Job candidates may choose to work for a startup to help build something new, to work in an environment that fosters and rewards creativity, or to get the thrill of climbing aboard a “rocket ship.” New employees rarely, if ever, guide the rocket ship’s trajectory, even though they often directly help determine it. And startup employees’ incentives usually skew heavily toward equity in the company’s option plan—rather than salary—even though these employees usually have no say in how the company’s fundraising activities will impact the eventual value and payout of the common stock held by the employees.
In April, well-known venture capitalist Bill Gurley wrote a detailed blog post on companies that are raising money at increasingly high valuations and what this practice means for not only these companies, but also their early investors and employees. Gurley highlights employees’ limited knowledge about their company’s capital structure, and he explains how lack of liquidity, plus “dirty terms” in mega-rounds and late-stage funding, can affect what returns employees see, if any. Large liquidation preferences, combined with dirty terms, may result in employees questioning whether there really is any value in the equity awards granted to them, and whether they can truly count on any return from their equity. Frankly, the Bay Area and other tech hubs are expensive, so it is fair for employees to ask for, and companies to think about, ensuring their superstar employees are suitably compensated. You can’t pay a mortgage with an illiquid option grant.
Discussions about the value of employee equity have increased in both frequency and urgency in recent months. Meanwhile, companies have been trying to determine how to meet growth goals while being as fair as possible to employees. One particular issue companies have grappled with in this regard is how to ensure that employees, as common stockholders, are not left empty-handed in acquisitions after investors, as preferred stockholders with a liquidation preference, have taken their share of the pie.
There are several ways startup companies can start to manage their liquidation preferences that will result in good outcomes for investors, better retention for companies, and better economic outcomes for employees. There are two primary levers to do so: (i) adopting a management carve-out plan so that key employees are paid before the investors, and (ii) recapitalizing the business to reduce or eliminate liquidation preferences of the investors.
Timing also matters. It is easier to be creative if there is a reasonable likelihood that the company will enter into a financing in the near- to medium-term, as some of the approvals required in connection with the approaches outlined below will be similar to those required in connection with a financing.
Below are a few options we have recently seen to address these issues.
Carve-Out Plan: A company could adopt a management carve-out plan to create incentives for members of management to continue working as the company gets close to a potential exit, or revisit an existing carve-out plan to ensure that a fair proportion is allocated to employees. A carve-out benefits current employees only; former employees do not receive payment from this pool at the time of an exit.
- Incentives: If the exit is very small, employees see some upside; if it is large, employees see upside from the carve-out plan and possibly even some from their equity awards.
- Simplicity: Carve-out plans are fairly cost-effective and straightforward to implement.
- Fiduciary Concerns: Because a carve-out is unlikely to skew outcomes among investors, and it does not require shareholder approval or changes to the company’s capitalization table, the company has less risk of fiduciary harm.
- Approvals: Only board approval is necessary.
- Investor Perception: Investors in future rounds may discount the company’s valuation to compensate for the carve-out, because they will receive less of the overall consideration in an exit.
- Employee Uncertainty: Because options are more standard, employees may have a harder time understanding the concept behind a carve-out. They might not feel the same level of certainty as they would with equity.
Reduce Liquidation Preferences: A company could reduce the liquidation preferences across the board by a certain percentage for each series of preferred stock. Unlike converting all preferred stock to common stock, the cap table still allows preferred investors to retain some of their preferences, but the changes to the preferential rights could require significant changes to the charter. These changes could complicate the implementation by requiring investor review. Going back to all prior investors could raise concerns about future investors’ enriching themselves at earlier investors’ expense.
- Employee Incentives: While the liquidation preferences are not entirely eliminated, a significant reduction could increase the likelihood of employees seeing some share in the exit, which improves incentives.
- Approvals: Approvals from the board, a majority of all preferred stockholders and a majority of each series of preferred stockholders will likely be necessary. Depending on the number of series of preferred stock, obtaining these approvals can be quite a challenge.
- Current Investors: Some current investors can perceive this change as unfairly renegotiating their existing liquidation arrangement with the company.
Convert Preferred Stock to Common Stock: Under this approach—which is not as straightforward as the first option but requires fewer approvals than the second option—all current preferred stockholders are converted to common stockholders, thereby removing past liquidation preferences. Some startups tweak this approach by issuing preferred holders a warrant (see below), which reduces risk but increases complexity. From a fiduciary perspective, treating all preferred stockholders the same can also mitigate risk.
- Employee Incentives: This approach entirely eliminates liquidation preferences for investors, so employees participate equally in returns.
- Approvals: Approval from the board and a majority of preferred stockholders will likely be necessary.
- Investor Perception: The cap table—at least at the preferred level—will become significantly cleaner, so new investors will have less to digest.
- Current Investors: Presumably, investors have negotiated rights as downside protection. Unfortunately, converting preferred stock to common stock negates these rights. Although this option is likely to benefit employees, it is not always fair for investors, particularly early investors.
Recapitalize at Next Financing: Historically, the most common approach has been doing nothing for now and planning to implement a recapitalization by converting all or a portion of preferred stock to common stock in connection with the next financing. A twist on this financing model is to: (i) convert all preferred stock to common stock; (ii) issue each preferred holder a warrant that allows them to receive some reduced amount of their liquidation preference on an exit, but only if they participate in the financing; (iii) create a new series of preferred stock for any note conversions or new cash investors; and (iv) conduct a rights offering so that existing investors can participate in the round at the new price.
- Fiduciary Issues: A recapitalization at the time of a financing is common and less likely to be interpreted as a means of punishing a particular class of stockholder in bad faith, which reduces litigation risk.
- Flexibility: This approach allows the company and investors to wait to recap until more facts are known. For example, the valuation at the time of the financing may provide better insight as to the likely exit value of the company.
- Approvals: No additional approvals will likely be necessary beyond those required in a financing.
- Delay: The obvious disadvantage is that it does not solve the employee incentive problem in the near term, and may reduce the likelihood that a company can retain its employees long enough to make it to the next round of financing.