Employee Matters

When allegations of corporate misconduct surface, one of the first questions companies may face is who should oversee the response. In some circumstances, an investigation led by management or in-house counsel may be appropriate. But allegations involving senior executives or directors, mission-critical compliance risks, or questions about management’s independence may require the board — often through an independent committee — to take a more active role.

In a new article for Reuters Practical Law, Sidley partner Holly J. Gregory examines when a board-driven investigation may be warranted and how boards can structure those investigations to withstand scrutiny from regulators, prosecutors, shareholders, and courts.

The article also considers recent Delaware decisions addressing directors’ responses to compliance red flags and highlights practical considerations for board-led investigations, including committee independence, investigative scope, preservation, privilege, documentation, whistleblower protections, self-disclosure, reporting, and remediation.

In more challenged private company financing environments, down rounds (i.e., an equity financing at a lower valuation than a prior equity financing) often go from a relatively uncommon occurrence to a more common aspect of many growth equity and venture capital financings. The interrelated impact of geopolitical and macroeconomic events such as valuation resets from post-pandemic highs, public and private market liquidity constraints, prolonged fundraising cycles, and shifts in bargaining power can have profound effects on growth equity and venture capital financing dynamics, making down rounds and valuation pressure more common. Down rounds have significant implications for all participants in the venture ecosystem: founders and management teams, investors, employees, and fund limited partners.

This article focuses on the basic mechanics of conversion price-based anti-dilution protections for convertible preferred stock. Anti-dilution protections need to be considered in the context of the impact on the pricing of the down round in question, and also on the potential impact of future adjustments.

Anti-Dilution Protections

In any equity financing, two types of dilution can occur when a company issues new shares: (1) percentage dilution occurs because the issuance increases the number of outstanding and fully-diluted shares, reducing an existing holder’s ownership percentage if that holder does not maintain their ownership percentage through additional investment, and (2) economic (or price) dilution occurs when a company issues shares at a price that is lower than the conversion price applicable to an investor’s shares, reducing the value of that investor’s position on an as-converted basis.

The conversion price-based anti-dilution protections discussed below are intended to mitigate economic (or price) dilution and the resulting percentage dilution on an as-converted basis. Investors may also help protect against percentage dilution through preemptive rights, which can permit pro rata participation in later financings, whether those are up rounds or down rounds.

Below is a simple illustration of how dilution can occur:

• Before a down round, if Investor A purchased 2,500,000 shares of convertible preferred stock at a price of US$5 per share, and after that financing there were 10,000,000 shares of the company outstanding, Investor A’s US$12,500,000 investment would represent a 25% ownership stake in the company.
• In the down round, the company sells 5,000,000 new shares to investors (other than Investor A) at a price of US$4 per share.
• Following the down round, Investor A continues to own 2,500,000 shares of convertible preferred stock, now out of 15,000,000 outstanding shares of the company, representing a decreased ownership stake in the company of 16.67%, valued at approximately US$10,000,000.

To help protect against the scenario above, Investor A would typically have negotiated for price-based anti-dilution protection when it originally purchased its convertible preferred shares. In a down round, these protections operate to adjust Investor A’s conversion price and therefore the rate at which those shares ultimately convert into common stock. There are two main types of conversion price-based anti-dilution protection: (i) full ratchet and (ii) weighted average.

Full Ratchet

While less common in practice, there has been an increased use of full-ratchet anti-dilution protections to bridge valuation gaps (sometimes, with a sunset date). When used, they can have a profound impact on down-round financing. With full ratchet anti-dilution protection, the conversion price applicable to Investor A’s convertible preferred shares is reset to the new lower price per share from the down round (which is US$4 in the example above), meaning each preferred share from then on would convert into 1.25 shares of common stock.

Now, as a result, if those preferred shares convert, Investor A would own 3,125,000 shares of common stock out of 15,625,000 outstanding shares, meaning Investor A would therefore have a 20% ownership stake (which is less than Investor A’s initial 25% stake, but greater than the 16.67% stake Investor A would have been left with without this full ratchet protection).

Full ratchet protection is not common, but when it does exist, the resulting impact in a down-round financing can be profound.

Weighted Average

Weighted-average anti-dilution protection is far more customary. With weighted-average anti-dilution protection, a formula is used to determine a new conversion price that will apply to existing preferred shares following a down round:

• New Conversion Price = Old Conversion Price * [(X + Y) / (X + Z)]
  • X = the number of shares outstanding on a fully-diluted basis before the down round.
    • Note that the nuances of the X variable are sometimes negotiated, with a company preferring a broader approach (often referred to as the “broad-based” weighted-average formula) that includes all shares on a fully diluted basis, and an investor preferring a narrower approach (often referred to as the “narrow-based” weighted-average formula) that excludes certain types of derivative shares such as options and warrants. The broad-based weighted-average formula is more commonly used.
  • Y = the number of shares that would have been issued to new investors in the down round had the full investment been made at the old price per share (which is US$5 in our example above).
  • Z = the number of shares issued to new investors in the down round at the new price per share (US$4 in our example).

In our example, the resulting math would be:

New Conversion Price = US$5.00 * [(10,000,000 + 4,000,000) / (10,000,000 + 5,000,000)]

• US$5.00 * [(14,000,000) / (15,000,000)]
• US$5.00 * [0.933]
• US$4.67

Under this approach, the adjusted conversion price applicable to Investor A’s convertible preferred shares is now US$4.67, meaning each of Investor A’s preferred shares is convertible into 1.07 shares of common stock.

Now, if those preferred shares convert, Investor A would own 2,675,000 common shares out of 15,175,000 outstanding shares, meaning Investor A would therefore have a 17.63% ownership stake (which is less than Investor A’s initial 25% stake, and less than the 20% stake Investor A would have had with full-ratchet protection, but more than the 16.67% stake that would have resulted without any protection).

