Apr 2 2012 by Brad

How Do I Protect My Option Grant From A Down Round In The Future?

Question: I am considering joining a startup that is currently in the process of raising their next round of funding. I will be joining as a VP, reporting directly to the CEO, and considered an “executive”. Given the environment for this particular industry, it is very likely that the company will face a down round – perhaps as much as 50% of their last financing a year ago. What should I expect in terms of protection from both dilution and going under-water on my option prices given that I will be joining before term sheets and close of the round? Will my options be priced based on the previous round? Can I ask for some guarantees about % ownership and stock price post-funding?

Generally this is very hard to do. During your hiring process, you should address this directly with the CEO and ask him (a) what he thinks the prospect for a down round is and (b) if he’s willing to give you any guarantees on your stock position if one occurs. Most CEOs will say (a) I don’t expect there to be a down round and (b) no.

If you feel like you can negotiate then go deeper and ask for his word that if there is a down round you will receive an additional option grant that gets you close to your current granted amount. A great CEO will not commit to this – rather he’ll say it’s up to the team to increase value in the business regardless of external dynamics. If the team has performed well but the external dynamics have negatively impacted the value of the company (and subsequent financing), then it’s up to the board to consider additional option grants for employees in the content of this.

Some people will talk about the idea of being “trued up” in a subsequent financing. A long time friend likes to say “there is only 100% of a company to go around” so when someone gets “trued up” it’s coming out of someone else’s ownership. If a CEO commits to true you up in the future, recognize that it’s not a formal commitment unless it is documented as the CEO doesn’t have the authority to do this unilaterally (he’ll need board consent to do it.)

Now, let’s assume nothing has been committed to you up front and a down round subsequently occurs. In some cases, the company will grant additional options to make up some of the difference in dilution. This is rarely an amount that preserves your previous ownership as you should be taking some dilution, along with everyone else, as a result of the new financing. But – if the financing dilutes you 50% then a reasonable amount to expect would be an option grant that results in you only being diluted 25% to 33%. Of course, these numbers will vary a lot based on the actual financing.

If it’s a very material down round, in addition to granting new options, the company might reprice the existing options that are outstanding. This used to be difficult to do and have all kinds of weird accounting ramifications that tended to prevent this from happening. However, many of the rules have changed and all that is now required is a mildly tedious legal process.