Venture Capital-Backed Companies

Venture capital-backed companies are partly or wholly held by one or more venture capital (VC) firms in exchange for access to capital. This structure is common for early-stage companies that can leverage the funds to fuel growth, acquire assets, and develop investments. In our experience, these companies frequently operate in the technology or biotechnology space. These are typically either companies that have begun to commercialize their products or innovations and can direct the funding into their growth strategy, or start-ups in high-growth or highly innovative segments that can utilize the seed money to invest in research and development. Following IPO, VC owners may continue to maintain a majority interest, sometimes due to lock-up agreements or other contractual obligations, or wind down their ownership after a certain number of years.

Cash is a scarce and critical resource for VC-backed businesses as many are pre-revenue companies and most do not generate profits in the first few years. As a result, any cash spent on compensation contributes to the burn-rate of existing capital, and high cash compensation costs may require a company to turn to investors for additional capital, diluting the equity interests of current owners. As a result, compensation structures for senior executives in these organizations are typically characterized as follows:

*Pay Element*	*Market Practice*
Base Salary	Modest base salaries, typically less than $500,000 for CEO and frequently less than $300,000 for other executives
Annual Incentives	Many early-stage companies do not have an annual incentive plan When a plan is in place, target incentive opportunities tend to be modest (30%-50% of base salary), and there is frequently no upside beyond target Goals typically linked to milestone achievements in product development and commercialization, rather than to traditional measures like profitability
Long-Term Incentives	Almost uniformly delivered through stock options or profit interests (an option-like vehicle available in LLC ownership structures that can potentially allow for capital gains treatment) Rather than providing annual grants of equity to executives, most companies provide, large, up-front grants upon hire that are intended to cover multiple years of service

VC-backed businesses tend to attract executive talent from more traditional public or private businesses. In order to sign on for a compensation package that is low in cash pay, with high earning potential based on the ultimate value of the company’s stock, executives at VC-backed companies have to be open to the risk of low cash compensation for a number of years in exchange for the potential, but not guaranteed, payoff upon an IPO or sale of the business. In many cases, the management team will be made up of younger executives willing to take a risk, or more seasoned executives who have made enough of a nest egg to forego the higher cash compensation levels they were accustomed to for a potential windfall if the early-stage business delivers on its promise.

Since one of the key differences between these companies and traditional companies is the long-term incentive approach, we will dedicate most of our discussion in this chapter to how equity is delivered at these businesses.

The most common equity vehicle among early-stage companies is a stock option. There are several reasons why this is the case. A stock option only rewards an executive for the value created from the time of grant to the time of exercise. This inherently aligns the interests of the executives with those of the owners. Options are also favored because they are exempt from IRC Section 409A, as long as they meet certain conditions (e.g., exercise price is greater than or equal to the fair market value on the date of grant based on a Section 409A compliant valuation of the company). Restricted stock units (RSUs) are less attractive for early-stage companies because they are subject to Section 409A, and as a result, require pre-set payment dates and can result in employees owing taxes when they vest in RSUs that are illiquid. With a stock option, taxes are not due at vesting but rather upon exercise. The employee can time the exercise to ensure that it does not occur until the shares are liquid. Option gains will generally be taxed as ordinary income upon the exercise of the stock option.

Profit Interests

If the early-stage business is structured as a partnership (e.g., an LLC), it may be able to deliver long-term incentive in the form of profit interests. Similar to stock options, profit interests typically entitle the employee to value based on the increase in the value of units in the LLC. Unlike stock options they are a grant of property and the employee receiving them elects to pay tax at the time of receipt based on an 83(b) election. There is typically no value at the time they are received, so there is no tax due. The employee will pay capital gains tax on any value received from the profits interests at the time they are sold. Congress is frequently in discussions to close the loophole in the tax code relating to profit interests and carried interests. We recommend that your company’s management team work closely with counsel if you are executing a profit interests plan.

Unlike most public or private companies, at early-stage businesses, participation in long-term incentive grants is often broad-based. In the tech industry, almost all employees may expect to receive stock option grants. We would expect that employees at least down to the level of a Director job title would participate. If your company does not grant stock options to all employees, employees may expect higher cash compensation, either through elevated base salaries or participation in a cash bonus plan.

