Should Startups Offer Early Exercise When Granting Stock Options?

SOME THINGS TO CONSIDER WHEN OFFERING EARLY EXERCISE STOCK OPTIONS

A founder recently asked me why it’s not the standard for startups to offer early exercise when issuing stock options. It’s a good question, and here are some key considerations. Note: This is not tax or legal advice, and the list below is not exhaustive.

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Pros of Early Exercise

• Attracting Talent: Candidates and prospective employees may see early exercise as a valuable benefit, making the job offer more competitive.

• Extending the Holding Period: In a young startup, the strike price may be low, allowing employees to exercise early and start their holding period, increasing their chances of qualifying for long-term capital gains or QSBS treatment if the company is acquired or goes public.

• Lower Tax Burden: If an employee or consultant exercises early, the exercise price and the fair market value (FMV) per the 409A valuation will likely be the same. This means there may be no taxable spread between the two. If they wait to exercise, the FMV could rise, increasing the potential taxable spread.

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Potential Downsides for the Issuer

• Creates Shareholders with Rights: Once an employee exercises, they become a shareholder with legal rights (e.g., inspection rights, voting rights). Holding unexercised stock options does not grant these rights.

• 83(b) Election Risks: 

• Employees who early exercise should consider filing an 83(b) election to avoid unfavorable tax treatment on unvested shares.

• If they fail to file, it can become an issue in future funding rounds, as investors typically require confirmation that all applicable 83(b) elections have been properly filed.

• Employees may also face unexpected tax burdens over time, which can lead to dissatisfaction or even resignations if they feel trapped by the financial consequences.

• Repurchase Obligation: 

• If an employee leaves before fully vesting, in order to claw back the shares the startup must repurchase unvested shares at the original purchase price.

• Compare this to standard stock options, where unvested portions simply expire, requiring no action or expense from the startup.

• Valuation Fluctuations: 

• While startups aim to grow, their FMV can fluctuate. Many companies that saw high valuations in 2020-21 have since experienced corrections.

• If an employee early exercised at a much higher valuation, they might now own shares worth 25-75% less than they paid, affecting morale.

• In contrast, if the employee had held unexercised options, the company could reprice them, offering a better outcome in a down market.

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Final Thoughts

Early exercise has advantages, especially for an employee or consultant seeking tax benefits and long-term gains. However, it also introduces complexities for both the service provider and the company. Startups should weigh these factors carefully when deciding whether to offer early exercise options.

Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

FTC Non-Compete Rule Changes: What Businesses Beed To Keep In Mind.

Noncompetes banned? What's Happening at the FTC?

The Federal Trade Commission (FTC) has recently finalized new rules governing non-compete agreements, marking a significant shift in how these agreements will be enforced across the United States. The FTC’s goal in adopting these new rules is workforce mobility and competition. While the rules’ full impact will unfold over time, businesses should prepare now by reviewing their noncompetes.

The FTC's Rule In A Nutshell

The rule bans noncompete agreements. 

On April 23, 2024, the FTC voted 3-2 to finalize a new rule targeting noncompete agreements. The rule will take effect on September 4, 2024, 120 days after its publication​​ (the “effective date” as it’s referred to here). 

The new rule introduces several important definitions:

• Noncompete Clause: Any employment term that prohibits or penalizes a worker for seeking or accepting employment or operating a business after their current employment ends​​.

• Senior Executive: Workers in “policy-making positions” earning at least $151,164 annually​​.

• Policy-making Authority: Final authority to make significant business policy decisions​​.

Requirements of the Rule

• Non-Senior Executives: Existing noncompetes will be deemed unfair competition and thus unenforceable. Employers must provide notice of this change by September 4, 2024​​.

• Senior Executives: Existing noncompetes are allowed if the noncompete was/is in effect before the effective date. Noncompetes after the effective date will be unenforceable​​. 

Notice Requirements

Employers must provide clear and conspicuous notice to affected employees no later than September 4, 2024. This notice can be delivered by hand, mail, or email. The FTC has provided model language for this purpose, which is provided below​​. 