Economic Dilution

As mentioned above, conversion price-based anti-dilution protections are designed to reduce the impact of percentage dilution, but they also mitigate economic dilution. Continuing with our example:

• Before the down round, the value of Investor A’s as-converted stake in the company was US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$5.00 * 2,500,000)
    • US$12,500,000

• Without any anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,500,000)
    • US$10,000,000

• With full-ratchet anti-dilution protection, the value of Investor A’s as-converted stake in the company would remain US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 3,125,000)
    • US$12,500,000

• With weighted-average anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,700,000 instead of US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,675,000)
    • US$10,700,000

Down Round Pricing Must Be Modeled Holistically

These anti-dilution mechanics may be familiar to and understood by most management teams, investors, and advisors, but the practical implications are often not as straightforward. In practice, the negotiated enterprise value, or pre-money valuation, of a company is typically set at the outset of a negotiation, but the resulting per-share price often is not. The per-share price must generally be solved for after giving effect to anti-dilution adjustments, any option pool increase, and the resulting post-closing capitalization. When solving for this price per share, if anti-dilution adjustments would be triggered, the result is that the end-result number of as-converted shares outstanding will be higher than otherwise, which can prompt an iterative calculation. The end-result number of as-converted shares outstanding, and therefore the preferred price per share, must be solved for again.

Existing investors’ anti-dilution protections typically create a direct economic tension with the investors proposing to lead the down-round financing. This is because new investors typically bargain for a specified ownership percentage and expect their investment to buy it. Existing investors may seek to maximize the value of their anti-dilution adjustments. Common stockholders and other unprotected holders, including management and employee option holders, end up bearing much of the resulting dilution and often are most heavily “crammed down.” On the other hand, existing and new investors typically want to ensure that the management team is protected and appropriately motivated, so the option pool increases, the number of end-result fully diluted shares outstanding again changes, and the entire iterative calculation dance begins again. Add in the fact that many down rounds are led by some subset of existing investors, and the tension around the per-share price calculations increases further.

Because of these dynamics, down-round pricing should not be modeled by simply picking a per-share price. Instead, the agreed pre-money valuation, anti-dilution adjustments, option pool increase, and post-closing ownership targets should be modeled together and holistically to ensure that the intended transaction is delivered.

Discussions over a down-round transaction often expand well beyond pricing mechanics and can raise questions about participation, including the potential emergence of a pay-to-play dynamic, board fiduciary duties, voting power, minority equityholder protections, contingency planning for future financing, potential waivers of anti-dilution protections, control-investor risks, the consent process, and the consensus-building required to secure key approvals.

One of the most common legal missteps among emerging companies involves the classification of the people doing the work. In the earliest days of a startup, founders often bring on talented individuals as “consultants” or “independent contractors,” compensating them primarily or exclusively with equity. This arrangement feels natural when cash is scarce and everyone is pitching in to build something from the ground up. But what begins as a practical solution can quickly become a significant legal liability if the company does not revisit these classifications as it matures and secures funding.

This article provides a high-level overview of the risks associated with worker misclassification, the key legal frameworks that govern these determinations, and the steps founders should take to clean up classification issues before they become costly problems.

The Common Pattern: Early “Consultants” Who Are Really Employees

It is extremely common for pre-revenue startups to engage early team members as independent contractors or consultants. The logic is straightforward: The company cannot yet afford salaries, payroll taxes, or benefits, so it issues equity in exchange for labor. On paper, the individual signs a consulting agreement, invoices the company (or doesn’t), and is treated as a 1099 worker for tax purposes.

The problem is that many of these individuals are, as a matter of law, employees regardless of what the agreement says. Classification is not a matter of mutual agreement between the parties. It is determined by the nature of the working relationship under applicable federal and state law. If the engagement looks and feels like employment, then government agencies and courts are likely to treat it as such.

When these individuals are never reclassified, the company accumulates exposure over time. That exposure includes unpaid wages, overtime, employment taxes, penalties, and potential liability under both federal and state law. These issues often surface at the worst possible moment: during due diligence for a funding round, an acquisition, or in response to a complaint filed by a disgruntled former worker.

Why Reclassification Should Be a Priority After Funding

Securing any meaningful financing event should serve as a trigger for the company to revisit every worker classification. There are several reasons for this.

First, the original justification for the consulting arrangement, namely the inability to pay cash compensation, has likely changed. Once the company has capital, it has the resources to bring workers onto payroll and provide the protections required by law. Continuing to classify a worker as an independent contractor when the company now has the means to pay wages and withhold taxes weakens any argument that the arrangement was legitimate.

Second, investors and their counsel will scrutinize the company’s employment practices during due diligence. Misclassification issues are a well-known red flag. Unresolved classification problems can delay or even derail a financing, reduce the company’s valuation, or result in specific indemnification obligations imposed on the founders.

Third, as the company grows, the risks multiply. More workers mean more potential claimants. Longer periods of misclassification mean larger back-pay and tax liabilities. And the shift from a small, informal team to a structured organization makes it increasingly difficult to argue that any given worker was genuinely operating as an independent business.

The bottom line is that reclassification is not merely a housekeeping exercise. It is a critical step in putting the company on sound legal footing for its next phase of growth.

Federal Law: The Key Frameworks

At the federal level, worker classification is governed by several overlapping tests, depending on the statute at issue.

The Fair Labor Standards Act

‍The FLSA uses an “economic reality” test to determine whether a worker is an employee or an independent contractor. The inquiry focuses on whether the worker is economically dependent on the company or is in business for themselves. Factors include the degree of control the company exercises over the work, the worker’s opportunity for profit or loss, the worker’s investment in equipment or materials, the permanence of the relationship, the degree of skill required, and the extent to which the work is an integral part of the company’s business. The Department of Labor has historically taken a broad view of employment under this test, and the consequences of misclassification include liability for unpaid minimum wages and overtime, liquidated damages, and attorneys’ fees.

The Internal Revenue Code

‍The IRS applies a common-law test that examines the degree of control and independence in the relationship. The IRS groups relevant factors into three categories: behavioral control (whether the company directs how the work is done), financial control (whether the company controls the business aspects of the worker’s role, such as how the worker is paid and whether expenses are reimbursed), and the type of relationship (including written contracts, benefits, and the permanence of the engagement). Misclassification under the tax code can result in liability for unpaid employment taxes, penalties, and interest. In some cases, officers of the company may face personal liability under the trust fund recovery penalty.

Exempt vs. Non-Exempt Classification

‍Once a worker is properly classified as an employee, the company must also determine whether the employee is exempt or non-exempt under the FLSA. Exempt employees are not entitled to overtime pay, but they must meet specific salary and duties tests. The most commonly applicable exemptions for startups are the executive, administrative, professional, and computer employee exemptions. Each requires that the employee be paid on a salary basis at or above a specified threshold and that the employee’s primary duties satisfy specific criteria. Founders should not assume that simply paying a salary or giving someone a managerial title is sufficient. The analysis turns on the actual duties performed, not the job title.

