Startup Employees: Do You Really Own Your Vested Shares?
Can the startup you joined take back your vested shares if you’re terminated or leave before an acquisition or IPO? Check the company’s equity plan agreement for a “clawback” provision which could essentially render those shares – that you worked so hard for – worthless.
Startups, like any other company, seek to attract and retain highly-skilled and sought-after candidates. However, because startups often can’t match the salaries of a more established company, one way they compete is by offering vesting schedules where employees earn shares as part of their compensation package. After those shares vest, the employee can then “exercise” them – that is, pay the company for the earned stock and own it.
True vested shares vs. “kind of” vested shares
Under a traditional equity plan agreement an employee can expect to buy and hold shares until an “exit” event, such as an acquisition or IPO. Once the shares are earned and the options are exercised, the employee owns the shares outright regardless of whether they remain with the company or seek employment elsewhere.
But if the agreement has a clawback provision – which is often tucked away or couched in language such as “redemption,” “forfeiture,” or “company repurchase rights” – the company can buy back the vested shares after a “triggering event,” (i.e. the employee leaving the company voluntarily, being terminated, or even being laid off) “clawing back” the employee’s vested shares before they reach their peak value.
The net effect of a clawback provision is that it forces the sale of an employee's vested shares back to the company. This means that the employee never really owned the shares to begin with as a clawback provision prevents the employee from realizing the potential spike in value that comes from owning the shares at the time of an exit event, such as an acquisition or IPO. Instead of earning thousands or possibly even millions of dollars, an employee who experiences a triggering event prior to an exit event may end up with nothing.
Clawbacks in action
Some Skype employees learned about clawback provisions the hard way when the company was acquired by Microsoft in 2011. At the time, few Silicon Valley employees had ever heard of stock option clawbacks. With news of the upcoming acquisition, Skype employees with vested shares were looking forward to a big payday, but for some employees that never happened.
First, Skype – which was funded by a private equity firm at the time – fired several employees shortly before its $8.5 billion acquisition. Skype then claimed the employees were fired for “performance reasons” and represented that the dismissed employees received most of their stock compensation. However, it was later discovered that some Skype equity plan agreements included a clawback provision giving Skype the right to repurchase the dismissed employees’ vested shares at the original grant price, effectively rendering the shares worthless.
Read below to learn what you need to do if you're thinking of joining a startup and are being offered shares as part of your compensation package:
Have your offer letter and equity plan agreement reviewed by an attorney familiar with startup culture. You don’t need to mention to the startup that an attorney is reviewing the offer, but it can be extremely valuable to work with one behind the scenes. An attorney with knowledge of the startup industry should be able to spot clawback provisions buried in equity plan agreements and offer potential solutions before you sign anything. Further, your attorney should be able to provide insight on compensation structures and vesting schedules.
Decline any clawback or company repurchase rights for vested shares before joining the company. Employees should not agree to these provisions under any circumstances. Read your equity plan agreement and stock option grant carefully. Prospective employees have the most leverage at this stage, particularly if the company is eager to have them join the team.
Ask for documentation along with your offer letter to clarify the terms. Some startups agree to give you stock options but won’t present you with the equity plan agreement until after you’ve joined the company. Don’t let this happen to you. After reviewing your offer letter, ask to see a copy of the equity plan agreement and stock option grant that the company will use to issue your shares. Have an attorney review this form before agreeing to the offer letter to confirm that the terms of the equity plan agreement and stock option grant don't include a clawback provision.
If you find a clawback provision after you’ve signed the agreement, NEGOTIATE. Even after you sign you still have some leverage. This is because most companies want to retain good employees and keep them happy. However, once a triggering event occurs, most – if not all – leverage is gone.
Consider challenging a clawback provision if you’re laid off. Say you suffer the same fate as those unlucky Skype employees described above: you didn’t know about the clawback provision in your equity plan agreement until after you were terminated. If a lot of money is at stake, consult with a litigator to see whether it's worth challenging the legality of the agreement.
Highly-skilled and sought-after candidates join startups, often taking lower salaries than they could demand elsewhere, with the expectation that they’ll have complete ownership of their vested shares after buying them. This, of course, is done in hopes that the vested shares will be worth a lot more in the event of an acquisition or IPO. Clawbacks of fully vested stock options were actually illegal under California state securities laws until about a decade ago. However, according to the National Association of Stock Plan Professionals, stock option clawbacks have been on the rise over the last few years. As a result, all prospective startup employees should be aware of these types of provisions and should have an attorney review the company’s equity plan agreement and stock option grant before joining the company.
Rick Duarte is the owner of The Duarte Firm, P.A., where he focuses his practice on business law. He received his law degree from the Emory University School of Law and has been named a “Rising Star” in Business Litigation by Florida Super Lawyers for 2016 – 2019. Rick also serves as general counsel to emerging and medium-sized businesses, guiding clients through corporate governance, risk management issues, and strategic decisions where business and law intersect.