Gary Marshall's Technology Law Blog

Founders of startups and senior executives who join startups often place too much value on their stock options. Stock options are extremely risky. You may count on your stock options as a possible way to make you rich some day, but you should be very careful if you are counting on them to be part of a reasonable compensation package.

There is the obvious problem that the stock in the company may never be worth anything. But there are many other potential problems with stock options as well. A recent case is illustrative.

It was rumored that one or several senior executives of Skype lost their stock options when Skype agreed to be acquired by Microsoft earlier this summer. As best I can tell many employees of Skype had the right to purchase shares of Skype in accordance with a stock option agreement. That agreement was subject to the terms of the standard company-wide Stock Option Agreement. This is very common. The company-wide stock option plan in turn was subject to the terms of an investor stock plan. There was a provision in the investor stock option plan that allowed the investors to buy back the vested stock options of former employees of Skype at the stock election price. So if you had a vested option to buy 100 shares at $1 each, and the shares were now worth $100 each, the investors could buy back your stock options at $1 per share, wiping out any value you had gained in the stock options. At least one former employee appears to have lost his stock options this way. It is also rumored that a number of senior executive were recently fired and that they too will lose their stock options.

Yee Lee, the individual who appears to have lost his stock options in Skype had written about his experience in a blog. The letter Ricardo Velez, Skype’s associate general counsel, sent him is available here, and his stock option agreement is available here.

(Mr. Lee might still have legal recourse. It is possible that Mr. Lee could argue that the contract terms that forfeited his stock options were unconscionable, or that he had an implied contract right to the options that superseded. I am interested to see if he fights for his options.)

I have read blog comments that this situation is unusual. I do not agree. I have reviewed many stock option plans for clients. The company-wide Stock Option Plan is often subject to the terms of one or more other documents. I always ask the clients to get me a copy of those documents so that I can review them. Sometimes the client thinks I am just trying to run up my fee. But as the Skype case demonstrates, it is important to follow up on the details. In my experience it is rather common that the Stock Option Plan or the additional documents contain one or more legal conditions that could potentially make the client’s stock options worthless. It has also been my experience that the company is not gong to make any changes in these documents for just one person. It is a take it or leave it offer. My standard advice to clients is to insist on enough salary or outright stock grants to make the job worth taking, and consider the stock options as a potential bonus that may or may not come to be. Or accept the risk that you are taking a large risk and that the risk factors are mostly beyond your control.

Do not rely on the fact that you are friends with the people in charge of the company. They may be your friends now. But when there is a large amount of money at stake, friendships tend to fade fast.

If you think the company has value, you should try to stay with the company until you can cash out. As one Skype representative has been quoted as saying in response to the Skype situation,

“You’ve got to be in it to win it. The company chose to include that clause in the contract in order to retain the best and the brightest people to build great products. This individual chose to leave; therefore he doesn’t get that benefit.”

Of course every situation is different. There is less risk if you are receiving stock options in a public company with a large number of shareholders, positive financial track record, and is not likely to undergo a major change in order to raise capital. There is more risk in a start up that has yet to make a profit, and has no market for its shares, and is likely to restructure itself through a merger or sale, or other stock manipulation, in order to raise capital.

Stock options are still a great way to get rich. But they also remain a very risky way to do so. If you go the stock option way, be aware of the high degree of risk involved.

This entry was posted on Tuesday, August 30th, 2011 at 4:46 pm and is filed under Business, Law, Social Responsibility, Technology. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.