors in favor of a 90-day post-termination exercise window that are not emphasized by Harjeet's posts. Startup founders, management teams and boards are going to want to consider these other factors. At the same time, Harjeet's posts are  very well done and make a compelling, pro-employee case. I think his arguments are a great contribution to the discussion.

Photo credit: Nisa Yeh, Creative Commons license.

Information asymmetry

Really cool to see this tweet today from Naval Ravikant of AngelList, encouraging startup employees and prospective employees who are offered stock options to ask questions.

To get at the information needed to assess the potential value of those options, Naval says, in a companion tweet to the one pictured: "Ask about Liquidation Preference, Exercise Price & Terms, Fully Diluted Shares & Company Repurchase Right[.]"

6a01156e3d83cb970c01901dc8b8fe970b-580wiTo that list, I would add, ask also about whether the company has a management incentive, or carveout, plan in place. These plans are often set up when the common stock of a company is under water.

And here's an earlier post I've written on the subject, Being Equitable with Employee Equity. It has an 8 point checklist that is similar to Naval's.

And here's a recent post from Joe Wallin wrote about what to do when getting ready to exercise a stock option.

Airbnb's Founder Dividend: No Clear Lesson for Employees with Stock Options

Is there a lesson in the news broken by Kara Swisher of AllThingsD that Airbnb founders have achieved (or plan to achieve) significant personal liquidity via a cash dividend? Should non-founder employees of hot startups exercise their stock options as they vest, to be eligible for early dividends, too?

5351000574_23a88fff36_oSwisher's piece takes up the perennial question of whether it's fair for founders to cash out, not just in front of investors, but before employees.

But the Airbnb story also has a unique twist. While it's not unusual for startup founders to take money off the table in the course of a round of financing, it is unusual is for money to flow in the form of a dividend. Normally, early founder liquidity comes via a redemption or private resale of some of the founder's stock.

By distributing cash in the form of a dividend, the startup lets the founder eat her cake and keep it too. After the dividend, the founder not only has cash to save or spend, she keeps the same number of shares she had before the dividend. Put another way, the founder did not have to surrender, give up, abandon (i.e., sell) any shares in the company in order to get the extra payday.

Paying a cash dividend on common stock is not an easy thing to do. For starters, the company's charter will likely have to be amended to deal with prohibitions and preferred stock preferences. That means having the investors on board. There are also "unlawful distribution" statutes to consider. These are laws that prohibit distributions if the company is (or would be, after making the distribution) unable to pay debts in the ordinary course. For startups that are not cash flow positive, it can be hard to meet the requirements for a legal distribution, outside the context of a financing.

Does it matter whether the founders of your company get early liquidity via a dividend rather than by selling shares privately or on a secondary market?

Yes. When money is flushed from a startup in the form of a dividend, that means it has less working capital. Now, be ready for the creative financiers and lawyers who came up with this scheme to defend it. They will say that dividends to founders only happen with investor buy-in and careful planning to ensure money is raised, over and above the amount needed for working capital, to finance the dividend, too. But think about that argument for a minute. Investors aren't gifting the cash that will go out the door to pay the dividend; they are buying additional shares from the company, preferred shares most likely, in exchange for that cash.

In short, when you argue that a startup's working capital is adequate even after accounting for a founder dividend, you are admitting that more equity was sold than necessary, had the offering capped out when the company's working captial needs were met. The sale of excess equity means excessive dilution, at least in percentage terms, to outstanding employee options.

True, had the company redeemed shares instead of paying a dividend, there would be the same depletion of working captial, as well as similar dilution from new shares issued to fund the redemption. But when founder stock is redeemed, the retirement of those shares has a mitigating, anti-dilutive impact. Depending on the price differential (what the new investors pay for the shares sold to finance the redemption, over and above the price per share paid to the founder to repurchase her stock), a redemption could significantly increase what percentage of the company a given stock option represents. 

If you exercise your vested options, then you own shares. When you own shares, any dividend paid on the common stock - even if targeted primarily for founders - will flow to you, too, pro rata, in proportion to the number of shares (not options, but shares!) you own. A good hedge on the potential for founder selfishness?

There are additional reasons to exercise options as they vest. I once sat on a board with a fellow who brought his checkbook to every meeting and exercised the new portion of his option that had vested since the last meeting. He was thinking in terms of maximizing long term captial gains treatment for his equity on exit.

He also believed in the startup and wasn't worried about losing his investment. That's the risky bit. If you exercise your stock options as they vest, the exercise price you pay is an investment that could be lost. You aren't hedging against failure like those who sit on their options until the company is sold.