State Law: Where the Rules Get Stricter

Many states impose classification standards that are more restrictive than federal law, and compliance with federal standards alone does not guarantee compliance at the state level.

California’s ABC Test

‍California applies a particularly stringent standard under its ABC test, codified by Assembly Bill 5. Under this test, a worker is presumed to be an employee unless the hiring entity demonstrates that the worker (A) is free from the company’s control and direction in performing the work, (B) performs work that is outside the usual course of the company’s business, and (C) is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. Prong B is often the most difficult to satisfy for startups, because early workers are typically performing tasks that are central to the company’s core business. California law also provides for significant penalties for misclassification, including penalties under the Private Attorneys General Act, which allows employees to bring representative actions on behalf of the state.

Other Notable State Frameworks

‍Several other states have adopted or are moving toward ABC-style tests, including Massachusetts, New Jersey, and Illinois. New York applies a similar multi-factor test and has aggressive enforcement mechanisms. States vary considerably in their approaches, and companies with remote workers in multiple states must ensure compliance in each jurisdiction where a worker is located, not merely where the company is headquartered. Founders should be particularly attentive to any state in which the company has workers, as the applicable test is generally determined by the worker’s location.

Cleaning Up Past Misclassification

For companies that have already been operating with misclassified workers, there are several steps to consider when undertaking a remediation effort.

The first step is to conduct an honest internal audit. Identify every individual who has been engaged as a contractor or consultant and evaluate each engagement under the applicable federal and state tests. Determine which individuals are likely misclassified and assess the duration and scope of the exposure.

The second step is to consult with experienced employment counsel. Remediation strategies vary depending on the jurisdiction, the number of affected workers, the duration of misclassification, and the company’s financial position. In some cases, the IRS Voluntary Classification Settlement Program may be available, which allows companies to prospectively reclassify workers with limited look-back liability in exchange for a modest payment. Similar programs or settlement frameworks may exist at the state level.

The third step is to transition misclassified workers to employee status going forward. This includes placing them on payroll, withholding applicable taxes, providing required benefits, and ensuring compliance with wage and hour laws, including proper exempt or non-exempt classification.

The fourth step is to address the equity arrangements already in place. Early equity grants made to individuals who should have been classified as employees may have been structured as contractor grants, which have different tax treatment than employee equity awards. Companies should work with both employment counsel and tax advisors to evaluate whether corrective filings or revised equity documentation are necessary, particularly with respect to Section 409A of the Internal Revenue Code, which governs deferred compensation and imposes significant penalties for noncompliance.

Finally, companies should implement classification policies and procedures that will prevent these issues from recurring as the company continues to hire. A brief intake process for every new engagement, whether employee or contractor, can go a long way toward ensuring that the correct classification is applied from the outset.

The Department of Justice announced a US$21.5 million settlement with five Deloitte entities to resolve allegations under the False Claims Act, the federal statute that penalizes companies for submitting false claims for government money. Notably, the DOJ alleged that the companies’ employment practices violated Title VII and the standard equal opportunity clause found in federal contracts, and that billing the government while out of compliance amounted to a false claim. The case is the second settlement secured under DOJ’s Civil Rights Fraud Initiative, a cross-agency enforcement push that pairs the False Claims Act with other tools such as the Equal Credit Opportunity Act. For startups, the relevant exposure is real: companies that sell to federal agencies and their subcontractors are bound by the equal opportunity clause, Title VII, and the compliance obligations that come with them.

For private companies backed by venture capital investors, acquisition is frequently the most likely path to liquidity. Founders are often laser-focused on product development, market expansion, and fundraising, without devoting the same early-stage discipline to ensuring the company is well-positioned for a future exit via a merger or acquisition.

M&A preparedness is not a late-stage exercise, but an operational strategy to position your company as an attractive, high-value target to potential acquirors.

Corporate Governance

Some of the most common obstacles to efficient M&A processes stem from issues related to corporate governance. Complex capitalization tables, unclear chain of equity ownership, and unresolved governance issues can create transaction delay and, depending on the structure of the transaction, loss of leverage.

Companies should consider focusing on three key areas of corporate governance to be prepared for future M&A processes: capitalization table discipline, stockholder rights, and board and stockholder alignment.

Capitalization Table Discipline

Maintain clear documentation of all equity issuances with proper board and stockholder approvals; confirm board minutes are complete, approved by the board, and signed; verify that 83(b) elections have been timely filed with respect to restricted stock grants to founders and early employees; and ensure 409A valuations are updated following major events that may impact valuation (such as a financing) and, absent such events, at least annually.

Stockholder Rights

Ensure all stockholders have signed the relevant stockholder agreements and that the company’s management team understands the protective provisions embedded within such agreements; similarly, ensure that the company’s management team is familiar with relevant provisions of any investor side-letters (think drag-along mechanics, rights of first refusal, and co-sale rights).

Board and Stockholder Alignment

Understand what approvals are required to approve a sale or merger of the company and whether any investor has blocking rights.

Contracting Discipline

Material contracts, such as key vendor and customer agreements, collaboration agreements, and licensing arrangements, are some of the first diligence requests in an M&A process. These contracts often contain assignment or change-of-control provisions that can require third-party consent, accelerate payment obligations, or trigger termination rights or other contractual rights that could significantly impact the trajectory of a deal. Accordingly, it is important for companies to maintain clear records of all material contracts, ensuring that all contracts are fully executed and include all attachments, exhibits, amendments, and restatements. Companies should track whether any material contracts have upcoming renewals or expiration dates. Additionally, tracking key provisions in such material contracts that may be triggered by an M&A (such as third-party consent requirements) will help streamline the M&A diligence and consent process.

Intellectual property is another value-driver for life sciences companies and technology companies, making it vital for companies to have documentation that clearly delineates intellectual property ownership. Companies should verify that all employees and contractors have signed Proprietary Information and Inventions Assignment Agreements (PIIAAs), review consulting agreements to confirm that intellectual property created by consultants/contractors has been validly assigned to the company, and obtain confirmatory assignments from founders and early contributors, if needed, and at the appropriate time. For companies with affiliated entities, confirm that the company’s core intellectual property assets sit within the target entity and not within any affiliated entities.

