Navigating Risk for Employees and Investors in the Current Economy
How the recession has influenced investment and business decisions
Maytak Chin
Posted Monday, February 1, 2010
Q: Tell us a little about your background. What led you to a career in corporate securities law?

A: Prior to law school, I was an editor at Random House for about six years, where I managed contract negotiations and deal structuring for books. Building on my experiences in the publishing industry, I began my legal career with a focus on emerging growth and start-ups in corporate securities. Mostly, I now serve as an issuer counsel, representing companies in venture capital financing, seed rounds, friends and family rounds, and in merger and acquisition activity. However, I have also done some work on the investor side, ranging from representing venture capitalist companies in the Silicon Valley to representing companies who are looking to acquire a target company.

Q: How has the recession affected venture capitalist business decisions?  

A: Venture funds conduct an internal calculation for a possible exit strategy from the company within a five to seven year window. With the current state of the economy, IPO [initial public offering] has been taken off the table as a viable exit strategy. Now, venture funds are turning to mergers and acquisitions for liquidation as the preferred exit strategy. Instead of anticipating that a company's product will enter into the market, venture funds are looking more towards guiding companies on the right track to develop in areas that will improve value, with the hopes that another company would be interested in an acquisition or a merger.

From late last year to just recently, venture funds were investing at much lower rates because money was tight. Investors did not have the ability to supply venture funds with the money they needed to go out and make more investment deals. Furthermore, venture funds were tied up with so many existing deals that they were on the brink of disaster. It would have been unwise to take on additional risk. As a result, many venture funds were trying to liquidate their funds because they could not handle the risk.

Q: Are there any legal ramifications for the shift in venture capitalists' preferred exit strategies towards mergers and acquisitions?

A: In a venture financing round, a company will usually offer preferred stock shares along with liquidation preferences and certain rights to the investor. Each time a new investor is added, the funding goes into a new round. When a start-up company sells or liquidates, the preferred share stockholders are first in line to collect their investment returns. 

In the current recession, there has been a rise in stockholder claims litigation. Stockholder litigation is prevalent in two situations. One circumstance is when the stockholders sue a company for going bankrupt without having the proper valuation. For instance, venture funds may sue companies that they have invested in as a strategy. The venture funds line up their claims to secure a payout if a company indeed goes bankrupt or mergers with another company. Another instance is when a company enters into a merger. When a company enters into a merger, all the preferred shareholders are entitled to payment first while the common stockholders may be left with nothing.

Before a merger, stockholders of a company must vote by a majority to authorize the merger. However, if a stockholder believes that the company is selling shares for lower than what the stock is worth in the merger, the stockholder can exercise what is called "dissenter's rights."   Essentially, the stockholder can take the company to court to determine the fair market value of the share. If the fair market value is determined to be higher than the selling price in the merger, the company will have to pay the stockholder the difference.

Q: In the start-up industry, most workers rely on their knowledge as their primary marketable asset. However, deciding what proprietary information belongs to the company, as opposed to the employee, can be difficult to determine. Do you think that the flux of the economy and unemployment has impacted the way companies protect their proprietary information?

A: Intellectual property is a key issue for most start-ups because it is a main asset, and highly valued by their investors. From 2004 through 2007, companies who relied solely on their intellectual property rights began to go under during the dot-com bust. The employees of these companies had no option to go to a new company because their knowledge was tied up with their previous employer. That led to problems.

Now, however, start-up companies have learned their lesson. If they did not have their intellectual property nailed down before, they are going to do it now. Assignments agreements have become very standard in recent years for companies in their early stages of development. There are certain restrictions in California law on convention of assignment agreements.

An assignment agreement basically states that any rights to the work that the employee has developed in the past, or as a current employee, that relates to the company business will be assigned to the company. By operation of law, the employee doesn't need to sign the agreement every time they take on a new project because the initial employment contract has provisions that cover future projects with the company. In exchange, the employee receives as consideration a salary, benefit packages, or stock options, to make the agreement an enforceable contract. With such an assignment agreement in place, there is very little chance that the departed employee will be successful in suing the company for intellectual property rights. Frankly, if you do not have that certainty at the time offorming a company, then no one will want to do business with or invest with the company due to the substantial risk of losing intellectual property when an employee leaves the company.   

