After a Down Round: Alternatives for Employee Incentive Plans

*Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional options, recapitalizations and retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.


If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

A Founder’s Guide to Making a Section 83(b) Election

Guest Post by: Kevin E. Criddle, Associate, DLA Piper

One of the more important tax decisions founders of early-stage companies will face is whether or not to make an election under Section 83(b) of the Internal Revenue Code for stock awards or other acquisitions of shares subject to vesting. By making this decision promptly upon acquiring the shares, founders can avoid missing the 83(b) filing deadline and protect themselves from significant tax consequences down the line. Below, we have set out six of the most commonly asked questions by our clients:

1) What is a Section 83(b) election?

Section 83(b) of the Internal Revenue Code allows founders, employees and other service providers to accelerate the time for determining taxable income on restricted stock awards or purchases subject to vesting. A Section 83(b) election is made by sending a letter (a sample form can be found here) to the Internal Revenue Service requesting to be taxed on the date the restricted stock was granted or purchased rather than on the scheduled vesting dates.

Founders that decide to make an 83(b) election need to do so promptly to ensure that they do not miss the 83(b) filing deadline. An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. The last possible day for filing is calculated by counting every day (including weekends and holidays) starting with the day after the grant date.

 2) What are the benefits of an 83(b) election?

There are several reasons why filing an 83(b) election may be beneficial for a founder. Most notably, Section 83(b) of the Internal Revenue Code allows founders to accelerate the determination of taxable income on an award or purchase of restricted stock to the date it was granted rather than on the date(s) the shares vest. If the restricted stock is purchased for an amount equal to its fair market value, an 83(b) election will result in no recognition of income as of the purchase date. Additionally, an 83(b) election advances the beginning of the one-year long-term capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale (long-term capital gain tax rates are 0, 15 and 20 percent for most taxpayers). Simply stated, an 83(b) election can result in significant tax savings under the right circumstances.

3) What happens if a founder does not file an 83(b) election?

If a Section 83(b) election is not filed by the deadline, a founder would pay taxes on restricted stock grants at each vesting date. The founder’s tax would be assessed at ordinary income rates on the amount by which the stock’s value on the vesting date exceeds the purchase price, if any. This may result in a significant tax obligation if the value of the shares has increased substantially over time.

4) What are the risks of an 83(b) election?

Despite its benefits, the 83(b) election is not without risk. Making a Section 83(b) election accelerates the date that taxable income is recognized from the vesting date to the date the restricted stock is granted or purchased. This means that if a founder makes an 83(b) election, pays taxes on income based on the fair market value of the shares on the grant date, and then later forfeits his or her shares, the founder may have paid tax on unrealized income.

5) What scenarios could make an 83(b) election more or less advantageous?

All things considered, a Section 83(b) election will likely be more (or less) advantageous for a founder in the following scenarios:

Section 83(b) Election is More Advantageous Section 83(b) Election is Less Advantageous
  • the amount of income reported at grant is small
  • the amount of income reported at grant is large
  • the stock’s growth prospects are moderate to strong
  • the stock’s growth prospects are low to moderate
  • the risk of stock forfeiture is very low
  • the risk of stock forfeiture is moderate to high

6) What are the steps to filing an 83(b) election?

To make an 83(b) election, the following steps must be completed within 30 days of the grant date:

  1. Complete a Section 83(b) election letter—a sample form can be found here.
  2. Mail the completed letter to the IRS within 30 days of your grant date:
  • Mail to the IRS Service Center where you file your tax return—the address for your IRS Service Center can be found here.
  • Preferably send the letter by certified mail and request a return receipt.
  1. Mail a copy of the completed letter to your employer.
  2. Retain one copy of the completed and filed letter for your records and retain proof of mailing.

As always, founders should consult with their tax advisors to determine how a Section 83(b) election applies to their individual circumstances.

Kevin E. Criddle, Associate, DLA Piper

Kevin Criddle’s practice focuses on securities and corporate finance, mergers and acquisitions, venture capital and private equity investments and general corporate counselling.


Business Plan Forecasting: Valuation Effects

The art of preparing forecasts in a business plan–and it is an art, not a science–involves the founder in a delicate balancing process. On the one hand, a forecast is a representation of a fact–the founder’s state of mind–and an intellectually honest founder will represent his state of mind accurately, for careless, let alone dishonest, preparations may involve liability. [1] On the other hand, the forecast is a critical element in the negotiation process. Thus, as one prominent source on business plan preparation has noted:

The entrepreneur should be careful to avoid negotiating in the business plan. For example, the entrepreneur who indicates he or she will sell 20 percent of the company for $200,000 has just established the upper end of the negotiating range. Sophisticated reviewers will realize that at worst they can acquire 20 percent of the venture for $200,000, and that they might be able to negotiate a better price. [2]

The problem is that the forecast is an “indication” of price and value since it drives valuation, even though the business plan says nothing about “20% for $200,000.” Potential investors, reading the forecast as an offer by the founder to value his company at a given number, will decode the standard language of venture capital valuation. Consequently, it would be ingenuous to prepare a forecast without at least knowing how the investment community will read it. To be sure, if the founder does nothing more than work backwards in the forecasting process, targeting the valuations he wishes to achieve and then filling in the forecast behind that number, he may have made less than a bona fide effort to be candid. Nonetheless, ignorance of how the audience will react to a forecast is not bliss in the venture universe.

