A Danger in Stock Option Agreements

When an employee accepts a new and exciting job opportunity, she usually is not worrying about whether a new employer can take her vested stock options back. Unfortunately, however, we are seeing more and more technology company employees discover that their employer can reduce or even eliminate the value of their options.

How? By exercising a company’s Right of Repurchase.

Typically, a company has no right to force a departing employee to sell stock back to the company, unless the employee first chooses to sell the stock to a third party (the so called “Right of First Refusal” or “ROFR”). The Right of First Refusal is ubiquitous. It simply allows the company to match the price a third party is willing to pay for the employee’s stock. While one can argue about the equity of the ROFR, the employee still elects to sell of her own free will.

By contrast, a repurchase right says that, when an employee leaves a company, the company can simply purchase the employee’s stock even if the employee doesn’t want to sell the stock. So, let’s say a founding team member vests a large option grant over four years before being terminated. Upon termination, the company can simply repurchase the stock. All opportunity for future upside is lost.

To make matters worse, the forced sale purchase price is skewed highly in the company’s (and venture investor’s) favor. Usually, the price at which an employee is compelled to sell is the “Fair Market Value” at the date of termination.   Most people refer to the FMV as the 409A price, which is the price at which the company is granting new options.

Everyone knows that the 409A price is a fiction – it is kept artificially low to entice new employees to join a company and often is a fraction what the shares would garner in an open market.   Therefore, at best, the employee is forced to sell at a significantly below market price, in addition to losing the upside. So, if an employee exercised shares at $1.00 a share and is forced to sell at an FMV of $2.00 a share, but the stock is worth $5.00 a share in the open market, the employee loses out on $3.00 a share at the time of sale, in addition to the future upside.

In the most egregious cases, the repurchase price is the same as the employee’s purchase price. Think about that for a second. An employee can work for years to earn inexpensive stock options. Often, stock options are the only good economic reason to work in a startup. Then, when the employee is terminated or chooses to leave, the company can force the employee to sell the stock at the same price that the employee paid. So, the employee receives absolutely nothing for her service.

I am not making this up. In a widely reported case a few years ago, Skype had just this term in its option agreements, which was used against senior executives in the Microsoft acquisition.

Companies that insert repurchase rights into their option agreements may not want potential employees to know they are there, of course. These provisions may be stuffed into boilerplate that a prospective employee can barely understand and hidden with misleading titles.

Below is an actual repurchase right from a stock option grant for a well known, high profile venture-backed business.  Note how the paragraph is titled “Private Company,” whatever that is supposed to mean?

Screen Shot 2016-06-13 at 1.26.56 PM-1

Last year, we saw a repurchase right described in the paragraph title as a “Limited Call Right.” Of course, there was nothing “limited” about the right. An employee will have to look carefully for these provisions.

Not content with the basic unfairness of forcing an employee to sell stock they don’t want to sell, the companies may further rig in game in their favor by giving the company a long time to decide. Often, a company will have a year to decide if they want to buy the stock back.   During that time, an employee better not go work with a competitor or make the company mad. If they do, the company can easily retaliate by forcing a below market sale of the employees’ stock. One could make an argument that these provisions amount to an “end run” around California’s prohibition on non-compete clauses.

My advice to all prospective employees: ask in an email whether a company that they are considering joining has a repurchase right in their option agreement. If they do, go work somewhere else.

There is a war for talent in Silicon Valley. Talented employees need to vote with their feet if these provisions spread through the ecosystem.

About Ben Black

Benjamin Black is the Co-founder and Managing Director of Akkadian Ventures, LLC. An eleven-year veteran of the private equity space, Ben co-founded Akkadian with Peter Smith, to specialize in offering early liquidity to entrepreneurs, early employees, and investors in successful private companies.

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