What's more, your investment risk is greater than that of a preferred stock investor, who will have the benefit of a liquidation preference. Liquidation preferences can be worth a multiple of the amounts originally invested. It's essential to know them and to understand them in order to assess how the common stock will fare in the distribution of proceeds from a sale of the company. These days, it is all too common for exits to be carefully managed to clear liquidation preferences, leaving common stock worthless. As for C-level execs whose options are underwater, they can be "incentivized" through a "sale participation plan" set up exclusively for management. You may think execs with stock options have the same incentive as you do to deliver upside to common shareholders, but that may not be true.

In a way, that brings us full circle. There probably is no sure fire way to hedge against founder willingness to break ranks with employees. If founders are willing to cooperate with investors on early dividend schemes, they may also be more willing to "manage" the company to an exit that treats the common stock - not their common stock, but yours - as an afterthought.

Photo, "Lunchtime at a startup, 6:30 pm at @airbnb with co-founders @jgebbia @bchesky," by Robert Scoble.

Being Equitable with Employee Equity

I continue to be troubled about (a) the Skype vested equity snafu and (b) Twitter CEO Dick Costolo's comments about how employee stock sales on secondary markets have to be reined in.

Reading-mangaThe Skype stories suggest that the company played fast and loose with the term "vested." As it turned out, even "vested" shares were subject to repurchase by the company at the employee's cost, if an employee quit before 2014. In hindsight, Skype might have played more fairly if it had avoided the term "vested" until the shares had cleared the final hurdle. And yet, reading the relevant Skype documents, it does appear that the terms were disclosed in advance (assuming the documents were available to employees).

And here's both the question to, and the answer given by, the Twitter CEO, pertinent to what I want to revisit today:

MIGUEL HELF: "As the CEO of a very fast growing company that's hiring a lot of people, trying to retain a lot of people in a very competitive market, how do you see the secondary markets, the trading in private shares that your employees can engage in? Is it helpful, is it a distraction? How do you communicate to employees about it, and do you have any specific policies?"

DICK COSTOLO: "It's a distraction. I mean, the simple answer is it's a distraction. I think that we and Zynga and Facebook have had to retroactively put lots of policies in place to sort of constrain that. One of the concerns is because that's sort of a brave new world, you worry about people who might be buying through those second markets, whether they're accredited investors, what they've been told by the person who might be trying to sell them the stock, and who's going to get in trouble at the end of the day if it doesn't all work out with them. So, they're definitely a distraction, and I think that going forward private companies and their investors will do things in advance of forming the company that restrict those transactions."

What will those restrictions look like? Will they apply to founder, angel and VC equity as well? In addition to the option plan documents, essential reading now may include other corporate documents and policies that could impact the value and marketability of vested equity.

Employees and prospective employees might do well to take a crash course on employee equity and industry practices before signing up in reliance on option grants.

I might like to give such a course, or write a manual for one.

The manual I would write would have two covers. The front would read, "The Top X Things You as an Employee Should Look for in Your Company's Stock Awards." The back cover would read, "How to Keep Faith with Your Employees by Letting Them See the Company's Capitalization as You See It." You could read the book starting from the front cover, or, alternatively, Japanese style from the back, but either way you'd end up in the same middle: tools with which to uncover a sober understanding of the ground rules of the particular employee option plan hammered out between the founders, C-level management and investors of your emerging company.

I'm not talking about taking the risk out of accepting options as a material part of compensation. Whether a company is going to succeed or fail is something I'll assume an adult can guess for herself.

I'm talking instead about failing to understand how the equity plan is structured, and how awards under a given plan relate to a company's charter and other corporate documents. These documents are all written and are all available for inspection - or should be.

I'll need to work on how to organize the manual and prioritize the concerns, but here in random order is a beginning checklist:

  1. What is the liquidation preference overhang on the common stock?
  2. Is there a management incentive or retention plan for C-level execs that operates (at least from the perspective of common stock) as senior equity?
  3. How was the exercise price determined?
  4. What is the vesting schedule and how does it work?
  5. Under what circumstances might the purchase shares be repurchased?
  6. If there are repurchase rights, how is the repurchase price determined? Does it depend on the circumstances of one's departure from the company?
  7. What contractual restrictions are there on the private resale of my shares, over and above the restrictions imposed by securities laws?
  8. Do the restrictions in the trading of my shares apply equally to founders? To angels? To VCs?

More to come, I think. This is about understanding the features and restrictions of securities the way a sophisticated investor might.

Skype's Employee Stock Option Plan: Worthless Only if You Quit Before 2014?

No question Skype's stock option plan is pretty damn complicated. And the extra grief of having to figure out how the plan relates to a "Management Partnership" which holds the shares issued on exercise of vested options . . .

442px-KolkhozianosIt's no wonder some former Skype employees were confused.