A new rule enforced by the Federal Trade Commission makes it unlawful for us to enforce a non-compete clause. As of [DATE EMPLOYER CHOOSES BUT NO LATER THAN EFFECTIVE DATE OF THE FINAL RULE], [EMPLOYER NAME] will not enforce any non-compete clause against you. This means that as of [DATE EMPLOYER CHOOSES BUT NO LATER THAN EFFECTIVE DATE OF THE FINAL RULE]:

• You may seek or accept a job with any company or any person—even if they compete with [EMPLOYER NAME].

• You may run your own business—even if it competes with [EMPLOYER NAME].

• You may compete with [EMPLOYER NAME] following your employment with [EMPLOYER NAME].

The FTC has published model language in several languages, available here.

Exceptions to the Rule

• Bona Fide Sale of Business: The rule does not apply to noncompetes entered into as part of a legitimate sale of a business entity or ownership interest​​.

• Existing Causes of Action: Noncompete causes of action that accrued before the effective date are not affected​​.

Legal Challenges and Potential Litigation

Like many controversial rule changes, the final FTC rule is expected to face legal challenges on issues like scope and the FTC's authority to regulate noncompetes. Barring an injunction by a federal court, the rule will go into effect in September. 

What’s the current state of the law in California regarding noncompetes? 

In California, under the California Business and Professions Code § 16600 et seq., non-competes in California were already mostly invalidated with very narrow exceptions for specific situations (e.g. the sale of a business). 

Most recently,  California AB 1076, effective as of January 1, 2024, makes it unlawful for businesses to include post-employment noncompete clauses in employment-related contracts or require California-based employees to enter into post-employment noncompete, and requires any business to send individualized notices to current and certain former employees that any noncompete agreement or provisions previously reached (including such post-employment noncompetes) are void.  

So what should a business do? Recommended Next Steps for Businesses

If you’re a business based in California or that has California-based employees, this FTC rule generally won’t change anything for you. As referenced above, California has legislation almost identical to the FTC rule regarding noncompetes. 

These federal rule changes set by the FTC are set to take effect by September. Assuming the FTC rule properly goes into effect, you’ll need to disclose the change to your affected employees using this model language from the FTC and consider adjustments to your current and future employment agreement to remain compliant.

Here Are Ways That You Can Stay Informed and Monitor Compliance

• Monitor Legal Challenges: Stay informed about ongoing legal disputes/challenges and their outcomes​​.

• Review Noncompetes: Assess and update existing noncompete agreements with senior executives and other employees​​.

• Explore Alternatives: Consider using non-disclosure agreements, retention/training repayment agreements, customer and employee non-solicitation agreements, and term agreements as alternatives to noncompetes​​.

For further details and specific advice on your situation, you may wish to consult the compliance guide furnished by the FTC, available here. Archetype Legal PC is also happy to help you understand the implications of these changes and what you might need to do for your own employees or executives.

Feel free to reach out to us via hello@archetypelegal.com to set up a free consultation.

Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Common Founder Mistakes

Hey everyone, Alex here with some stories to share on some pitfalls for founders to watch out for. While not an exhaustive list, here’s a list of common mistakes I’ve seen founders make that harm the ability to raise funds, maintain a productive workforce, and eventually sell the company.

1. Cutting Corners. This includes, but is not limited to, obtaining the necessary professional advice to build the proper compliance, tax, financial, and legal framework to limit issues investors or a prospective acquirer will discover during due diligence and could kill the deal. Dozens of times a year we have clients come to us who used online services and screwed up important things during the formation stage. They then end up paying new attorneys two to three times more than they would have paid had they worked with a competent attorney from the beginning.

