Unvested shares don't just "buy back" themselves
The hand that giveth must also taketh away.
TL;DR: If your employee has unvested stock when she leaves, that unvested stock must be repurchased by the company within a given timeframe (usually, 90 or 120 days). Otherwise, that unvested stock could stay with the terminated employee… technically forever.
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What do you mean Jessica still owns her stock?
It was Wednesday afternoon.
I had shut myself in my office, put my phone on DND, and was scrolling down the documents that my client had emailed me earlier that week.
We were gearing up for their Seed round, and here I was, sliding my two fingers up and down my laptop’s trackpad, trying to piece together what had gone on at this company over the past years like a detective putting together clues left behind at a crime scene.
“Jessica’s common stock purchase agreement, here we go… 100,000 shares of common stock, ok… four-year vesting, good… signed agreement, good… signed stock power, great… Hmm, what’s this, terminated before the cliff? Ok… what does the agreement say about unvested shares… repurchased within 90 days of termination. Standard.”
I called one of the founders.
“I see Jessica was terminated. Do you know if the company paid her for the unvested stock?”
“I’m not sure, but I don’t think so, let me check.”
They hadn’t. And the 90-day window had passed.
“Ok, so… she still owns 1% of the company.”
“What do you mean? She never vested anything”
“Right… but the unvested stock was never bought back from her.”
This round was going to be more expensive than expected.
The Dark Side of Vesting
There’s plenty of content out there (including my previous post) on setting up vesting when beginning an employment or service relationship.
But not enough is said or written about what happens to vested/unvested stock at the end of the relationship. Here’s a quick overview on the fate of unvested equity when the relationship terminates.
Restricted Stock vs. Stock Options
A quick refresher here:
Restricted stock is shares that the employee owns from Day 1, subject to vesting (hence, the “restricted” in “restricted stock”).
Stock options are not stock just yet; instead, they become stock when the employee exercises the option (think of it as the employee having the option to get stock).
This distinction is important since how the unvested portion is treated differs based on the equity type.
Unvested stock
Normally, restricted stock agreements provide for one of two methods for the company to “reclaim” the unvested shares.
Repurchase Option
This is the more common method. The employee purchases the shares when joining the company. The company purchases back the unvested shares when the employee leaves the company. In other words, the company has a “Repurchase Option”. Usually there’s a time period (normally, 90 or 120 days of the employee leaving) for the company to exercise the Repurchase Option. Until and unless the Repurchase Option is validly exercised, the ex-employee continues to hold the unvested shares.
Automatic Forfeiture
This method is less common and is normally used when the employee is awarded stock (for “free”) and, so, doesn’t pay cash for it. Under this method, the forfeiture of the unvested shares is automatic when the employee leaves the company. The company does not have to take any further action – paying cash, serving a written notice – to get the shares back. That said, it’s good practice to inform the ex-employee, as a fait accompli (a done deed), that the unvested shares have come back to the company, attaching the stock power with the blanks filled in.
Unvested stock options
The fate of unvested options are more clear-cut with stock options. By the way, just so you know – while we say “vested options”/“unvested options” casually in speech, the proper way of phrasing it is “option for vested shares”/“option for unvested shares” or the like.
Revert immediately
When an employee is terminated, the unvested options automatically revert back to the option pool (in other words, the unvested options are automatically forfeited). The ex-employee can no longer exercise them.
Revert at end of exercise period
There’s a set time period for the employee to exercise the vested options after leaving the company, which depends on the termination ground (the “exercise period” or “exercise window”). For example, if the employee leaves of their own will (that is, they’re terminated on voluntary grounds), they normally have the months to exercise the option (although some companies are allowing longer periods). If the employee doesn’t exercise the vested options during the exercise period, then this balance reverts back to the option pool on the last day of the exercise period.
Stock and options are mirror opposites?
If you think about it, yes, in a sense, stock and options are kind of mirror opposites.
With stock, you own it until the company buys it back, whereas with options, the company “owns” the stock until you buy it from the company.
Upon termination, the company has a time period to buy back unvested shares… or, with options, the ex-employee has a time period to buy the vested shares.
Avoid the mistake (or fix it)
As is usually the case with startup law (and law generally… and many, many things in life), an ounce of prevention is worth a pound of cure.
Doing it right
Whenever an employee is terminated, the company should look at the stock agreement to figure out the next steps.
Is the unvested stock subject to repurchase? As soon as possible, notify the ex-employee that the company is buying back the unvested shares, pay the cash (via wire or check), and hand over the filled-in stock power that documents the repurchase of the unvested shares.
Is the unvested stock subject to forfeiture? Without delay, notify the ex-employee that the unvested shares have already been transferred back to the company upon the termination date and provide the filled-in stock power documenting the forfeiture of unvested shares.
Making it right
Did you miss the window for repurchasing the unvested shares? The fate of those shares depends on the language of your stock agreement. You’d want to talk with a competent lawyer on this – let me know if you’d like to be connected with one.
In properly drafted stock agreements, the company will automatically exercise the Repurchase Option as of the last day of this period. If the company hasn’t paid the cash to the ex-employee, then this is a quick fix: pay the cash today (likely extra, to account for interest or as an incentive) and call it a day.
In poorly drafted stock agreements, the company must proactively exercise the Repurchase Option – actually provide a written notice to the ex-employee and deliver the outstanding cash, all within the mentioned time period. If this window closes, then the company may have a problem. At this point, probably your best option is negotiating a settlement with the ex-employee.
Remember, the work doesn’t stop at “goodbye”
As you probably already noticed, parting ways with an employee isn’t just about the difficult conversation. There’s a whole legal process involved, even when parting on amicable terms. So, if you and an employee are going separate ways, let that be a trigger for you to look into any equity that this person has, the underlying documents which granted that equity, and immediately take action regarding its fate.
Startup Ecosystem Member Highlight
Over the past years, I’ve had the opportunity to meet with amazing people who are super passionate about startups. I’d love to introduce them to you through this newsletter, as they can be helpful to you as you start, grow, and scale your startup.
And since this post is about equity, the highlighted member has to be an equity professional (and a certified one at that)!
Meet Jason Mann, CEP
Jason is Director of Content at NASPP (National Association of Stock Plan Professionals) and a Certified Equity Professional. Not only does he know all things equity inside and out, he’s also creating and orchestrating insightful content on the topic through NASPP. In fact, they just launched a new newsletter, The Cap, which is geared toward private companies (which includes startups!).
Jason’s drive for equity comes from his days at Carta, where he witnessed first-hand how equity can truly change lives. Prior to that, he served in the Air Force (from which he was medically separated), worked as a day trader, and was an international rugby player for the Philippines Volcanoes!
Importantly, along with the content creation, I really admire Jason’s work because his knowledge is rooted in practice: bring up a facet of equity, and he has a story to tell!
Make sure you connect with him on LinkedIn and follow The Cap.
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Until next time!
Stepan
A bit about me: I’m a corporate lawyer with 10+ years of experience helping 100s of companies navigate the legal journey, including early-stage startups and unicorns. I quit my private practice to start Corpora and help founders raise money faster and more affordably. Let’s connect on LinkedIn.