The stock option designs for early-stage companies will typically have what we would characterize as “plain vanilla” design structures. What we mean by this is the following:

Exercise price: Set equal to the fair market value (FMV) of the stock at the date of grant. Price will typically be based on the most recent valuation of the company stock preceding the grant. It is rare to see the exercise price set above the FMV on the date of grant. You will never see the exercise price set below the FMV on the date of grant because that would make the option subject to Section 409A.
Option term: Most common approach is to set the option term to ten years. There is little benefit to setting the option term to be a shorter period, particularly since there is substantial uncertainty about the timing of an IPO or other liquidity event. Ten years is the longest allowable term for an incentive stock option (ISO) and is the most common practice for non-qualified stock options.
Vesting: Options typically vest over three to five years. The most common structure is ratable vesting over the vesting period. For example, four-year vesting would be 25% per year over each of the first four anniversaries of grant. Many tech companies will allow for monthly vesting, so the first 25% vests upon the first anniversary of grant, followed by 1/48th of the award vesting at the end of each of the next 36 months until the option is fully vested at the end of four years.

Unlike public company stock options, there are several issues that are different for early-stage private companies.

Grant Frequency: Most early-stage companies grant stock options at the time of hire that are expected to cover multiple years, typically aligned to the vesting period. Follow-on grants may be made once the original options are largely vested or if an employee receives a material promotion or increase in responsibilities. The rationale for the up-front grants is to provide the employee with upside from any increases in value from the time they were hired. If the value of the company steadily grows, the employee is much better off receiving the grants up-front than through annual grants where the exercise price will be restruck each year at a new higher price. The downside of this approach for the company is that there is limited ability to adjust allocations up or down from year to year based on demonstrated performance or changes in responsibility. Additionally, if the value of the company decreases from the date of grant, all stock options will be underwater without the opportunity to receive a new grant of options at a lower exercise price.
Grant Determination: In public companies, long-term incentives are typically delivered as a target annual dollar value of an award. In early-stage companies, the common benchmark is a percentage of the total shares of the company. The CEO may receive an up-front grant in the range of 3.0% to 7.0% of shares outstanding, and other C-Suite executives may receive an option grant in the range of 0.5% to 2.0% of shares outstanding. The lowest participants will receive option grants as small as 0.01%-0.05% of common shares.
Total Share Reserve: Given the greater use of equity as a compensation vehicle, the total option reserve for early-stage companies is generally in the range of 15% to 25% of common shares outstanding.
Exercisability: In traditional public companies, options typically become exercisable as soon as they are vested. In an early-stage company, exercisability could be restricted until the occurrence of an IPO or another liquidity event (e.g., sale or partial sale of the company). This allows the company to restrict the number of owners of shares of the company’s stock and avoids the employees triggering tax liability when their shares are not liquid.
Valuation: In a public company, no valuation methodology is needed as the stock market provides a continuous valuation of the company’s stock. In a private company where the company’s shares typically do not trade unless there is a fundraising event, an alternative approach for valuation is needed. Under IRC Section 409A, an independent, third-party valuation is accepted as a safe harbor approach for valuing a company’s shares. These valuations are performed by specialist valuation firms that follow established valuation approaches (e.g., comparable transactions, discounted present value, etc.). While there is potential to comply with Section 409A using other valuation approaches, in our experience, almost all private companies with stock options engage an independent third party to do the valuation.
Company Call Right: Companies may have the right to force the exercise of the stock option and repurchase the underlying shares. In most cases, this is triggered by an employee’s exit from the company and a desire for the company to limit the number of shareholders who are no longer affiliated with the company. One downside of exercising the company call right is that departing employees get liquidity on their shares that is not available to continuing employees. In a company friendly design, the call right could be to repurchase the shares at the original grant value. This would significantly devalue the options as they would have no value once an employee departs from the company.
Treatment of Options Upon Termination: Typically, in an early-stage company, all unvested stock options will be forfeited when an employee leaves the company. There may be exceptions for death or disability and in rare cases retirement, though most early-stage plans do not address retirement. There is more variance in the treatment of vested but unexercised stock options. A common provision among public companies is to require that the unvested stock options be exercised within 90 days of termination. If this same provision is applied in a private company, terminated employees will be forced to exercise an illiquid stock option and pay the taxes out of their own funds. An alternative approach is to let vested but unexercised stock options remain outstanding for the remaining option term. This is an employee-friendly alternative; however, it may result in former employees receiving considerable value from the company’s performance following their departure.
Tag-Along Rights: In the event that a portion of the shares held in the company by its current owners are sold to a third party, some option plans will allow for the option holders to participate in the sale of shares on a pro rata basis. For example, if 20% of the shares of the company were sold by the founder to a third-party, the company would allow the option holders to sell up to 20% of the shares underlying their vested stock options to the third party as well.

Key Questions for Committee Members to Ask:

How do our cash compensation levels compare to other VC-backed companies?
Do we need to refresh our option grants once outstanding stock options vest in full?
Do we have sufficient equity remaining in the pool to support executive hiring needs?
What is our strategy for treating the stock options of terminated employees?