2. Lack of a Data Room. The failure to create an organized data room with company records exposes the company to day-to-day operational issues and hinders long-term success. A cap table management platform can be very helpful, and we also advise our clients to set up a company email such as dataroom@[startupname]. Then, whenever the company has signed contracts, scanned copies of corporate records, or financials, leadership can email it to the dataroom@ email and it should help eliminate corporate records from slipping through the cracks. I had a CEO tell me he was up all night trying to close out a deal because he had to track down NDAs, signed employment agreements, confirmation of 83(b) elections, etc. that were requested by the lead investor’s counsel during due diligence. Utilizing a simple alias like dataroom@ email may have eliminated such a stressful evening.  

3. Understanding the Time Commitment That Goes Into Raising Capital. Raising capital can be a full-time job, and founders wear multiple hats. Finding an appropriate balance between product development, establishing the company culture, and making appropriate hires, all while also attempting to track down investment, is extremely difficult. Having a plan of attack that allows founders to manage their time wisely helps reduce burnout and preserve important cash and resources.

4. No Network. As the saying goes, your network is your net worth. Founders can have a great idea, but no track record or connections. You learn a lot when it is not your first rodeo, and that includes making important connections to help open doors. Having advisors who can make important connections goes a long way to creating a path for success.

5. You Need A Story That People Can Get Excited About. When you’re raising capital, you’re actually a salesperson who is convincing investors why your company and vision are a good investment, and getting investors excited about and invested in where the company is going. 

   For example, startup founders come to me often and say, “I’m going to raise money using a SAFE, should it be a discount SAFE or a valuation cap SAFE, I see these are the two popular options”. When this happens, I encourage them to take a step back and ask first if a SAFE is even a smart vehicle to use. 
   
   The SAFE form was created by YCominbator, a prestigious incubator. Therefore, if you’re a startup that is graduating from the program, you’re going to have a lot of investors interested in investing. However, if you have no track record, a SAFE may be a tough sell as (i) it has no interest rate, and (ii) there is no majority date. Therefore, sophisticated investors may want you to consider a convertible note, which may be a more attractive proposal for the investor.
   
   However, let us say you are using a SAFE and need to decide on if you’re going to use a discount SAFE or a valuation cap SAFE.  The decision is tied to your narrative and what and how you’re selling your company and your vision. If your pitch to investors is that you are raising a bridge fund to float you until a large, fixed price round in the next 3-6 months, then a discount is appropriate. You’re selling that you’ll offer a discount as a “thank you” for investing a few months before the round. However, if your pitch is that you’re doing a SAFE round now and then a larger round in 12-18 months, then unless the discount is very large, investors will expect their investment to offer a bigger return than 10-25% increase in value during a period in which the money was tied up in a SAFE and not earning any interest. They’ll want to lock in a valuation cap to achieve a higher reward as an early investor who invested when the company was at its most risky state.

6. Get a Co-Founder with Different, Complimentary Skills. Starting and building a company, and doing so while trying to avoid the pitfalls mentioned above, takes a varied skill set (and a lot of time). Most people will not be able to unilaterally have a great idea, keep company documents organized, negotiate contracts, manage finances, find and utilize a strong network, tell a great story to investors, and raise capital, all while also building a new product or service. While hiring an effective team can take a lot of this off of your plate, having a co-founder whose skills compliment your own will strengthen company leadership and effectiveness.

Hopefully, after you’ve read this article you’ll be able to avoid these kinds of common mistakes. That said, raising money is complicated, so if you still have questions or are looking for help with legal issues for your business, you are more than welcome to contact us at hello@archetypelegal.com.

Beneficial Owner Reporting - Corporate Transparency Act

In 2021, Congress passed the Corporate Transparency Act (“CTA”), a law requiring a new beneficial ownership information reporting requirement as part of the U.S. government’s efforts to make it harder for bad actors to hide or benefit from improper gains through shell companies or other opaque ownership structures.

Starting January 1, 2024, the CTA will mandate "reporting companies" to submit a report to FinCEN, disclosing info about their "beneficial owners." Those formed before 2024 have until 2025 for their initial report. Proposed regulations issued on September 27, 2023, extend the initial report deadline for companies formed between 2024 and 2025 to 90 days from formation. Companies formed after 2025 must report within 30 days.

