There may be cases where the $1,000 written to the company may be given to an existing stockholder – perhaps an investor or founder in exchange for his or her shares. That is, the person suggesting you exercise the options or handling the transaction may be personally and directly benefitting from the check the employee writes. Examples include founders or existing shareholders cashing out of shares or using the options proceed to pay off personal debt of the founder. It’s not necessarily a bad thing but it’s usually a good idea to understand if the capital being ‘invested’ by the employee for the options exercise will be used to further strengthen the company’s capital position or put into the pocket of another employee or investor.
Holders of stock options of start-ups have very little information rights when it comes to knowing what is really going on at the company and its finances. Additionally, private companies have exceptional protections from disclosing information. During an exercise option, the employee may ask the company “should I exercise my options?” and it’s hard to get anymore than a ‘yes’, ‘no’, or ‘it’s up to you’ reply. The reality is the 2 sides are not playing the same game. It’s akin to playing poker against someone else and the employee must show his or her entire hand to the employer and the employer doesn’t have to show any cards. It’s a little odd when funds are being exchange and one side knows the entire story and the other side does not.
For instance, the company may be growing, look successful, and have lots of investors, but the company may be laden with debt or the investors may have significant liquidation preference on its investments (meaning that the investors get all their money back first before anything is shared with the other shareholders). Even if the company is forthcoming about where they are today, tomorrow, the company may decide to take on a big line of credit tomorrow or change how the stock is valued. Asking the right questions at the time of exercise can help an employee gain a better picture into the company’s stock’s prospects today and tomorrow. Of course, anything can change over night, but employees are not given the same information investors and venture capitalists are upon a new investment – even though both are writing checks. In short, an item is for sale, one buyer gets to see the full package, another side does not.
Stock options can be very expensive to a company, especially its existing shareholders. So much that employers tend to not be very proactive when it comes to stock option exercise time for various employees. For example, many stock options agreements have a 10-year expiration term – it’s rare an employer gives a long-term employee a heads up 3-6 months before expiration. Or upon an employee’s departure, reminds the company about the timeframe where the employee must exercise his or her stock options. In most cases, the employer will say “it is up to the employee to be responsible for this decision.” That’s not a bad stance as it limits the employer’s liability and keeps them out of the business providing investment advice. However, there are a lot more things happening that may motivate the employer to play dumb and let the options expire without mentioning it to the employee.
Let’s say a departing employee has the option to buy 100,000 shares at $1 and today, there are 1,000,000 shares of stock available, and the stock is worth $10 per share and the investors and founders own all those shares. And offer is on the table for the company to be bought for $20,000,000 share 6 months from now – well after the timeframe allowed for the employee to exercise his or her options. The employee exercises them on departure and the buyout happens months later. The buyer offers $20,000,000 for 1,100,000 shares of stock (the 1,000,000 originally owned by investors and founders and the 100,000 owned by the employee after stock option exercise) or $18.18 per share. The investors and founders walk out with roughly $18,180,000 and the employee walks out with $1,818,000. Sounds like a good deal, but if the employee did not exercise his or her options, the existing investors would get the whole $20,000,000 instead of $1,818,000 less – that’s a lot of incentive to have someone not join the club.
In most cases, founders and very early-stage employees are given their shares. That is, they paid for them with sweat equity rather than case. True, many founders did not take salaries and put out personal funds along the way, but many founders never actually had to buy any of their shares with cash. The employees wanting their stock options do. Founders don’t have tax bills to pay for receiving their founder stock; employees must pay taxes to the IRS on their stock options, even if the options cannot be immediately sold. In some cases, employees dip into their savings or take out loans to cover these costs.
If the stock price never amounts to anything, the employee is left with a big tax bill and a liability. The same fate is not true for investors and employees that have received actual shares versus stock options. If the company goes to zero or never moves, the employee still must bear the burden of serving the debt and tax liability. The side that is receiving the exercise funds does not have the same permanent liability. For example, if the founders and investors want to walk away from the company and shut it down, they can do so without much personal tax or debt servicing liabilities.
Depending about the start-up, the company can change how it handles its stock options program. Let’s look at a few examples:
The company has some bills to pay.
If the company is running short on cash or has some debt to service, the company may be more forthcoming to its departing employees about their stock options. A company strapped for cash may encourage early stock options exercise programs – citing getting the employee more involved or starting the clock on the long-terms capital gains tax. Meanwhile, the company may be trying to build up capital to satisfy obligations or debt covenants.
The company knows its stock isn’t going to where it needs to be.
Start-up employers may offer generous stock options packages to employees – perhaps even upping the number of shares for sign-on or bonuses (rather than giving more cash or lower cash amounts). The employee might feel like he or she is getting a better package, but it is not the case.
Business challenges are real, and companies must change directions or pivot, especially in start-ups. However, stock options programs can be easily altered to serve the needs of the company at any point to best serve the company’s needs. In general, this is acceptable – except there is great temptation to not be forthcoming with the employee about the situation.
Most of these conflicts can be eliminated with a ‘winning solves everything’ approach. However, it’s rare that everyone involved wins. What other conflicts have you seen when it comes to employee stock options?