Being proactive can save time and expense during the M&A diligence process.

Regulatory Compliance

Depending on industry and geography, regulatory risk can become a gating diligence issue. Companies should identify areas of risk and preemptively resolve any outstanding compliance risks (e.g., data integrity, marketing, industry-specific licensing, etc.). In particular, life sciences companies should consider pursuing regulatory planning with the assistance of healthcare and/or FDA counsel (as needed) to ensure, among other things, that regulatory filings, communications, and approvals are complete and accessible.

Deal Team Preparation

Once the company has decided to start a sale process, identify at the outset who will be part of the core deal team, which will typically consist of a select number of employees and outside advisors. Members of executive management and other key internal personnel with specialized knowledge about the company’s corporate governance, labor and employment practices, employee benefits structure, assets (IP, real estate, etc.), litigation exposure, and regulatory compliance are typically included within the core deal team. Further, at the appropriate time, companies should engage outside advisors, such as outside legal counsel, financial/tax advisors, and investment bankers, all of whom can help quarterback the transaction and efficiently drive the deal process.

After the deal team is in place, consider implementing deal confidentiality procedures to maintain the integrity of the sale process:

• assign code names to the project and company participants;
• limit working group size and access; and
• consider antitrust issues and the use of “clean team” agreements and data rooms.

Data Room Readiness

Prepared companies treat diligence readiness as an ongoing process and not an exercise triggered by a letter of intent or term sheet. First, select a virtual data room that provides strong security and activity tracking. Second, build the company’s data room with organizational discipline, using logical folder structures (corporate, IP, finance, regulatory, benefits, etc.) and uploading documents in a searchable, digital format with consistent document naming conventions. Lastly, in connection with building the data room, flag with the guidance of deal counsel any confidentiality concerns and access restrictions that need to be put in place. For example, are there any documents that need to be redacted or anonymized? Does the transaction present antitrust sensitivity requiring documents to be shared through a “clean room”?

In all, a well-maintained and categorically organized data room significantly accelerates a sale process and signals sophistication to potential acquirors.

The most successful exits rarely begin when a banker is engaged. Ideally, they begin years earlier with strategic and operational foresight. Companies that understand the value of M&A preparedness can preserve negotiation leverage and act more decisively when M&A opportunities arise. After all, engineering an exit is more than closing a deal — it is positioning the company so that the right deal finds you.

Not every liquidity transaction is a “Tender Offer.” Many private company secondary transactions are one-off, individually negotiated sales of shares by a founder, employee, or early investor to a new or existing investor. These transactions avoid much of the regulatory apparatus discussed in our companion article on Tender Offers, but they are far from unregulated and raise their own legal, tax, and practical considerations for the seller, the buyer, and the company.

Secondary Sales vs. Tender Offers

If a secondary transaction does not meet the definition of a “Tender Offer” (a determination made under the Wellman test discussed in another Catalyst article), the Tender Offer rules – including those mandating minimum disclosures, a minimum offering period, withdrawal rights, and others – will not apply. Instead, the terms of each transaction are negotiated between the buyer and the seller, with the company sitting in the middle as the party whose consent is needed and whose stock records must reflect the transfer.

Documentation and Settlement Mechanics

Secondary sales are typically documented in a secondary stock purchase agreement negotiated between the buyer and the seller. Although such agreements typically follow a similar format, they are usually tailored to the transaction at hand, addressing sale mechanics, representations and warranties, waivers and disclaimers, and any additional rights, and they typically feature company consent, the waiver or expiration of rights of first refusal and co-sale rights, and the allocation of transfer costs and taxes.

Settlement mechanics deserve more attention than they often receive. Because private company shares are not held through a clearing system, closing is a coordinated exercise among the buyer, the seller, and the company (or its cap table administrator), and it can get complicated if the seller must first exercise stock options or convert other securities. In that case, the mechanics must often provide an advance of the exercise price to the seller (whether by the buyer or the company), the company’s processing of the exercise, and the calculation and processing of any associated tax withholdings. The agreement should spell out the sequence of events and the responsibilities of each party clearly; note also that option exercises may take several days to process, so the timeline should be clear and precise.

Securities Law Considerations

Exemption from Registration

As these are still transactions in private company stock, they must be conducted in reliance on a valid exemption from the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”). Because the seller is not the issuer, the question is whether the seller can resell its shares without being deemed an “underwriter.” Two approaches have become the most common over the years:

1. The “Section 4(a)(1½)” exemption: Historically the most commonly used exemption, especially prior to the introduction of Section 4(a)(7), this is a product of practice and case law rather than statute. The idea is that a resale by a non-issuer should be exempt under Section 4(a)(1) (which exempts transactions by persons other than issuers, underwriters, and dealers) so long as it is conducted in the manner required of an issuer’s private placement under Section 4(a)(2): generally, a sale to a limited number of sophisticated or accredited purchasers with access to information about the issuer, with no general solicitation and with the purchaser taking the shares for investment. The full list of conditions is longer, and although the Section 4(a)(1½) exemption is typically viewed as a well-trodden path, it requires careful analysis and structuring of each transaction. Note also that there is no statutory safe harbor and no preemption of state blue sky requirements when this exemption is invoked.
2. Section 4(a)(7): Added to the Securities Act by the FAST Act in 2015, Section 4(a)(7) effectively codified the Section 4(a)(1½) exemption into the Securities Act, although it introduced a number of additional requirements (including that each purchaser be an accredited investor, that no general solicitation be used, and that the securities have been outstanding for at least 90 days). Notably, where the issuer is not a reporting company, the seller must make available to the purchaser prescribed information about the issuer, including a description of its business, the names of its officers and directors, and its most recent balance sheet and two years of income statements. Securities sold under Section 4(a)(7) are “covered securities” exempt from state registration requirements, although they remain restricted securities in the buyer’s hands. Section 4(a)(7) was not intended to invalidate the Section 4(a)(1½) exemption when it was introduced and is typically viewed as a more certain path to an exemption for individual secondary transactions.

There are other exemptions that may be available to sellers, including Rule 144, but these are much less frequently used due to compliance complexity and limited availability in light of the typical structure of such transactions.

