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.”
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.”
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:
- Have your startup offer letter and equity plan agreement reviewed by an attorney familiar with startup culture. An attorney should be able to spot clawback provisions buried in legalese and suggest ways to negotiate them out of existence. (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.) Your attorney will likely coach you both on compensation design and legal terms such as equity and favorable capital gains rates.
- Decline any clawback or company repurchase rights for vested shares before hire. Babak Nivi of Venture Hacks advises startup hires to “run screaming from” startup offers with clawbacks or repurchase rights for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.” Legal experts add that potential employees have the most leverage at this stage, particularly if the company is eager to sign them.
- Ask for backup documentation along with your startup offer letter to clarify the terms. Some startups agree to give you stock options, but some only get around to the option agreement months after you’ve been working there. After reviewing your offer letter, ask to see a copy of the form the company will use to make the stock option grant – that is, not your particular grant letter or numbers, but the terms of the grant. Russell suggests reviewing this form before agreeing to the offer letter to confirm that the grant will not have a clawback provision.
- Beware of Cancellation Plans. The standard expectation in startup equity plans is that your unvested shares carry over after an acquisition (a Continuation Plan). However, some startup stock plans include a Cancellation Plan or forfeiture clause that allows your unvested equity to be wiped out in an acquisition, says Russell. “Ask for the good stuff – a Continuation Plan.”
- If you find a clawback clause after you’ve signed the agreement, negotiate. Russell says even after signing you still have some leverage, “because the company wants to retain its good employees and keep them happy.” Significantly, founders and CEOs themselves may not be aware of clawback clauses in employees’ stock option agreements, Russell says. “I’ve had founders say about clawback clauses, ‘That can’t be right – vesting is vesting; employees own those shares,’” Russell says. “It’s not surprising, since their job is not to be experts on securities law. The question is, why are attorneys adding this language?”
- Consider challenging a stock option clawback if you are laid off. Say you did not know about the trap door in your contract until you were terminated. If a lot of money is at stake, talk with a litigator to see whether it’s worth a legal challenge. According to the law firm Rabner, Baumgart, Ben-Asher and Nirenberg, for example, clawback rights tied to non-compete clause violations are likely unenforceable in New York and New Jersey.
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 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.”