Historically, in the world of venture-backed startups, investors and entrepreneurs worked from the shared understanding that, once an employee provided “sweat equity” through their services, such employee was entitled to enjoy the future benefits of that equity. As a result, stock plans and award agreements typically did not provide for the right of the company to repurchase vested shares held by current and former service providers.
However, we are increasingly seeing pressure on startups to add vested share repurchase rights into equity incentive programs. This trend follows the entry by private equity into the venture capital swimming pool and the reduced returns on investment experienced during the dot-com bubble burst of 2001, the Great Recession of 2008, and the market disruptions caused by COVID-19.
What is a vested share repurchase right, and when can it be triggered?
A vested share repurchase right enables the company to repurchase vested shares held by former service providers on or following their termination of service. The right can be triggered by the occurrence of specified events, such as a termination for “cause,” a breach of restrictive covenants (e.g., noncompetition or nonsolicitation), and often in the case of private equity-backed companies, merely the end of continued employment.
What is the “repurchase price” for the vested shares?
Depending upon the circumstances of termination, the repurchase price for the vested shares can be the original purchase price or the fair market value at the time the shares are repurchased by the company, or the lesser of the two. If the company wanted to avoid a cash windfall going to the departing employee, it would include this latter repurchase price in the exercise documentation for the stock option or the purchase agreement for the restricted stock award, as applicable. In addition, a new trend is that the repurchase price can be paid by the company through the use of a promissory note for up to 10 years (meaning that not only can the company repurchase vested shares, but it can put off the payment for those shares years into the future).
When should a company consider using a vested share repurchase option?
Standard stock plans and award agreements typically include a vested share repurchase right that is triggered upon terminations for “cause,” and the repurchase price is typically the lesser of the original purchase price or the fair market value at the time of repurchase. This is because no one wants the situation where a service provider does something harmful or egregious or engages in criminal activity and is able to walk away with a chunk of vested equity. Outside of those extreme situations, the repurchase option won’t apply, and service providers will be able to keep their vested shares.
If a company wants to include a repurchase right in its equity incentive plan, especially one that is different than the standard fare, it should consider the following:
- The reputational effects on the company;
- The impact on attracting and retaining talent;
- The definition of “cause”—whether it is broadly or narrowly defined; and
- The likely costs of the litigation that may arise when a vested share repurchase right is triggered.
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