Antifraud – Rule 10b-5

Secondary sales are frequently marked by an asymmetry of information between the parties. An employee seller may know the company’s operations but not its financing plans; an investor buyer may sit on the board and know both. Whatever the direction of the asymmetry, Rule 10b-5 still applies to the purchase or sale of any security – public or private – and prohibits material misstatements and omissions in connection with the transaction. Insiders who trade with less-informed counterparties while in possession of material nonpublic information face real exposure, as does a company that facilitates such a trade. Parties commonly manage this risk through “big boy” letters and non-reliance provisions, in which each side acknowledges that the other may possess undisclosed material information. These provisions help but are not a complete defense, as their enforceability often turns on the facts and circumstances and their specific wording. As with Tender Offers, any information material to an investment decision should be disclosed to both parties before they commit to the transaction (including by the company, even though it is not a direct party to the transaction).

Corporate Law Considerations

Transfer Restrictions and Protective Provisions

Many VC-backed companies restrict transfers of their shares to third parties. These restrictions typically include a right of first refusal in favor of the company and major investors, co-sale rights, a board consent requirement, and – especially for preferred stock – protective provisions requiring the approval of a majority of the preferred holders for specified actions. Each must be reviewed, waived, or complied with before closing. Protective provisions are easy to overlook: a transfer of shares, a repurchase, or other distribution by the company on account of its stock, or a sale large enough to change the outcome of a class vote may require consents beyond the board. Larger sales should also be checked against “Deemed Liquidation Event” definitions and interested party transaction rules.

Capital Impairment and Distribution Requirements

Where the company itself is the buyer, the transaction is a repurchase and is subject to statutory limits on distributions. Under Delaware law, for example, a corporation may not repurchase its shares when its capital is impaired or when the repurchase would cause impairment, and directors who approve an unlawful repurchase face personal liability. Debt agreements and preferred stock terms frequently add restrictions on repurchases and restricted payments. A company repurchase should therefore be supported by a board determination of available surplus and reviewed against all contractual covenants and protective provisions.

Using the Company’s Consent as Leverage

Because the company’s consent is almost always required, a secondary sale is an opportunity for the company to tidy up its relationships with both the incoming buyer and the departing seller. Companies regularly condition consent on the following:

1. Additional obligations on the buyer, including:
   1. A joinder to the company’s voting, right of first refusal and co-sale, and drag-along agreements, often without the information or registration rights afforded to lead investors.
   2. A market standoff or lock-up agreement in anticipation of an IPO.
   3. Confidentiality obligations and limitations on further transfers of the shares, including to competitors.
2. Releases and confirmations from the seller, including:
   1. A general release of claims against the company.
   2. Confirmation of the seller’s remaining equity, if any.
   3. Reaffirmation of confidentiality, invention assignment, and other continuing obligations, particularly for current and former employee sellers.

Tax Considerations

Tax consequences to both the seller and the buyer deserve special attention and are too often addressed only after the price has been agreed. For the seller, the central questions are whether the gain is capital or ordinary, whether the holding period qualifies for long-term treatment, and whether the shares are qualified small business stock eligible for the Section 1202 exclusion (i.e., QSBS). Employee sellers face additional issues: a purchase price above the company’s most recent 409A valuation may be treated in part as compensation; shares acquired on exercise of incentive stock options may suffer a disqualifying disposition; and so on. Both sides should understand these issues before the price is set, and structuring matters. Parties also often negotiate separate tax obligations and indemnities directly into the agreement.

Secondary sales offer flexibility that Tender Offers do not, but that flexibility comes with the burden of getting each transaction right individually. While that burden is real, it also carries a benefit: the parties can be more thoughtful about structuring, and the company can control timing and negotiate for terms that benefit it.

Despite cautious optimism following an upturn in biotech M&A in mid-2025, development-stage biotech companies continue to face significant financial headwinds including increased layoffs, higher borrowing costs, healthcare pricing reforms, and ongoing market correction following the pandemic-era investment boom. Companies should take proactive steps to build financial resilience: routinely identifying clinical and regulatory inflection points that could threaten liquidity; maintaining robust contingency plans that account for insolvency regimes in all relevant jurisdictions; engaging in fact-finding during periods of financial health to identify potential cash shortfalls; evaluating hypothetical liquidation scenarios early to understand timing and resource requirements; running structured strategic alternative processes (including asset sales, mergers, or licensing deals) well before reaching a crisis point; and budgeting for the time and cost of navigating financial distress, including the reality that dissolution processes can take three or more years to complete.

On April 16, 2026, the Division of Corporation Finance (Division) of the U.S. Securities and Exchange Commission issued an exemptive order (Order), effective immediately, that changes certain rules pertaining to tender offers of securities. The Order covers tender offers for both reporting and nonreporting companies.

The Division’s stated rationale for the Order is threefold: (1) to address market inefficiencies created by the 20-business-day minimum offer period; (2) to reflect technological advancements that enable faster dissemination of, and access to, offer materials; and (3) to reduce offerors’ and security holders’ exposure to unnecessary market fluctuations during the offer period.

Shorter Offer Period for Private Companies

Most notable in the Order, tender offers conducted by private companies, as well as by wholly owned subsidiaries of such issuers for the issuer’s own securities, will now be subject to a 10-business-day minimum offer period.

There are some conditions for this new relief to apply:

• Cash-only, fixed-price consideration. The consideration offered must consist solely of cash at a fixed price.
• Early notice of price or percentage changes. Any change to the percentage of securities sought (beyond the 2% de minimis threshold) or to the amount of cash offered must be communicated to holders no later than 9 a.m. Eastern time on the fifth business day before expiration.
• Notice of other material changes. Any other material change in the terms of the offer must be communicated no later than 9 a.m. Eastern time on the second business day before expiration.

Notably, the Order does not grant any relief to third-party led tender offers, which is expected to result in a clear timing advantage for issuer-led liquidity transactions for private companies.

Shorter Offer Period for Public Companies

For third-party tender offers subject to Regulation 14D, a shortened 10-business-day period is available but only when (i) the offer is made pursuant to the terms of a negotiated merger agreement or similar business combination agreement between the target company and the offeror and (ii) the offer is made for all outstanding securities of the subject class. In addition, the target company must file and disseminate a Schedule 14D-9 no later than 5:30 p.m. Eastern time on the first business day following commencement.

By contrast, for issuer self-tenders subject to Rule 13e-4, the abbreviated period is available when the offer is made for less than all outstanding securities of the subject class.

