Is an employee equity plan = sharing ownership? Important for earlier stage employees
Spela Prijon, Tamas Varkonyi
It’s common, and it happens everywhere: a trend can entice people to hop on it for perception reasons. We see the same with equity, if the fundamental reasons for sharing ownership are not clear, then it’s natural that people would create arbitrary loopholes that allow them to not follow through, leaving co-owners (grant holders) high and dry.
So, what do people who don’t want to share ownership do, to still appear as having an employee scheme?
They implement tricky clauses in their contracts, that make it difficult for employees to actually get their earned equity.
You can skip this section and jump right into examples if you’re not the abstract-discourse type.
Most clauses we highlight below aim to provide a loophole for actually having to give out equity. One reason why it’s still happening is the information asymmetry between creators of employee schemes and the receivers of grants, making it easy to misrepresent/misunderstand the offered grant.
The purpose of equity is to invest it. To invest it in your people who in return grow the value of it. For it to fulfil its investment purpose it has to leave the founder’s back pocket and not hope that employees fail, therefore saving equity. One should ask themselves, what happens when you’re trying to explain your equity plan to harness its motivational power and employees learn of the tricky clauses? Will it have a net negative or net positive effect? Will you have invested your equity well?
In our opinion the situation is simple. If you don’t want to share ownership - don’t. By creating a scheme you’ve spent a lot of money on lawyers, documentation, accounting and financial planning. The issue with the anti-ownership clauses is that the created documentation will just exchange hands and rarely materialize into anything.
Examples of “loophole” clauses
Extremely long cliff
A typical vesting schedule is 4 years long, with the first year being a cliff. After the first year, the grant accrues monthly. So after 13 months at the startup, you’d receive 13/48 of the grant.
A cliff makes sense, it’s a type of “probation” period. The length of the cliff can be debated, but it’s fair to say that the majority of good-fit employees will have a fair chance of passing the cliff and earning the first quarter of their grant.
But in some cases, the cliff is extended to the entire duration of the vesting. For example: 4 year vesting, 4 year cliff.
This is no longer about optimizing for probation/good-fit employees. The average startup employee tenure is below 4 years, making it very unlikely that most of your class-A players will end up with the granted amount. Even more so for early stage employees, for whom the likelihood of an imminent exit event is lower = making it so that they really have to stay 4 years, to receive their grant.
Loose bad leaver clauses (voluntary resignation = bad leaver)
Good/Bad leaver clauses make sense. In the event of criminal activity, you don’t want that person on your cap table, therefore you write that under the bad leaver definition. If someone is a bad leaver, they have to return all vested and unvested grants.
As a “regular” employee, you assume that bad leaver means criminal activity or something similar. The name insinuates that. And good leaver means you left amicably.
But since companies are the ones that define what good/bad leaver means, they can put some “amicable” situations under the definition of a bad leaver.
For example, the most common loophole is for voluntary resignation.
A bad leaver clause could say: ”Anyone that is no longer employed and isn’t a good leaver is a bad leaver”.
The definition doesn’t say much as it is too broad, therefore the definition of a good leaver will either be 100 pages long to make sure it includes all amicable departures or it will be vague enough to make it easy to take away grants.
And what sometimes happens is that the good leaver definition only states the following as a qualification: Leaving because of injury, disability, redundancy, retirement.
Effectively removing the possibility of being a good leaver if you leave under " voluntary resignation".
Leaving before the exit event #1: 100% Buybacks (”clawbacks”)
A buyback can make sense, for a similar reason as above. If there is a bad leaver, they defrauded the company and are facing criminal prosecution, it makes sense to enforce the buyback clause in order to not have that person on the cap table.
But again, the documentation is written by the company and therefore buybacks can be defined in a company-friendly way.
For example, a company can enforce a buyback (for the same price as the grant was bought, making the gains of the employee = 0), if an employee leaves before the exit.
Again, disproportionally targeting early employees, since the majority of liquidity events are 10+ years away.
Leaving before the exit event #2: Faded Buybacks (”clawbacks”)
A similar approach as above, but less immediate.
It still conditions the keeping of earned equity with an exit event, but gives the employee more time (and hope).
For example, a company could say that if in the year after the employee’s departure, there is not an exit event 25% of the vested equity is returned to the company.
If there is still no exit event 2 years after the departure, then 75% of equity is returned to the company.
This disproportionally targets those early employees who helped value-creation in the most critical of times.
Short exercising windows upon departure
A very common and well known issue in the US. But not so much in Europe, even though an exercising window is always part of employee equity contracts (exceptions are instruments that don't have an exercise price).
There are two parts to the company's decision on the length of the exercise window:
Is it part of the qualifying criteria for having a tax optimized employee scheme?
Does the company want employees to actually get equity?
For example, in the US, an ISO scheme has to be exercised in the 90 days after departure to keep the tax advantages. If it is exercised later, then it becomes an NSO, with less tax advantages. But at least the employee gets to keep their earned equity.
A company can’t influence the law at the moment, but it can still leave it up to the employee to decide if they want to exercise after 7 years, albeit under less tax-optimized terms.
Often it’s “easier” for the company to stick to 90 day windows. One of the reasons is so that the company doesn’t have to track these outstanding grants and can calculate/plan whether they can be regranted to new employees.
Final note The contracts are just contracts and not laws/written in stone. If you find a clause, similar to the ones described above negotiate it or as a founder: change it. It’s easy to fix.
If you find any tricky clauses in your contracts, reach out and anonymously nominate your employer - we’ll be happy to reach out and advise your company on a good employee plan going forward. You will do every team member a favour.
If you find yourself described in any of the above, reach out and let’s change your scheme together.
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