Legal Diligence on Stock Options and Vesting

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Compensatory Equity Awards

One of the ways startups conserve cash and attract talent is to pay employees lower cash salaries but reward the risk they’re taking on the startup by promising them a portion of ownership in the company—equity. Typically, employees are not given ownership directly, but the option to purchase stock in the company, an option that can be exercised not right away but over time, referred to as vesting.

Equity can be awarded in different ways, most typically through stock options, but also through warrants and restricted stock awards.*

Compensatory equity awards are awards of stock, options, restricted stock units, and similar awards issued to service providers of a company. Under the securities laws, companies may issue compensatory equity to service providers without those service providers being accredited if they comply with another exemption, such as Rule 701.

founder You will want to make sure that if you are investing in a company that is granting compensatory equity awards, typically in the form of stock options to employees and contractors, that they are doing so correctly. All option grants must be approved by the Board, and priced at the time of board approval. To avoid adverse tax consequences to the optionee (in the case of options), the options must be priced at no less than fair market value as of the date of grant. Companies do not have to obtain independent third party valuations of their common stock, but if they do, the burden of proof is on the IRS to challenge a valuation. For this reason, many companies start obtaining third party valuations of their common stock for option grant purposes as soon as they have closed their first fixed price financing. As mentioned above, they should all be recorded in the stock or options ledger and included in the cap table.

Founder Vesting

Founder vesting refers to a legal mechanism whereby founders have to continue to provide services for some period of time or have their shares potentially repurchased by the company. Founder vesting may follow a similar pattern to employee vesting, where the founder gains permanent ownership of their stock over the course of typically three or four years, with potentially a one-year mark for 25% ownership and monthly increases thereafter.

founderSince founders have typically purchased their stock up front as part of the corporate formation, the mechanism for founder vesting is typically a repurchase right of the shares by the company for the lesser of the fair market value of the shares or the price they paid for them. Since founders usually acquire their shares for a very small purchase price (a tenth or hundredth of a penny per share), being at risk of having those shares repurchased at the price is effectively a forfeiture condition.

As an investor, you will want the founders as well as the employees to be on a vesting schedule.

In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.*

Let’s run through an example of why this is important.

exampleSuppose a company has three founders. When the company was founded, each founder owned a third of the company, or 1M shares each. What happens if, after you invest your money, one of the founders leaves? Does that founder continue to own 1M shares? That might be painful for both you as an investor and the other co-founders, especially if that founder’s expertise is going to have to be replaced by another founder who is going to want to receive 1M shares (this will dilute the value of the shares you and the remaining co-founders hold, an issue we’ll discuss in detail).

How do you solve this problem? Make sure the company has a repurchase right to buy back unvested shares at the lower of the cost or fair market value of the shares, which will lapse over a service-based vesting period. In other words, make sure founders are on a vesting schedule.

You would prefer companies you invest in to have provisions in their founder stock repurchase agreements that cause unvested shares to be “automatically” repurchased unless the company takes an affirmative action to not repurchase them.

confusion If you are investing in a company and are insisting on founder vesting, be careful to give some thought as to who will enforce these provisions against the company when and if they come due. For example, suppose you are investing in a “solopreneur”—your founder vesting agreement may as a practical matter not be meaningful if it is the founder who has to enforce it against him or herself.

The Fully Vested Founder

If you have founders whose shares were issued vested, or who have already vested, or have substantially vested, you can re-start their vesting schedule by having them execute a new vesting agreement.

exampleTwo founders set up a legal corporate entity early in their work and have been pursuing a startup idea for three years. They have finally made enough progress to go out and seek their first outside funding. If they had put themselves on a four-year vesting schedule, they would be 75% vested. As an investor in a very early-stage company with two key founders, you want to make sure that they are motivated to stick around going forward. If the vesting schedule is not addressed, one founder could leave the day after the investment with a substantial portion of the company.

founderInvestors may require that vesting on founders’ shares be reset at the time of the investment. The reason for this is that investors might not want founders who are fully vested or nearly fully vested to lose motivation for staying in the company long-term. This is accomplished by having the founders execute a new Founder Stock Vesting Agreement, which gives the company the right to repurchase the unvested shares at the lesser of fair market value or the founder’s cost, which less of FMV or at-cost repurchase right lapses over the vesting period. This is not problematic from a tax point of view for the founders involved. In fact, the Internal Revenue Service has issued guidance that in some circumstances it is not even necessary for founders in this situation to file Section 83(b) elections, since they will have already owned the shares when the vesting conditions were placed on them.*

founder Founders may resist having their vesting schedules reset. From their perspective, they have worked hard for those three years (in the above example), and in many cases have invested their own money or foregone salary. Founder vesting will then become a point of negotiation and will likely be incorporated in the term sheet.

Employee Vesting

Employee vesting refers to vesting on employee stock option grants. Sometimes investors will require that all employee option grants have to vest over a specified schedule (such as monthly over a 48-month period, but with a one-year cliff), unless approval is given by the investor’s designee on the board or a majority of the investors.

All employees should be on vesting agreements for the stock or stock options that are part of their compensation. The most typical vesting schedule is four years with 25% vested after the first year of employment, often referred to as the one-year cliff, with vesting monthly after the first year.

Change Of Control Vesting

caution Sometimes companies provide in their documents that upon a sale of a company, holders of unvested shares or unvested options have their vesting accelerated. This is favorable for employees, but from an investor perspective you would want to make sure that such a program is well thought through.

exampleA startup wants to hire an experienced enterprise software sales executive. That executive is willing to take the significant risk of joining this early startup because she is being offered 5% of the equity. If the company gets acquired in a year, and she gets fired because the acquirer does not need another head of sales, she will have only 1.25% of the equity. Being a savvy salesperson, she negotiates an acceleration provision in her employee agreement, that if the company gets acquired, she vests 50% of her unvested stock, and if within three months she gets fired by the acquirer for no cause or is asked to move more than 100 miles away, she vests the rest immediately. Without these provisions, the sales executive may not be excited about an acquisition opportunity that is otherwise good for the startup and its investors.

caution You will want to look out for this in your due diligence. This makes a company more expensive for another company to buy, because the buyer company will have to re-up the equity incentive of the workers. This re-upping may result in the buyer reducing the amount of consideration paid to the target company stockholders.

There are two types of change of control vesting:

  • single trigger acceleration

  • double trigger acceleration

Single trigger acceleration is 100% vesting upon one event—the change of control transaction. Double trigger acceleration is acceleration of vesting upon the occurrence of two events:

  • a change of control, or

  • the termination of the founder without “cause,” and sometimes if the founder quits for “good reason” within a certain period of time (such as 12–18 months) after the change of control.

As an investor, you would prefer “double trigger” acceleration because this way the buyer of the company will not have to re-up the continuing employees on equity grants to the same degree it otherwise might if all of the continuing employees had their vesting equity fully vested on the sale.

The example above has both a single trigger and a double trigger provision. What should you do? You can try to negotiate aspects of that employee agreement as part of the investment. This is the “golden rule” at work. She who has the gold, rules.

Key Corporate Formation Documents

founderIt is not uncommon for founders to form companies themselves, without any legal assistance. In almost all situations this means the founders have missed something. It is not uncommon for founders who try to do it themselves to not timely file 83(b) elections, fail to adopt bylaws, fail to execute stock purchase agreements at all, and other mishaps.

If you are reviewing the corporate documents for a startup, you should see at least the following documents:

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