Five Equity Challenges VC-Backed Companies Need to Address
As the VC-backed market faces headwinds, startups continue to navigate through significant challenges. IPOs are on the decline, funding is shrinking, and the time between funding rounds is increasing. Naturally, these trends bring significant challenges to people leaders and change the way that companies think about equity.
In this article, we will discuss five key areas that people leaders need to consider when reevaluating a VC-backed organization’s equity strategy in the current market. These areas include:
Falling 409A valuations
Exercise windows and employee tax implications
Choosing the right vehicle
1. Falling 409A valuations
With private market equity values declining, you may be faced with the dreaded “underwater Stock Option”. In this scenario, the estimated value of the stock is lower than the strike price of the stock option, essentially rendering the award worthless. This is a problem as it means critical talent can leave “for free”.
The first step is to understand the impact on employees. That means evaluating what individuals have in- or out-of-the-money and, of that, what is vested or unvested. Depending on the outcome of this analysis, making additional awards to critical talent could be the simplest solution.
In certain scenarios, additional awards may be insufficient to address the issue, or the company may not have enough shares or not want to further dilute equity, which may bring option repricing to the table. This is where outstanding options are canceled and reissued at a new, lower strike price. This was a common approach after the dot com bubble burst in 2000, and we saw it after the financial crisis of 2008. While this addresses the issue at hand, this can be looked at unfavorably by investors and requires careful communication with employees.
2. Exercise windows and employee tax implications
The vast majority of stock options come with a 10-year term meaning 10 years after the award is received, the employee has to “use it or lose it”. RSUs also come with their own expiration date, typically 7 years, often combined with a double trigger vesting schedule which further complicates things. A final scenario is that RSUs were awarded with an 83(i) provision which defers employee tax liability, but only for 5 years.
Each of these scenarios can lead to a situation where employees have to pay tax while simultaneously being unable to sell any shares to cover their tax liability.
At the time of grant, 7-10 years feels like a long time and most companies plan to go public long before that point. However, with the current market, it seems likely that many companies will put their IPO plans on hold for the time being.
As a consequence, you might find that employees are getting close to having to exercise their stock options. With an RSU, you could face a scenario where the RSU is set to expire before the second vesting event, typically an IPO, is triggered, forcing the company to either cancel the RSU or accelerate the vesting schedule. In a public company, the employee can sell off some of that stock to cover the taxes, however, the only way an employee can do this in an illiquid scenario is by selling to a 3rd party that typically won’t give a great price per share.
A real-life example of this situation is where, in order to address expiring Options and RSUs, Stripe accelerated the RSU vesting schedule and went through a “down” round of funding in addition to a tender offer in order to provide employees with the liquidity to exercise their stock and pay their tax bills.
3. Choosing the right vehicle
While RSUs make sense for a private company on the verge of an IPO and help to align with the public markets that they will soon be a part of, it is not ideal for a private company in the long term. In addition to the aforementioned challenges of expiring terms and double triggers, RSUs are typically communicated in the form of dollar value in order to align with public company practices - when combined with falling private market valuations, that perceived value can quickly diminish in the eyes of employees.
As such, options remain the vehicle of choice if an IPO is not on the immediate horizon.
For companies that have shifted to RSUs, this may mean a return to Stock Options going forward.
4. Handling dilution
As companies spend longer in the Pre-IPO phase, they issue more equity, and typically the level of overhang increases towards an IPO. Companies that grow aggressively and spend longer in the private phase typically attract liquidity concerns from investors who may be more protective over their share given the current market.
Practically speaking, it may be more difficult than it has been to replenish the pool to support current hiring and refresh strategies.
This may mean a more targeted approach to equity, moving away from the “equity for all” model that has been so prevalent in recent years, to a focus on employee groups that equity engages the most.
Companies with high overhang levels and limited pools may also look to more “exotic” ways to manage equity usage such as that used by Lyft, Stripe, and Coinbase which reduced their award sizes but also shortened the vesting period as a way to offset that impact.
Employees understand the world they are in and they can read the headlines. They are most likely more than aware that their equity is not worth as much as it once was.
Communication between executives and employees around company performance and trajectory has always been important to connect the value of equity awards with company success and this requirement is now greater than ever. Providing clarity to employees in terms of current valuation, changes to company strategy, rounds of financing, and timeline to IPO, will foster trust with employees.
CPOs have the unique opportunity to work closely with founders and executives to help clarify, hone, and roll out this message.
A final thought
In addition to making changes to your equity strategy, it’s time to think more broadly about the total rewards philosophy. Not too long ago, VC-backed companies were lean, low-paying career opportunities for risk-taking individuals looking to create long-term wealth through stock options. Since then with the influx of VC funds, this market has moved to look and feel a lot more like a public company with high base salaries, 401(k) matching, equity for sales roles, free coffee, kombucha on tap - the works.
Now is the time to rethink some of this spending with the goal of surviving and riding out this VC downturn, focusing on a narrower pool of talent, and adopting an EVP that can realistically be fulfilled, rather than going head-to-head with highly profitable public competitors.
Navigating the equity challenges in the VC-backed market requires proactivity. Staying informed about the market and options to address these challenges will be critical for people leaders in the near future.
Arriving at an equity strategy that aligns with this new landscape will likely require discussion with senior leaders, as well as perspectives from a cross-section of the workforce. Combining these perspectives with rigorous modeling of potential solutions enables people leaders to bring tangible, workable, and impactful solutions to their executive peers.
Ready to tackle the equity challenges in your VC-backed company? Our team of experts at Nua Group can help you navigate these complexities and find tailored solutions for your workforce. Contact James Seechurn today to schedule a consultation and discover how we can assist you.