After a company completes a down round financing, its next independent third-party valuation report (often referred to as a 409A valuation) will almost always indicate a lower fair market value for the company’s common stock than the prior valuation report (see The Lowdown on Down Rounds) for more information on down rounds generally). The same result may also occur due to general economic conditions. This lower valuation is likely to result in many employees holding options that are “out of the money” or underwater (i.e., the exercise price of their stock options will be greater than the fair market value of the underlying shares of common stock) and/or newer employees holding lower priced options than longer tenured employees. For employees of startup, venture-financed, and other similar private companies, equity (as opposed to cash) is the true value proposition and underwater stock options can be highly demotivating.
While there’s no “one size fits all” solution, companies can turn to a number of alternatives to plan for their future and incentivize employees, while still preserving cash for operations.
How to Handle Equity Compensation After a Lower Valuation for Common Stock Following a Down Round
- Option 1: Accept the new valuation as indicative of fair market value such that new hires and refresh grants will have a lower exercise price than prior grants.
- Pro: Easy to implement, since there is nothing to do for outstanding grants.
- Con: May impact morale, since long-standing employees will hold out-of-the-money options with new employees having a lower exercise price. This approach can also draw attention to the challenges the company is facing.
- Option 2: Continue to use the pre-financing higher value to make grants.
- Pro: Won’t alert rank-and-file employees to the fact that the company is facing challenges. This may be a more attractive solution if reduced valuation is expected to be a temporary situation and not indicative of a long-term change.
- Pro: Unlikely to impact morale, since new employees are treated the same as long-standing employees.
- Con: Executives with access to information and more sophisticated employees may understand that the options are being granted out-of-the-money, which may lead employees to believe that their options are not valuable and that the company is acting unfairly.
- Option 3: Option repricing — reset the exercise price of out-of-the-money options to the new fair market value indicated by the independent third-party valuation report.
- Pro: Simple to implement. While theoretically the action could be seen as a negative change since it can cause qualification issues for incentive stock options, most companies can implement an option repricing with a simple board action (assuming no new terms, such as extended vesting, are being imposed at the same time).
- Pro: Easy for employees to understand.
- Con: Resets the incentive stock option holding period and causes a recalculation of the US$100,000 limit for incentive stock options, which can lead to more disqualifications. Further, this could cause employees to argue that they have been negatively impacted.
- Con: May affect employee morale by highlighting current pressures on the business.
- Con: Serial repricings can be problematic under Section 409A by calling into question whether the options have fixed exercise prices. Companies should consult their accountant to understand the full impact of repricing before deciding to take this approach.
- Option 4: Option exchange — exchange out-of-the-money options for new options or restricted stock units (RSUs).
- Pro: By exchanging out-of-the money options for new options and/or new RSUs, a company may impose new terms, such as extended vesting or fewer shares. This may help with retention, dilution, and lowering the accounting impact.
- Pro: Granting RSUs can provide additional downside protection to employees, which may help a company avoid the serial repricing issue.
- Con: To effectuate an exchange, a company must follow formal tender offer procedures, which require the offer to stay open for at least 20 business days and provision of disclosures to eligible employees.
- Con: An exchange can impact morale, since employees may feel like something already earned is being taken away from them. An exchange can also highlight current pressures on the business.
- Con: An exchange is expensive to implement, which may make it prohibitive given that a company in this situation is already trying to conserve cash.
Management Carveout Plan (MCP)
Often as a result of a down round, the liquidation preference stack grows large enough that the common stock itself may be perceived as worthless. An MCP allows employees to participate in a change in control transaction even if the common stock they hold is underwater.
Generally, an MCP “carves out” a percentage of the net proceeds from a change of control transaction to be allocated among management. The percentage of net proceeds allocated can vary based on the level of proceeds in the transaction. In addition, the payments under an MCP are usually reduced by any proceeds from options (and sometimes common stock) in order to avoid double dipping (i.e., the need for an MCP lessens once options are “in the money”). A company must also consider whether an MCP should carve out from convertible debt and/or whether the bonus pool will be funded by all equity holders or only certain classes. Notably, MCPs can be challenging from a Section 409A perspective in the event a change in control includes contingent consideration. As such, they must be carefully structured to avoid creating tax issues for participants.
A company may struggle over whether to conduct a down round financing, and the difficult decisions do not stop there. As described in this article, a company must also make important decisions regarding its equity compensation in order to give the company the highest probability of success. If you would like to discuss any of these (or other) actions in further detail, please contact your Latham lawyers.