Negotiating and Structuring Your Stock Compensation (Know The Key Documents): Part 2

Author(s): Clayton Foster
Synopsis: Assessing equity comp in a start-up requires careful analysis of the rights already negotiated by previous investors. Without a complete understanding of those rights, a deal that looks great today could end up being much less than meets the eye later. This article by Clayton Foster is also featured on the website.

Many executives are unpleasantly surprised to find that there is a gap between what they expect from the equity compensation package they negotiated at hire and what they ultimately receive, either at termination or in a corporate transaction (e.g., a merger). Most frequently, problems come up because the documents and rules that affect equity compensation are so complex.

Part 1 of this series looked at the way that conflicting or inconsistent provisions between different documents may interact with one another to produce unfortunate results. Part 2 considers which existing documents and rules non-founder executives must take into account when negotiating for equity compensation during the early (pre-public) stages in a company’s development and growth. For purposes of this article, I’ll be referring to non-founder executives simply as “executives.”

The private company context

Stock in a privately held company is, as a general rule, illiquid (i.e., it can’t be freely transferred to a third party). Of course, any company that begins its corporate life by granting stock to employees (including employee-founders) hopes its stock will become liquid — and thus worth real money to the employees — at some point in the future. In many cases that liquidity will never occur. However, when liquidity does occur, it most often results from a corporate M&A transaction (e.g., sale or merger) or an initial public offering. The wildcard at even the most successful start-up is timing: how long will it take to get there (if, in fact, the company does get there)?

As the company progresses through its start-up phase into maturity, stock ownership comes to mean something different than it did at the earliest stages. At each point in the corporate life cycle, new equity documents will reflect the special concerns posed by that stage. These documents may be cumulative or they may supersede one another in whole or in part. They may include provisions that apply to all shareholders equally, or they may provide special rights or limitations to one class of shareholders, or even only to certain individual shareholders. An executive negotiating for equity compensation at any point in the life cycle must be sure to understand how each of the outstanding documents interact with each other, as well as how such documents will interact with his or her own package.

Pre-investment phase

Initially, equity rights will be governed by a combination of corporate charter documents and individual founder agreements. At this earliest stage, documents are drafted for the purpose of protecting the initial founders from one another or from outside predators (i.e., subsequent unrelated investors or buyers), for example, by ensuring that corporate ownership remains in the hands of working owners. The founders will be concerned about corporate control, voting rights and operational issues. These concerns may be incorporated into their stock ownership agreements.

EXAMPLE: You are negotiating to come in as CEO of Fast Track Co. six months after the founders organized the company. Your first job will be to close the initial (“Series A”) outside investment round (which is likely to be from non-institutional “angel investors”). The two founders still own 100% of the outstanding common stock of the company (which they purchased outright in the initial capitalization transaction), subject to an employee option plan for which they have authorized a 15% allocation. However, everyone expects to sell 25% of the company in the Series A round. The founders have offered you a 10% stake (pre-investment) in the form of stock options, to be issued outside of the stock option plan pool but using the same forms (and vesting schedule) as those authorized under the plan.

What to do? An executive who joins a company during this pre-investment phase needs to carefully review with counsel any documents that might have the effect of limiting his or her rights to realize the full benefits of a negotiated equity compensation package. The early stage still provides opportunities to protect those benefits, but only if the executive has a big-picture view of how everyone else’s equity interests will play out over time. In this stage, the executive should be trying to put himself in a position that is equivalent (or at least similar) to the founders: i.e., a position that establishes a strong bargaining stance with respect to the changes that inevitably will be demanded by the future investors.

In addition to the basic charter agreements and equity plans (which include the articles/certificate of incorporation, corporate by-laws and employee stock plans), early stage companies often enter into one or more of the following agreements with founders and start-up employees:

1. Shareholder buy-sell agreements. Closely-held companies frequently start out with a “buy-sell” agreement between the company and its founding employee-shareholders. Typical equity-related provisions in a buy-sell may include:

  • A right in the remaining shareholders to buy out any shareholder who leaves employment with the company at a formula price (often with a note)
  • A right of first refusal in the remaining shareholders to buy out any shareholder who wishes to transfer shares to a third party, also at a formula price (often with a note)
  • A requirement in the remaining shareholders to buy out the estate of a deceased shareholder (frequently by using key-man life insurance to finance the purchase)
  • A right to participate in future financings and/or a right to maintain a certain percentage level of ownership in the event of future financings (for example, through additional equity grants)

2. Founders’ stock purchase agreements. Founders’ stock purchase agreements may be in addition to, or in lieu of, a shareholder buy-sell agreement. This agreement will include:

  • Vesting provisions (including, in some cases, acceleration on change in control or termination)
  • Restrictions on transfer, including rights of first refusal in the company.

3. Other founder agreements. Founders’ employment or change in control agreements may also carve out special rights with respect to equity: acceleration, founders’ liquidation preferences (i.e., a preference above the common stock but below the preferred stock), rights to maintain etc.

4. Restricted stock purchase agreements (non-founder). In a closely held company, even non-founders may have restrictions on their equity that are similar to those found in a shareholders’ agreement. For example, some early stage companies subject all restricted stock purchased by employees to repurchase rights on termination (at fair market value), even when such stock is fully vested.