Conditions Applicable to All Public Company Tender Offers

Regardless of whether the tender offer is a third-party offer or an issuer self-tender, all of the following conditions must be satisfied:

• Cash-only, fixed-price consideration. The consideration offered must consist solely of cash at a fixed price.
• No going-private transactions. The offer must not be subject to Exchange Act Rule 13e-3.
• No cross-border exemptions. The offer must not be made in reliance on the cross-border exemptions under Exchange Act Rule 14d-1(d) or Rule 13e-4(i).
• No competing offer at launch. At the time the offer is publicly announced, the subject securities must not already be the subject of another pending or previously announced tender offer by a different offeror.
• Extension required if a competing offer emerges. If a competing tender offer is publicly announced after commencement, the initial offeror must extend its offer so that it remains open for at least 20 business days from the date it originally commenced.
• Press release with hyperlink at launch. The offer must be announced via a widely disseminated press release or wire service by 10 a.m. Eastern time on the commencement date, including basic terms (identity of offeror, class of securities, consideration, and expiration date) and an active hyperlink to a website where holders can access the tender offer materials.
• Early notice of price or percentage changes. Any increase or decrease in the percentage of securities sought (beyond a 2% de minimis threshold) or any change in the consideration offered must be publicly announced no later than 9 a.m. Eastern time on the fifth business day before expiration.
• Notice of other material changes. Any other material change in the terms of the offer must be publicly announced no later than 9 a.m. Eastern time on the second business day before expiration.

Key Takeaways

The Order offers meaningful practical improvements for liquidity transactions structured as tender offers.

Most significantly, and in light of the increased prevalence of liquidity transactions, including tender offers, in tech among privately held venture capital and private equity-backed companies, parties should now give serious consideration to the meaningful timing advantage that an all-cash issuer-led tender offer would present as compared to other structured liquidity transactions. In addition, for public companies, the Order now offers greater flexibility in aligning tender offer timelines with other typical deadlines that arise in such transactions, including proxy timelines, antitrust, equity compensation, and the Committee on Foreign Investment in the United States.

Of course, the Division expressly noted that all antifraud and antimanipulation provisions of the federal securities laws continue to apply — including Sections 10(b) and 14(e) of the Exchange Act and the rules promulgated thereunder — and that responsibility for compliance with all applicable federal securities laws rests with the offeror.

Federal prosecutors in Manhattan and the Commodity Futures Trading Commission charged a Google software engineer on May 27, 2026, with using confidential internal search data to make money on Polymarket, a platform where people trade contracts tied to whether a specified event will occur. It was the second such case in weeks, following one involving a service member accused of trading on classified information, and it pushed insider trading style theories well beyond stocks and bonds into event contracts.

The charges raise unsettled questions about whether confidential business information is protected in these markets the way it is in securities markets, and how far the CFTC’s enforcement authority reaches. For companies, the immediate concern is that standard insider trading and confidentiality policies were written with company stock in mind and may say nothing about employees trading on outside prediction platforms using nonpublic internal data. Regulators applying familiar fraud theories to a new market is the development to watch.

As prediction markets expand beyond elections and sports to cover corporate, regulatory, and geopolitical events, employees, directors, and other insiders who know something nonpublic may be able to profit from that knowledge without ever touching a share of stock. The government’s position, reflected in the first insider trading case brought over these markets, is that existing insider trading and antifraud principles already apply to event contracts. That leaves a gap for most companies given that standard insider trading policies, confidentiality agreements, and codes of conduct are typically drafted around trading in the company’s own securities and may not reach these platforms at all.

To avoid legal, reputational, and compliance exposure, organizations – whether public or private – should address prediction markets before an incident rather than after, including by: prohibiting misuse of confidential business information, naming prediction markets explicitly in the company’s relevant policies, extending confidentiality obligations to information that could move an event contract, training people on the risk, and adding monitoring and reporting controls.

Incentive stock options (ISOs) have long been a favored form of equity compensation for companies, particularly startups, to attract, incentivize, and retain employees. When properly structured, ISOs offer two key federal tax benefits: (i) ISOs are not taxed as income when granted by the company or exercised by the employee, and (ii) subject to applicable holding periods, any gain on stock acquired from the exercise of an ISO is taxed at a more favorable capital gains rate (however, the spread at exercise may be subject to the alternative minimum tax (AMT)).

But the regulatory framework that gives ISOs potentially advantageous tax treatment comes at the price of their flexibility once granted. What companies may view as a “minor” change to the terms of an ISO may be treated as a “modification” under the tax regulations, which can have significant, unanticipated consequences and, in some cases, cause the ISO to lose its preferential tax treatment altogether, and in the worst-case scenario, become subject to Section 409A and the 20% additional tax thereunder. In such instances, the option no longer qualifies as an ISO and is thereafter treated as a nonqualified stock option (NSO) for tax purposes, meaning that it is taxable upon exercise and any resulting stock is not eligible for favorable capital gains treatment.

Loss of ISO treatment may be frustrating to both companies and their employees, and therefore, it is important to understand the implications of an option amendment before implementation.

Summary of ISO Requirements

In order for an option to qualify as an ISO under Internal Revenue Code § 422, it must satisfy all statutory requirements, including the following, on the date of its original grant:

• Option must be granted to an employee of the company (or its parent or subsidiary)
• Option must be granted under the company’s written equity plan
• Exercise price must be at least equal to the fair market value of the underlying shares (and for employees who are >10% stockholders of the company, the exercise price must be at least 110% of fair market value)
• The term of the option is no longer than 10 years (or no longer than five years for >10% stockholders)
• No more than US$100,000 of shares (based on the fair market value as of the date of grant) may first become exercisable in any calendar year

To the extent an option fails to meet the statutory requirements, or is in excess of the US$100,000 annual limitation, it is treated as an NSO for tax purposes.

Modifications of ISOs

Under applicable tax rules, a “modification” of an outstanding option is generally treated like a newly granted option as of the modification date. “Modification” is broadly defined to include any change that provides additional benefit to the optionholder, regardless of whether the optionholder actually benefits from such changes.

When an option is “modified,” it must re-satisfy all ISO requirements based on and as of the modification date to continue to be treated as an ISO. To the extent that ISO requirements are not met as of the modification date, the option is thereafter an NSO for tax purposes. In most cases, ISO status that is lost due to a modification cannot be restored.