There are instances where I've encountered a new client who did not have an assignments agreement in place. It becomes difficult to secure protection over the company's intellectual property rights since the employee has already departed before the company becomes your client. One way to handle the situation is to give the employee consideration to sign the assignments agreement, if there is still some semblance of a good relationship with that employee. The consideration for an employee at the time of the signing is their salary. If the employee has already departed the company can give the ex-employee something of value in exchange for their agreement to the assignments contract. As long as there has been an exchange of consideration and the parties freely enter into the agreement, the contract will be enforceable.

However, if the departed employee was laid off or is disgruntled for some reason, there is no chance in getting them to agree to sign the assignments agreement. That then becomes a risk. At that point, hopefully there is something you can point to as a way to show that the departed employee had assigned his or her intellectual property rights to the company. If there is nothing in place then there is a big risk and the start-up company will have to disclose that to an investor or during a merger or acquisition. 

Q: Earlier, you mentioned that employees sometimes get stock options as a part of their compensation package. From a start-up company's perspective, what are some liability issues to consider when offering stock options?

A: Before 2007 stock options were an attractive mechanism to recruit and attract talent for start-ups that did not have much capital to offer their employees. Now, it is strongly inadvisable for early start-ups to offer stock options to their employees for a couple of reasons. One has to do with § 409A of the internal revenue code, which essentially put an end to stock options within the start-up industry. Although passed in 2004, § 409A really took effect in the beginning of 2008. 

The crux of the provision prohibits companies from granting stock options below fair market value. Before § 409A, companies gave employees an advantage and offered company shares that were exercisable for far less than the value of the common share price. The difference between the exercisable price and the fair market value is considered deferred compensation according to the federal government under § 409A. Since the difference in the stock value is now deferred compensation, the company is required to withhold the appropriate amount, and the employee owes taxes on it when they trades in their shares. If a company does not withhold the proper amount it will be penalized for not complying. Because the federal government finds this practice so egregious, the employee is actually responsible for a 40% excise tax on the deferred compensation. The Securities and Exchange Commission penalizes companies for previously offering their employees stock options below fair market value.

Q: What is the liability under § 409A and how has it affected start-up companies in the current economy?

A: The liability under § 409A is a really big issue. Merger and acquisition deals can fall apart if a company does not have the proper procedures in place to ensure that it's stock options were granted at fair market value to their employees. An acquiring company will walk away from the negotiations table because it cannot incur the risk associated with § 409A liability. At any moment, the IRS can come and wipe out the company.

From a company's perspective, the real risk is when an employee sues the company for the value of the 40% excise tax, claiming that the company had assured them that the shares were worth the fair market value when the options were granted. If the company did participate in this deferred compensation payment structure, the risk of being sued for § 409A violation becomes a significant liability that a company will have to disclose to any investor.

As you can see, employee severance cases all tie back to financing. When preparing to do a financing deal, investors may balk when they notice that an employee who has been terminated still holds a significant share of the company's stock. Their primary concern is liability for a suit; that is, what is the likelihood that the terminated employee will come back to sue the company. 

Q: What can a company that participated in a deferred compensation payment structure do to minimize § 409A liability?

A: From now on, § 409A makes pretty clear that options cannot be granted below fair market value. For stocks granted before § 409A took effect, it is almost impossible to determine the fair market value of the stock, since the price must be what the share was valued at the time it was granted. For instance, say you have an option was granted in 2003. How do you go back in time and determine what the fair market value was in 2003? It is a difficult task.

