Can your startup take back your vested stock options? Check your contract for a “clawback” clause, which could render those options you worked so hard for essentially worthless.
Startup typically offer a vesting schedule that lets employees earn shares over time, part of a package to keep good employees at the company. After your options vest, you can “exercise” them – that is, pay for the stock and own it. But if you leave the company and your contract includes a clawback, your company can force you to sell that stock back to it. The agreement might require you to sell it back at the price you paid for it or at the Fair Market Value as of your termination.
This means that instead of earning, say, thousands or possibly even millions of dollars if your company goes public and the value of your shares shoots into the stratosphere, you may wind up with zero.
The clawback – an apt moniker if there ever was one – will probably be tucked toward the back of your stock option agreement. It may be couched in language such as “company repurchase rights,” “redemption” or “forfeiture.” But what it means is that the company can “claw back” your vested stock options before they become valuable.
True stock ownership vs. “sort of ” ownership
In startups, especially those backed by venture capital, “employees are expecting traditional ownership of their stock, which is that you can buy and hold shares until an event such as acquisition or IPO,” says Palo Alto, Calif.-based attorney Mary Russell, founder of Stock Option Counsel, P.C., which serves employees, executives and founders. “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 and 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 clawback rights, individuals earn shares they don’t really own” free and clear.
In these cases, the contract may stipulate that the company can buy back the vested shares after a “triggering” event, such as you leaving the company or being terminated with or without cause. If you are still at the company when it’s sold, you’ll receive the full value of your shares. But leaving or termination may trigger a clawback, in which the company forces you to sell back your discounted shares. “Since the real value of owning startup stock comes with an ‘exit’ event like an IPO or acquisition,” Russell explains, “this early buyback prevents the stockholder from realizing that growth or ‘pop’ in value.”
That’s exactly what happened to some Skype employees when the company was bought by Microsoft in May 2011. At the time, few Silicon Valley employees or financial reporters had ever heard of stock option clawbacks. Skype employees who had vested shares were looking forward to reaping a lucrative reward for all their hard work.
But for some employees, that never materialized. First, Skype – which was funded by the private equity firm Silver Lake Partners -- fired several executives just before the $8.5 billion acquisition. Questioned by reporters from TechCrunch and other places, Skype said the executives were fired by performance reasons and received most of their stock compensation. However, as Reuters reported, a Bloomberg reporter discovered some Skype contracts also had an “incomprehensible” clawback provision, which gave the company had the right to repurchase their vested stock from employees -- effectively cutting them out of profits from the sale.
One former engineer and product manager executive, Yee Lee, had voluntarily left Skype after little more than a year and had reportedly “made some nice coin” on his vested stock options. Like others, he was infuriated to find that Silver Lake required him to sell them back to the company at the original grant price, rendering them worthless. In an angry post, the UCB and Stanford University grad warned Silicon Valley employees to “lawyer up” if they work for a company funded by a private equity firm. Lee, who now works for Facebook, wrote at the time: “Seriously, how greedy do you have to be to make $5 billion and still try to screw the people who made that value possible?” Media response was sympathetic, with one Reuters business blog “upgrading Skype and Silver Lake to ‘evil.’”
One thing is certain: Clawbacks have the potential to cost startup employees a fortune. Drawing on SEC figures and other publicly available data, Russell presents a hypothetical example of an early hire at a startup that went public at a $1 billion valuation. Assuming the employee had no restrictions on equity, such as clawback rights to vested shares, the individual could hold the shares until the IPO and earn about $1.7 million. However, in the event of a clawback of vested shares, the forced buyout price would have been an estimated $68,916. As Russell notes, “If this company had a clawback (which it did not), this employee's departure before the IPO would have led to forfeiture of $1,635,654 in value of vested shares.”
Protect yourself
Of course, there are times that a clawback provision actually benefits society, such as those for CEOs and other C-suite executives who agree to forfeit their shares if they are involved in white-collar crime. But blameless tech employees are another matter. So how can you protect yourself against this legal flim-flam? Experts have this advice:
In California, clawbacks of fully vested stock options were actually illegal under state securities law until about 10 years ago, according to Russell. “So naturally, with the stories of Google, Facebook and other Silicon Valley pioneer companies, the expectation of workers here is that they own their vested shares after they buy them,” she says. All those years of grueling work, including late nights and weekends, they reason, would finally pay off.
However, “clawbacks on the rise” were among the 10 top trends for 2016, according to the National Association of Stock Plan Professionals . Russell told Forbes.com that although she hasn’t seen a huge jump in stock options clawbacks, “ we are definitely seeing enough so that all startup employees should be aware of it and do their due diligence. And that means asking the company for its equity policy and negotiating the terms in the fine print before you join."