Common Modifications and Their Impact

Companies may contemplate any number of changes to their outstanding options. Most often, companies propose amendments to (i) grant early exercise rights, (ii) accelerate vesting, (iii) extend exercise periods, or (iv) change exercise price.

Grants of Early Exercise Rights

To make option awards more competitive or attractive for its employees, a company may consider granting early exercise rights, which allow employees to exercise outstanding but unvested options, subject to a right of repurchase. Early exercise allows employees to own shares earlier and accordingly start their capital gains holding periods earlier.

While early exercise rights that are added to an option after its original grant date would seem to be a modification because they appear to provide an additional benefit to the optionholder, the ISO regulations specifically provide that this is not a modification of an ISO and can be added without jeopardizing the ISO status.

Acceleration of Vesting

In connection with acquisitions, layoffs, changes in control, or other special scenarios, companies may consider adding single-trigger or double-trigger acceleration terms to outstanding options to allow employees to vest in unvested options upon the occurrence of such events.

As a general matter, accelerating vesting does not itself constitute a modification for ISO purposes. However, acceleration might cause more shares to “first become exercisable” in a single calendar year, potentially causing all or a portion of the option to exceed the US$100,000 ISO limit for that year. Any excess over the limit is treated as an NSO.

Extensions of Exercise Periods

Most employee options are originally granted with a three-month post-termination exercise period (with certain extended periods provided for death or disability and shorter periods for a termination for cause). When an employee departs, a company may consider extending the exercise periods of the employee’s options to allow them additional time to decide whether to exercise them for shares.

Two separate ISO issues arise with respect to extensions: (i) extending the post‑termination exercise window is generally treated as a modification, causing re‑testing of ISO status as of the extension date, and (ii) regardless of any extension, an exercise that occurs more than three months after employment ends (excluding disability or death) cannot receive ISO tax treatment. In other words, if the ISO is in-the-money when the exercise period is extended, it will become an NSO, and even if the option remains an ISO, if it remains outstanding and exercisable after the three-month post‑employment period, it becomes an NSO at the end of such three-month post-employment period.

Adding Exercise Method (such as Promissory Note)

Adding an additional method of exercising an option, such as allowing exercise with a full-recourse promissory note, is typically expected to be treated as a modification, even though this may have been permissible to include when the ISO was granted. If the ISO is in-the-money or otherwise cannot requalify as an ISO at the date of this modification, it would be expected to become an NSO.

Changes to Exercise Price

If the price of a company’s stock decreases over time, a company may consider repricing any underwater options to restore their retentive purpose. Options are “underwater” if the exercise price per share is greater than the current fair market value of the share, meaning that an employee would inherently lose value by exercising their option. To fix this, a company may want to amend underwater options to reduce their exercise price to the current fair market value.

A reduction in exercise price is among the clearest examples of a modification and results in a deemed new grant of the option. Because ISOs must have an exercise price at least equal to the fair market value on the grant date, a repricing to lower that value will generally cause the option to fail the ISO test; however, repriced ISOs generally should be able to re-satisfy all ISO requirements based on and as of the modification date and typically will continue to be treated as an ISO (although if there are changes that make requalification not possible, such as no longer being an employee, the ISO will lose its ISO status in the repricing). Note that repricing can effectively double count prior ISOs, as the repriced grant is treated as a new ISO, such that the award could exceed the US$100,000 limitation when including the prior ISOs as new awards.

Consider the AMT

As a final thought, if the ISO holder would otherwise be subject to the AMT, the loss of ISO status may be less detrimental than for someone not subject to AMT. Losing ISO status would subject the holder to ordinary income tax rates, which may not be dramatically different than the AMT rates (26% or 28%, based on 2026 rates). Additionally, the vast majority of ISOs are not exercised and held for the required ISO holding periods and become NSOs in any event. Accordingly, the loss of ISO status is less impactful than it would otherwise be, although the tax benefits of an ISO when utilized to get long-term capital gain are measurably better where possible.

The last few years have seen a wide proliferation of secondary liquidity programs among VC- and PE-backed technology companies. Late-stage private company VC and growth financings now typically feature a secondary component, and it is not unusual to see secondary-only transactions among revenue-positive technology companies. The wide adoption of these transactions has brought with it a changing landscape of liquidity timeline expectations, valuations, and terms. Additionally, these programs often require careful structuring and a variety of legal and business considerations that are novel even to many experienced executives in technology companies.

Tender Offers vs. Secondary Transactions

When a high-growth company begins thinking about providing liquidity to its shareholders while it is still private, the first question that arises is whether the proposed transaction will be a “Tender Offer” (a legal term that brings with it a number of additional regulatory requirements) or a one-off secondary (a less regulated bilateral agreement between two parties). The determination is often made by legal counsel with reference to the Wellman test, a fairly dated eight-factor legal test that stems from a case called Wellman v. Dickinson. That said, the Wellman test is fairly straightforward and most of the eight prongs are usually met in a “typical” secondary program, in which case the analysis often comes down to the first two prongs, which are determined by reference to the number of potential eligible sellers and what percentage of the overall outstanding company capitalization they represent. The standard is subjective and depends on facts and circumstances – for instance, if an offer is made to hundreds of shareholders representing 10%+ of the company’s outstanding capitalization, you are most likely looking at a Tender Offer.

Tender Offer Rules

Tender Offers implicate U.S. corporate, tax, and securities law, and can equally implicate foreign laws when the eligible sellers are abroad. Private company Tender Offers, however, do offer significantly more flexibility than public company Tender Offers (i.e., no schedules, no SEC review, and more structuring flexibility with respect to the offering terms):

Securities Law

Section 14(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), including the antifraud and antimanipulation provisions contained therein, as well as the extensive rules and regulations promulgated thereunder, including Regulation 14E, must always be considered and consulted when conducting a Tender Offer. Most notably, Tender Offers typically require a disclosure document, a reasonable means to tender the securities, and a minimum open period during which eligible sellers can consider whether or not to participate in the Tender Offer.

It is important to note that, on April 16, 2026, the U.S. Securities and Exchange Commission (SEC) issued an exemptive order that changed some of the rules pertaining to Tender Offers, including the minimum offering period for offers conducted by the company itself rather than directly by a third-party purchaser. An article summarizing these changes is also available on Sidley Catalyst.

In each jurisdiction where an offer is made, including foreign jurisdictions and any relevant U.S. state, local securities laws should also be reviewed.