If a company is able to determine the fair market value for the stock at the time it was granted, the company can make proposed amendments to the option that comply with § 409A. However, such an amendment requires that the employee can only exercise the option on certain events in which options matter the most, such as the employee's death or a change of control of the company. During an acquisition, most companies will allow employees to exercise their options as a common holder. As a result, employees can gain from the higher fair market value, as compared to the exercise cost. Like venture capitalists, employees in this situation are investing time into the company in anticipation that an exit strategy will provide a significant reward for their work.  It becomes a win-win situation. That is one way of retroactively handling § 409A liability.

Q: What precautions should a company take into account to ensure compliance with § 409A when offering stock options to employees?

A: § 409A liability turns on whether the stock was granted to the employee at fair market value, so start-ups should not offer options until they are ready to financially implement a valuation procedure, which usually happens after a Series A or Series B round of funding. Why? It is hard to determine the fair market value for a company which is not public. This is especially the case for a start-up that has no revenue and does not know what the future holds.

There are two safe harbor valuation procedures outlined by § 409A that are generally used. If a company can meet these safe harbors valuation standards, it will avoid § 409A liability. One way is to hire an independent valuation firm. The other is for the company to find someone who is knowledgeable on valuation procedures and who may submit a valuation report for the board's review.

Q: Are there alternative stock option payment plans that a company can offer that are outside the scope of § 409A?

A: A company can offer what is called a restricted stock, which is not subject to § 409A.  It is like an option, but the employee must buy the stock up front rather than having an exercise period. Presumably, a company can offer the employee stock at a founder's price, which is a relatively low per share price, so that the employee will be able to benefit significantly from the upside. The downside of a restricted stock payment plan is that the employee needs to have cash on hand to purchase the stock. Many employees just do not have cash readily available.

Q: What happens when an employee leaves the company? What happens to the stock owned by the employee?

A: Whether it is stock options or shares of restricted stock, the stock is usually subject to the company's repurchasing rights. Essentially, if an employee leaves and their shares have not yet vested, the company has the ability to buy back those shares. Because the company has an interest in retaining their stocks when an employee departs, it typically buys back the unvested shares from the employee. The viability of repurchasing all the shares from an employee depends on how many shares the employee may hold, what price was paid for those shares, and how much money the company has on hand.

Q: What do you anticipate to be the next attractive investment option for venture funds and why?

A: The recession seems to be slowing down some, and the purse strings are starting to loosen up, especially around the cleantech industry. The increased involvement and investment from the federal government in the cleantech space mitigates some of the risk in investing. Furthermore, because most of the money from the government comes in the form of federal grants, it stabilizes the company financially and does not dilute the venture fund's investment interests. As a consequence, cleantech has become a very attractive industry to invest in. Is this our next bubble? Or has this bubble already burst? We have yet to see. 

In the first round of funding, the first investors, who are theoretically taking the largest risk because the company is small and does not have a lot of history, will take Series A shares at a certain price. Usually between six months to a year, and sometimes less, another investor will offer to take Series B shares Series B share are often times senior to the Series A shares.  By the time the company gets to a Series C round, the company has built a history and a substantial valuation. Series C stockholders pay much more for a smaller stake in the company.

Dissenter's Rights are recognized under California Corporations Code § 1300-1313.

In California, the primary restriction on convention of assignment agreements disallows companies to require an employee to assign inventions that were developed on the employee's own time using his or her own resources, unless such inventions meet specific criteria. The company must provide notice to the employee regarding this limitation. Also, an assignments agreement cannot contain a non-competition provision that is triggered upon the employee's departure from the company. See California Labor Code § 2872 for more information.

For example, a company may have givenemployees a share of the option that was exercisable at 10¢ a share, but the fair market value per common share was priced at $1. The difference between the $1 and the 10¢ would be considered deferred income.

See SEC v. The Hain Celestial Group, Inc., Litigation Release No. 21195, September 3, 2009.

David Richardson is an associate in the Sacramento office of DLA Piper. Mr. Richardson focuses his practice on new company formation, emerging growth, venture capital and mergers and acquisitions.