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Chapter 20 Equity

Equity Management

Equity management is another area that is important to organize and where you should have discipline as early as possible during a startup. There are a few areas to pay careful attention to:

 Stock compensation form documents. It is useful to have form documents for option and stock grants, grant exercise documentation, and share transfers. Note that if you operate in different countries, you will likely need to have different stock compensation plans.

 FAQ for employee questions. There are always a handful of questions employees have and having clarity on them will help employees value the stock compensation. Some of the most common include:Tax implications of the grants, which can be very different if the grant is an option grant (Non‐qualified vs. Incentive Stock Options), restricted stock, or restricted stock units.How to roughly think about the value. You should not give an exact value, but provide guidance on how to think about the valuation.How and when to exercise options. Employees will often want or need to exercise their options when they leave the company, but also may have opportunities to early‐exercise for a more favorable tax treatment.What happens when an employee leaves the company. For many years, most venture‐backed companies have followed a standard 90‐day post‐termination exercise period. No matter why the employee is leaving the company, they have 90 days to exercise their vested stock options otherwise lose them forever. This created unfair situations where employees, many without a lot of discretionary cash, were forced to either spend a material amount of money on the stock of the company that has no market liquidity, with tax implications too, or lose the value that was part of their compensation for years. In the last few years, many companies that have significant employee stock option plans have started to use other vehicles, such as restricted stock, or a post‐termination exercise plan (PTEP), that provides a number of years after termination for the ex‐employee to exercise. Although not perfect, it is fairer to the employee.How an employee receives additional stock compensation. Typically, employees will receive more stock compensation if they receive a qualified promotion or continue working for the company. The grants for longevity may be a small amount every year or two, or mirror grants as they finish vesting. Almost every employee will want to know the answer to this, so it is a very good thing to include in an FAQ.Note that employees in different countries may have different tax implications for employees as well as post‐termination treatment.

 Board approval and communication. You will want to keep the Board informed of your stock compensation and how much of the reserved employee pool is remaining.Develop a clear philosophy and formulaic approach to most grants. Typically, an employee grant will be based on their seniority/market competitiveness of the role and cash compensation. This way when you include stock compensation grants in Board Books for approval, you can list the ones that were based on the formulaic approach previously discussed with the Board and call out ones that fell outside that approach, typically for executive hires.You should work on a stock compensation budget that generally should last for one to two years (or the first 20–30 employees for early stage), depending on the stage of the company. This provides visibility for you and the Board about how fast the company is granting vs. expectations as well as make clear to all when a plan refresh is likely required. Often your VCs will have a rule of thumb of how much dilution they would expect each year from option grants. So, it is a good idea to poll the group to ensure good alignment.Produce a standard report that goes with each Board Book that shows a list of the stock grants with name, title, and grant amount, calling out any grants that fall outside the normal formulaic grant guidelines. Include in a report a second page that has the current status of the company's cap table with all of the fundraising rounds, all employee stock plan refreshes, and total amount of stock plan pool remaining. Doing this with every Board Book creates a level of transparency and accountability (for both the Board and the company) on the employee stock plan.

 Equity management system. For years, startups relied on Excel spreadsheets to manage their cap table and equity plans. Although free and flexible, the lack of corporate controls, disciplined processes, and central source of truth means even the best spreadsheet approach will eventually break down. Modern startups now have the ability to use a number of software packages, some with free versions, that will provide controls and sources of truth for your equity management. In addition, some will let you process the entire stock compensation process in their software, provide you stock compensation expense for your financials, and give you a liquidation waterfall analysis. By establishing an equity management system as early as possible for your startup, preferably day one, you will be able to scale cleanly and without the inevitable pain that comes with managing equity on a spreadsheet.

Secondary/Tender Transactions

Secondary transactions are where existing shareholders sell their shares to another party, often with the company being a facilitator of the transaction by being an intermediary. The most common case of this is during a larger fundraising event where some of the early investors or founders want to sell a small amount of their overall shares to give themselves some liquidity.

Whereas a standard fundraising transaction is where all of the cash is kept by the company (sometimes called a primary transaction), in a secondary, a material amount of cash is not staying with the company. This ends up with a lot more complexities to consider. These include:

 Will this impact your 409a valuation? Often these transactions end up with a price per share for the common that is higher than the recent 409a price. Impact on your 409a should be understood before execution of the deal and communicated to the appropriate parties.

 Tax implications on the company and the employees. Depending on the form of equity (stock, incentive stock option (ISO), or nonqualified option (NQO)), there are different tax requirements on the company and employee. For example, the company will likely need to have tax withholdings if a current employee is selling NQO options.

 The regulatory requirements vary. Depending on the scale and number of people involved, it may trigger the transaction to be considered a tender offer, which has legal disclosures and a blackout period.

 Waivers from preferred investors in the cases of right of first refusal and right of co‐sale restrictions.

 Internal communications. In most cases, these transactions end up with some people being able to sell some shares and some who are not. You will want to be aware of employee morale and the importance of balancing transparency, privacy, and fairness.

 Third‐party systems. With primary transactions, it is typically very straightforward. With secondaries, especially ones that trigger a tender offer, you will want to use third party marketplace software, which will greatly help with the required shareholder communication, flow of funds, and overall compliance.

 Keep your partners informed early. Your outside counsel will be the primary partner involved in a transaction, but you will want to make sure that your audit partner and their valuation team are along for the ride and informed along the way so there are no surprises come audit time.

409a Valuations

409a valuations have become an important requirement for startups. Essentially, the minute you have an option grant or if you start the company with an investment on day one, you will need to have a third‐party 409a valuation. The 409a valuation establishes the fair market value of the common stock, taking into account a number of classic valuation variables such as recent fundraising, benchmarks, industry valuation multiples, etc. For most startups, the 409a will be valued using a recent financing as a base and then taking discounts for marketability. As a sanity check, there is usually a percent of the last preferred round that will seem reasonable to the valuation company (and the Board). This will change greatly depending on the stage and the type of preferred security, but roughly the range could go from 25% to well over 50%.

Once you have a valuation, you can grant options using that price as the strike price. You will want to have the valuation fairly close to the date when the Board approves the option grant. As you scale and build a quarterly heartbeat of Board meetings, you can simply do a 409a once a quarter to be effective close to the Board meeting.

Most of the time, the only valuation you'll need for operational purposes is a 409a. However, during an acquisition or when you are buying a company or assets, you will need to have a valuation done for accounting reasons. When you do, it is a good idea to build clear documentation and support as these valuations will be challenged much more by your financial audit firm during the annual audit.