Founders Series: Stock-Based Compensation – Part III

In the second post examining stock-based compensation issues, we looked at the types and uses of stock options . We now examine additional stock-based compensation considerations that founders should take into account.

Other Stock-Based Compensation Considerations

 Vesting

It is important to consider vesting schedules and the incentives caused by such schedules before implementing any stock-based compensation program. Companies may elect to vest awards over time (such as vesting all on a certain date or in monthly, quarterly, or annual installments), based on achievement of pre-established performance goals (whether company or individual performance) or based on some mix of time and performance conditions.

Typically, vesting schedules will span three to four years, with the first vesting date occurring no earlier than the first anniversary of the date of grant.

Change in Control

Companies should also be particularly mindful of how awards will be treated in connection with a change in control of the company (e.g., when the company is sold). Most broad-based equity compensation plans should give the board of directors significant flexibility in this regard (i.e., discretion to accelerate vesting (fully or partially), roll over awards into awards of acquirer’s stock or simply terminate awards at the time of the transaction).

Plans or individual awards (particularly awards with senior executives) may and will often include specific change in control provisions, however, such as full or partial acceleration of unvested grants and/or “double trigger” vesting (i.e., if the award is assumed or continued by the acquiring company, the vesting of some portion of the award will accelerate if the employee’s employment is terminated without “cause” within a specified period after closing (typically from six to 18 months)). Companies should carefully consider both (i) the incentives and retentive effects of their change in control provisions, and (ii) any investor relations issues that may arise through the acceleration of vesting in connection with a change in control, as such acceleration can lower the value of their investment.

Employer Protections

There are a number of protection provisions that a company will want to consider including in their employee equity documentation, including the following:

Limited Window to Exercise Stock Options Post-Termination

If the employment is terminated with cause, stock options should provide that the option terminates immediately, and is no longer exercisable. Similarly, with respect to restricted stock, vesting should cease and a repurchase right should arise. In all other cases, the option agreement should specify the post-termination exercise period. Typically, post-termination periods are typically 12 months in the case of death or disability, and 1-3 months in the case of termination without cause or voluntary termination.

Repurchase Rights

With respect to restricted stock, private companies should always consider having repurchase rights for unvested as well as vested stock. Unvested stock (and vested stock in the event of a termination for cause) should always be subject to repurchase either at cost, or the lower of cost or fair market value.

With respect to vested stock and stock issued upon exercise of vested options, some companies will retain a repurchase right at fair market value upon termination under all circumstances (other than a termination for cause) until the employer goes public; other companies only retain a repurchase right under more limited circumstances, such as voluntary termination of employment or bankruptcy. Companies should generally avoid repurchasing stock within six months of vesting (or exercise) in order to avoid adverse accounting treatment.

Right of First Refusal

As another means to ensure that a company’s stock remains only in relatively few friendly hands, private companies often have a right of first refusal or first offer with respect to any proposed transfers by an employee. Generally, these provide that prior to transferring securities to an unaffiliated third party, an employee must first offer the securities for sale to the company-issuer and/or perhaps other shareholders of the company on the same terms as offered to the unaffiliated third party.

Only after the employee has complied with the right of first refusal can the employee sell the stock to such a third party. Even if an employer was not contemplating a right of first refusal, outside venture capital investors are likely to insist on these types of provisions.

Drag-Along Rights

Private companies should also consider having a so-called “drag-along” right, which generally provides that a holder of the company’s stock will be contractually required to go along with major corporate transactions such as a sale of the company, regardless of the structure, so long as the holders of a stated percentage of the employer’s stock is in favor of the deal. This will prevent individual employee shareholders from interfering with a major corporate transaction by, for example, voting against the deal or exercising dissenters’ rights. Again, venture capital investors often insist on this type of provision.

This concludes our series on stock-based compensation. Up next, we will focus on equity incentives for new hires.

 
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