But the news reporting of this I'm reading is missing a nuance that seems important to me: the repurchase-at-cost feature of Skype's scheme seems only to apply to persons who voluntarily quit the company too soon or were fired with "Cause." By "too soon" I mean before November 19, 2014, which is what a key defined term ("Completion Date") ends up meaning.

Here's the bulk of the pricing provision that would apply if you stuck it out or got yourself fired (without cause) early:

"if the Grantee’s Employment is terminated (A) by the Skype Group without Cause, (B) by the Grantee for any reason after the fifth (5th) anniversary of the Completion Date or (C) upon the Grantee’s death or Disability, . . . the Call Price shall be equal to the Fair Market Value of an ordinary share of Skype, determined as of the date as of which the Call Right is exercised pursuant to the relevant Call Notice."

That is to say, serve the company through November 19, 2014 before quitting, or die on the job in the meantime, and the company is going to have to pay you fair market value to buy your vested stock back. And if Skype fires you in the meantime, it will have to have "Cause"; otherwise, fair market value applies.

The "fair market value" definition is as fair or fairer than most, too: 

“'Fair Market Value' shall mean, as of any date (i) prior to an Initial Public Offering, (x) for purposes of the Plan, the value per Ordinary Share as determined by the Board in good faith taking into account the most recent valuation report prepared by an independent third-party appraiser selected by the Company (such report to be prepared taking into account the fair market value of the entire equity of the Company and any relevant factors determinative of value, without, however, giving effect to any discount attributable to the size of any Person’s holdings of Ordinary Shares, any minority interest, any lack of marketability, any control or any voting rights or lack thereof (and without any control premium or change in control premium)) . . ."

You can keep peeling the references back of course -- what is the definition of "Cause," what happens on a sale of the company (as happened), what happens on an IPO (which could have happened), what other nuances or issues arise from the limited partnership vehicle that holds the shares, and more -- and if you had options under this plan, you should have done that peeling.

But at least two key documents appear to be publicly available as part of Skype's S-1 filing from earlier this year. And they yield more insight into Skype's option arrangements than journalists suppose. (One key concept, "Change of Control," is defined in a shareholders agreement that, best I can tell, was not yet published as an exhibit by the time Skype withdrew its registration.)

Image from Wikimedia.

Joe Bartlett Article, "The Dilution Concern for Founders"

The securities attorney Joe Bartlett is a spirited writer, so its awesome to see him blogging about startups.

And talking turkey about dilution typically suffered by founders and their earliest seed investors:

"Take a sample of one hundred venture-backed companies that have been successful enough to undertake an initial public offering, and you will find a disturbing fact lodged in a high percentage of their prospectus disclosures. That is, the earliest stage investors (the founders and angels) hold very small equity percentages and garner similarly small returns on their investment in the company."

You'll want to read the post for the nuance of the analysis and the color of Joe's prose, but I draw two upshots from the piece:

  • get to break even early and avoid the Series C and D rounds; and
  • establish a precedent for founder participation in the option pool (doesn't help angels, of course).

Both tasks, as Joe says, are easier said than done.

Possible Tax Planning Opportunity for Startupers with Vested Stock Options

Should you exercise the vested portion of your stock options before the end of this year, to get the maximum potential tax benefit from the temporary 100% exclusion of capital gains on the later sale of Qualified Small Business Stock?

That question was a mouthful! The issues are complicated enough to require background on terminology and explication of the rules. If this topic interests you, be sure to read Joe Wallin’s recent post on how the rules work and how recent federal legislation enhances potential tax benefits, but only for transactions that occur before the end of this year.

Most of what you read about this planning opportunity will frame it as a benefit for angel investors, as well as for startups looking to close on financings by the end of this year. But some creative lawyers and accountants are noting that the rules should be able to be utilized by stock option holders, too, to the extent that they exercise options to purchase stock that otherwise meets the legal criteria.

Deciding to exercise a stock option prior to a liquidity event or when otherwise lacking a market for the relevant company’s shares is always risky. I know one guy who always exercises his options as they vest, in order to optimize the possibility he will receive capital gains treatment on liquidity or other disposition of his shares. People so inclined to make that tradeoff – paying real cash now for stock that may end up never being liquid or gaining in value – probably have every reason to strongly consider exercising any “backlog” of vesting by the end of this year, if they would otherwise be inclined to make the investment.

Even if you exercise now and even if all of the other necessary criteria are met, you don’t get the extra (or the normal) benefit of excluding gains on Qualified Small Business Stock unless you hold the stock for five years. Most of us, the koolaid we’re drinking is flavored to lead us to believe we ain’t going to be around in a deal for five years. So maybe this planning opportunity is for those who can permit themselves to contemplate that they may working a longer runway, may be in it for the long haul, or may just be doing some “downside” planning.

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