A reporting company encompasses entities filed within the US or foreign entities doing business within US states, territories, or Indian tribes. There are over twenty types of entities exempt from the reporting requirements. These entities include, but are not limited to, publicly traded companies meeting specified requirements, banks, venture capital fund advisors, insurance companies, inactive entities, many nonprofits, and certain large operating companies.

"Beneficial owners" are individuals who directly or indirectly control or own at least 25% of an entity's ownership interests and it is normal for companies to have multiple beneficial owners. Accountants and lawyers who provide general accounting or legal services are not considered beneficial owners as standard arms-length advisory or other third-party professional services are not considered to be “substantial control.”

For companies formed after 2024, up to two "company applicants" must be identified. A company applicant is an individual who directly files or is primarily responsible for the filing of the document that creates or registers the company. 

Reports will include full legal names, birthdates, current addresses (or business addresses for company applicants involved in entity formation), and ID information from documents like a US passport, driver's license, or foreign passport if no US document is available. If you are required to report your company’s beneficial ownership information, you will do so electronically through a secure filing system available via FinCEN’s website. This system is currently being developed and not available at the time this blog is published.

You can find the answer to many FAQs here, and as new information comes out we plan to create a helpful checklist and other resources to aid our clients with these new reporting requirements. Archetype is committed to helping our community stay compliant, and don’t hesitate to reach out if there is any assistance we can supply on this matter, or any others.

California's Employee Pay Data Reporting Law

On September 30, 2020, California Governor Gavin Newsome signed SB 973 into law, which requires private employers with more than 100 employees (irrespective of employee’s location) to report certain pay data to the Department of Fair Employment and Housing (DFEH) by March 31, 2021 and on a yearly basis thereafter. While California will be the first state to require such employee data be submitted to state agencies, the general requirements of SB 973 won’t be new to many employers. 

Existing federal law currently requires certain employers file with the Equal Employment Opportunity Commission (EEOC) an annual Employer Information Report (EEO-1) which contains employee data. SB 973 seems to mimic the Federal law and posits that on or before March 31st of each year (starting March 2021), private employers in California with 100 or more employees who are also required to file an annual report with the EEOC, must submit pay data to the DFEH related to its employees covering the prior calendar year. For purposes of SB 973, an employee is an individual on an employer’s payroll whom the employer is required to include in an EEO-1 report and for whom the employer is required to withhold federal social security taxes. 

The DFEH will maintain data for a minimum of 10 years and is generally prohibited from making public any personally identifiable information contained within the data submitted. Personally identifiable information submitted to the DFEH under SB 973 requirements would generally be treated as confidential information and most often will not be subject to a California Public Records Act request. 

Employers subject to SB 973 generally have to report the following: 

1. The number of employees by race, ethnicity, and sex for the following job categories: executive or senior level officials and managers; first or mid-level officials and managers; professionals; technicians; sales workers; administrative support workers; craft workers; operatives; laborers and helpers; and service workers. 

2. The number of employees by race, ethnicity, and sex who make an annual amount within each of the pay bands used by the U.S. Bureau of Labor Statistics in the Occupational Employment Statistics survey (including the hours worked by each employee)
   

Employers with multiple establishments will have to file a single report for each establishment and file a consolidated report that includes all employees.  In submitting the data, employers are permitted to provide clarifying remarks on the data, but are not required to do so. Employers are permitted to submit a copy of their EEO-1 Report to satisfy their reporting requirements under SB 973. Failure to comply with SB 973 or provide the required data may result in the DFEH or the Employment Development Department (EDD) seeking an order requiring compliance and the DFEH or the EDD are entitled to recover any costs associated with seeking such an order. 

On November 2, 2020, the DFEH issued a frequently asked questions (FAQ) page to assist with compliance. The current FAQs provide background information on why this data needs to be collected, whether the pay data submitted will be publicly available, various data privacy and protection concerns, and answers other miscellaneous questions to ensure compliance. More information from DFEH and EDD to assist employer-compliance will most likely be released as we get closer to the filing date requirement.