Investment Phase

Once outside investors enter the picture, a new set of documents — and understandings — come into play. Whether such investors are venture capitalists or angel investors, they will be looking to protect their investment with a variety of equity-related rights similar to (but better than!) the types of rights included in founders’ agreements. Such investors’ rights are likely to include:

  • Liquidation preferences (including high-multiple preferences): This valuable right gives preferred stockholders the ability to get back their original investment (and in most cases, a premium over that investment) from any proceeds received on a liquidation event. Only after the liquidation preference is satisfied will common stockholders share in the remaining proceeds (if any), and that pot will frequently be shared on a pro-rata basis with the preferred stockholders as well (a “double dip”). If the liquidation preference is high enough, even executives who hold a significant percentage of the common may end up with very little of the proceeds from a sale.
  • Antidilution protection: Usually stated as a complex formula, this right operates automatically to allow the preferred stockholders to hold their original percentage of the capital of the company when certain types of new shares are issued to subsequent investors. This means that even when common stockholders are diluted (for example, as a result of new investors coming in or additional employee shares being added to the employee plan pool), the preferred stockholders are not, and thus they stay at the same ownership level while the common stockholders’ percentage ownership is reduced.
  • Participation rights (and rights to maintain) in all future offerings: This is a nonautomatic form of antidilution, which gives investors the right to elect to participate in any future offering (on the terms of the offering) up to the extent of their ownership percentage.
  • Registration rights: This refers to a combination of rights which give the preferred stockholders the ability as a group to force the company to register stock for resale under certain circumstances (e.g., initial public offering or secondary offering after IPO), as well as to “piggy-back” onto other registrations that would not necessarily have otherwise included such preferred stockholders.


  • Rights of first refusal and co-sale rights on preferred and founders’ stock sales: These two rights apply when an investor or founder seeks to sell their stock to a third party. The remaining investors have the option of either purchasing the stock from the seller (the right of first refusal), or of selling a certain amount of their own stock to the third party in lieu of the original seller(the co-sale right). Co-sale works like this: assume that a founder has a buyer for 10,000 shares. He must get board approval for the sale and give notice to the preferred stock investors, who own 25% of the company. The investors exercise their co-sale rights. The founder may only sell the buyer 7500 shares; the remaining 2500 will be sold to the buyer by the preferred shareholders.

The rights are usually contained in several documents, including the company’s revised Articles (or Certificate) of Incorporation, Preferred Stock Purchase Agreement(s), Co-Sale Agreement and/or Investors’ Rights Agreement. The founders may, or may not, be parties to some or all of these agreements.

EXAMPLE: You are negotiating to come in as CEO of Fast Track Co. immediately after its second round of financing (the A round was an angel round, the B round was venture capital). The Board has agreed to provide you with a combination of options and stock grants for common stock that result in a 5% (fully diluted) equity stake. The two founders, who now own 15% of the company, have been moved aside into advisory roles, and their original shareholder agreements have been amended and, in large part, superseded. The investors have a comprehensive preferred stock package (including all of the rights set out above), and the founders are signatories to the Co-Sale and Investors’ Rights Agreements. In addition, the founders negotiated their own mini-versions of anti-dilution protections and liquidation preferences as part of the Series B financing.

What to do? You and your attorney should request copies of the existing documents, review them, and try to ensure that your agreement incorporates (at the very least) the same kinds of protective provisions as those included in the founders’ agreements. If the company balks, you’ll need to consider alternatives. For example, depending on your bargaining power, you may be able to negotiate reload options and/or cash bonuses that come into play at the time of a dilution event. In this context, reload options — which give you additional options (at the then-current price) any time your ownership percentage falls below a certain level — may act as a form of antidilution protection (similar to a right to maintain, as described above). Without some form of protection, your “5%” will be illusory. Moreover, if all of the existing liquidation and antidilution preferences come into play, your upside on a future liquidation event may be very limited indeed.

What it all means for your equity compensation

As a private company grows and takes on investment, its capitalization and equity structure will change. This is a fact of (corporate) life. Equity provisions such as those described above are intended to protect the early (and preferred) stockholders, and thus have the effect of limiting — or even eliminating — much of the equity upside for later employee-shareholders. As explained above, anti-dilution provisions, rights to maintain, founder liquidation preferences, and other special rights limit the amount of the pie that is left to be divided amongst employee shareholders on a liquidation event (i.e., merger, sale or liquidation). In other cases, the provisions are themselves self-limiting. A requirement that an executive sell back vested stock for fair market value at termination is really no more than a stock appreciation right (and prevents the executive from holding on to vested stock that may become more valuable at a future date).

Any executive who negotiates for an equity stake in a private company must ask the question: What (and whose) rights are out there? I’ve worked with many sophisticated executives who thought that just reviewing the corporate capitalization table — which shows the various securities (e.g., common stock, preferred stock, warrants) outstanding, the shareholder ownership percentages, and the amount (and type) of investment in the company to date — would tell them what they needed to know. But the cap table is only a snapshot of the existing structure. As we have seen in this article, corporate documents and equity agreements show us a much more detailed (and complicated) picture. The savvy executive’s goal is to see that big picture — and visualize what could happen in the future — before he or she agrees on an equity compensation package. Otherwise, the deal that looks great today could end up being much less than meets the eye later.

This article was first published by the website () as Part 2 of a 3-part series.

© 2007 Clayton Foster, all rights reserved.