The answer, then, is that the forecast should be prepared with two considerations in mind. It should represent the founder’s best thinking as to likely future events. But, at the same time, the founder should not close his eyes to what the consequences of his forecast will be; accordingly, he should at least understand how venture capitalists approach the forecasts in the context of the valuation process.

Most venture capitalists contemplate a five-year time horizon on the theory an exit strategy is feasible at the end of five years. Therefore, the founder’s forecast should go out as far as the investors are looking. [3] Depending upon the maturity of the company and the ability of its product to excite, an informed founder can usually estimate what kind of compounded rates of return the venture capitalists are looking at over a five-year period. If the founder “guesstimates” that the venture capitalist will be looking for a 38 percent compounded rate of return, a quick calculation shows the venture capitalist will be anticipating its investment will quintuple in five years. If the founder is planning to raise $250,000 from the venture capitalists, then the founder knows a forecast which shows anything less than $1 million in net after-tax earnings in year five will mean he has to surrender more than 12.5 percent of the company. To illustrate, the venture capitalist can then be counted on to multiply 1 million times a price/earnings multiple (and that usually is somewhere around 10 because, among other reasons, that number appears often in the marketplace and is easy to work with); once the venture capitalist comes up with a $10 million valuation, he will then calculate that his $250,000 should be worth $1.25 million in year five and find himself agreeing to take 12.5 percent of the company for $250,000 in year one if, and only if, he sees (and believes) forecast earnings of $1 million or more in year five.

A final word on this point. Borrowing from the speech of Kenneth Olson to the 1987 M.I.T. graduating class, [4] the forecast is both a prediction and a target. If you don’t shoot high, the Law of Self-fulfilling Prophecies dictates that you won’t reach high. Exuberance in preparing one’s forecast, if intellectually honest, is an integral part of a founder’s mental terrain.

Lest one get the impression that the previous discussion baldly suggests the forecast should come out exactly where the founder wants it to, it should be remembered that professional venture capital investors are not stupid. They will test the forecast and explore thoroughly the assumptions used, smoking out numbers that are intellectually dishonest or, to put it in the vernacular, do not pass the “red face” test. A very steep climb in earnings in some remote period, for example, will be suspect. Because it is easier to kibitz a forecast in the early years, a spike upward in year five, when anybody’s guess is as good as anybody else’s, will reveal itself as result-oriented. Moreover, an intellectually dishonest set of projections may provoke a negative reaction or outright rejection without further investigation. Furthermore, many investors view the forecast as a quasi-promise [5] by the founder, a representation that he proposes (albeit not legally bound) to make the forecast come true. The forecast is not so much a prediction of the future–five years is too long a time frame for precise predictions [6]–but an undertaking by the party in control to accomplish a given objective. Indeed, a confident forecast of summary results may become a critical issue in the financing negotiations. Experienced investors are accustomed to confront the founder with his rosy forecast, agree to a valuation based thereupon, and then insist that a system of penalties be institutionalized, taking equity away from the founder if and to the extent he fails to achieve the projections he authored. As elsewhere noted, most venture financing’s entail multiple rounds and, accordingly, are of the benchmark variety even if not explicitly so provided in the Purchase Agreement. The second-round investors, generally the same parties who invested in the first round, will be influenced in their pricing decision (in turn driving the founder’s dilution) by the founder’s record measured by the forecast. On occasion, the inability to meet an overly optimistic forecast may be the trigger for a control “flip”–ousting the founder from office.

[1] In the public venue, the case of Beecher v. Able, 374 F Supp. 341 (S.D.N.Y. 1974), suggests that the forecast must be based on facts that would lead one to conclude the results are “highly probable.” Id. at 348. The overall atmosphere has changed since that case was decided, spurred by the SEC’s more tolerant attitude toward forecasts and the Private Securities Litigation Reform Act.

[2] Siegel et al., The Arthur Young Business Plan Guide (1987). The art of forecasting is sometimes known as the “bull’s eye” theory. Under this theory, one shoots the arrow first and then paints the bull’s eye around the arrow wherever it happens to land.

[3] See generally Haslett & Smollen, Preparing A Business Plan, in Pratt’s Guide 31 (1994).

[4] Olson, Learning the Dangers of Success: The Education of an Entrepreneur, New York Times, July 19, 1987.

[5] See White, The Entrepreneur’s Manual: Business Start-Ups, Spin-Offs, and Innovative Management 147-48 (1977).

[6] In Regulation S-K, Item 10(b)(2), the SEC, while it “encourages” forecasts in public disclosure statements, appears to endorse the conventional view that long-term forecasts are misleading. The Commission is correct, of course, but that view is not apposite in a venture placement. The investors know the forecast results will not come true unless the founder somehow makes them come true.

The Entrepreneur’s Shares: A Balanced Approach To Founder’s Equity

Guest post by Daniel I. DeWolf, Evan M. Bienstock, Samuel Effron, and Ilan Goldbard – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

When accepting money from outside investors, entrepreneurs are generally asked to give up some degree of control over their start-up, exchanging equity in their company for cash. In an effort to minimize the control they relinquish, upon formation of their company entrepreneurs can grant themselves equity that comes with special rights. These rights, such as special voting privileges or guaranteed board seats, allow founders to maintain control of their company in spite of a dwindling ownership percentage. They may also include special rights that make it possible for a founder to cash out some of his equity prior to an IPO or other exit event.

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