Corporate Law

Tender Offers conducted by a third-party purchaser implicate corporate law governing transfers of securities and, as is typical for VC-backed technology companies, potential transfer restrictions. Tender Offers may also inadvertently trigger “Deemed Liquidation Event” provisions in the company’s governing documents.

Tender Offers conducted by the company that issued the securities in the first place may implicate rules concerning repurchases or redemptions of securities, impairment of capital, and dividends.

Of course, shareholder protective provisions and other restrictive covenants in equity and debt agreements must be consulted.

Lastly, Tender Offers often implicate interested party and corporate opportunity considerations, as executives and board members are also often eligible to participate, and careful consideration must be given to cleanse any such issues via relevant corporate law provisions.

Tax Law

Tender Offers require extensive tax planning, both with respect to the impact on eligible sellers and on holders of stock options or other employee equity. Section 409A deferred-compensation rules, dividend rules, compensatory versus capital gains treatment, and other tax rules may all be implicated if not carefully structured. It is typically expected that eligible sellers will receive some level of disclosure with respect to potential tax implications of their investment decision.

Structuring Considerations

There are two primary decisions that any company contemplating a Tender Offer must consider at the outset:

1. Eligibility Criteria. Who should be eligible to sell their securities in the Tender Offer? A number of factors are typically considered here, including:
   1. Will the Tender Offer proceeds have a positive or negative impact on employee retention?
   2. Are there early investors who require returns for their funds?
   3. Will there be a “consolidation” effect on the cap table? Will some shareholders be happy to sell and separate from the company sooner than others?
   4. Will there be an expectation of continued liquidity programs?
   5. Will there be a positive or negative impact on the company’s valuation?
   6. How will this impact public perception of the company and its shareholders?
2. Identity of Purchasers. Will this be a direct third-party purchase by a single purchaser or a group of purchasers, or will it be conducted as a repurchase by the company of its own securities? The differences between the two can impact the following:
   1. Time period required for the Tender Offer to remain open.
   2. Primary responsibility for preparing the Tender Offer documents and for the accuracy of those documents.
   3. Difference in fees and costs associated with the Tender Offer.
   4. Whether the company has funds to conduct the Tender Offer or whether such funds must be raised from third-party sources.

Less pressing, but nonetheless important, considerations include which party will pay the fees and costs of the Tender Offer, whether the purchaser will require additional investor rights or side letters, whether any third-party portals or paying agents will be used, and how decisions regarding eligibility, extensions, and the like will be made.

Pricing the Tender Offer

The price offered for the company’s securities in a Tender Offer is often the result of negotiation. That said, there are a few considerations that repeatedly come up as the potential purchaser is considering what price to set for the Tender Offer:

1. The price paid for the company’s securities in the most recent fundraising round. Law firms, secondary market platforms, banks, and others with significant experience in these transactions now have plenty of statistics to share with their clients regarding typical pricing for Tender Offers vis-à-vis the last round, how much time has passed, any discounts, and so on.
2. The likely impact on future fundraising and liquidity opportunities. Tender Offers in companies nearing a liquidity transaction are very common, and pricing in the Tender Offer may indicate the likely valuation the company’s securities will receive in an IPO or M&A transaction. Thus, the pricing serves as a “signal” out to the marketplace as much as to the selling shareholders.
3. The likely impact on the shareholder base. If the company’s shareholders have been signaled for years that they are holding very valuable stock, a discounted price in the Tender Offer may lead to disappointed employees and investors, even though the offer may look like a great deal to the purchaser.
4. Impact on equity incentives. A highly priced Tender Offer may have an impact on the valuation of the company’s securities, including the exercise price of its stock options and the value of its RSAs and RSUs. Depending on which securities are used for equity incentives at the company, the price paid for securities by a third party may require a change of course after the transaction. Companies may also want to consider an exercise or grant freeze during the Tender Offer period, which may impact the company’s ability to hire or retain talent while the offer is open.

Timing and Disclosures

Finally, any company considering a Tender Offer must do so in the context of potential upcoming major transactions, changes in leadership, launches, or other major events that would be viewed as material to an investment decision and therefore would require disclosure to the eligible sellers. Typically, as well, some level of financial information is provided as part of the Tender Offer disclosures, and companies often think about the publicity and timing implications of this. As such, the likely timing of the offering and how it fits within the company’s and the investors’ broader timelines is an important consideration that should be proactively addressed prior to the launch of any Tender Offer.

When it comes to non-competes, the state of California is not like much of the United States. The state maintains one of the most employee-friendly legal regimes in the country when it comes to post-employment restrictions, and those who fail to appreciate the breadth and force of California’s prohibitions risk not only unenforceability but also significant legal exposure.

California’s legal landscape demands that startups and investors approach restrictive covenants with clear eyes. Noncompetition agreements and customer nonsolicitation clauses are void. Employee nonsolicitation provisions are very likely void. And the increasingly popular strategy of repackaging a restrictive covenant as a trade secret protection, including by prohibiting the “use of proprietary information in order to” compete, solicit, or recruit, should be drafted and enforced narrowly to avoid an argument that they are operating as noncompetes in disguise.

The Foundation: Business and Professions Code Section 16600

California’s hostility toward restrictive covenants is rooted in Business and Professions Code Section 16600, which provides, in relevant part, that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Courts have interpreted this provision broadly. Unlike jurisdictions that evaluate noncompetition agreements under a “reasonableness” standard, weighing the employer’s legitimate interests against the burden on the employee, California’s statute operates as a near-categorical prohibition. A contractual provision that prevents a former employee, consultant, or advisor from freely pursuing their livelihood is void on its face, regardless of how narrowly it is drafted, how short its duration, or how limited its geographic scope.¹

The California Supreme Court held that the statute prohibits noncompetition agreements except in narrow statutory exceptions such as the sale of a business or the dissolution of a partnership. The court expressly rejected the argument that California should adopt a “narrow restraint” exception permitting noncompetition clauses that impose only limited restrictions on an employee’s future activities. The message was unambiguous: In California, noncompetition agreements with employees are void.

The Legislature also made it unlawful for an employer to enter into or attempt to enforce a noncompete agreement that is void under California law, even if the agreement was entered into outside of California.

Beyond Noncompetes: Employee Nonsolicitation Covenants

Founders and investors often assume that even if noncompetition agreements are off the table in California, employee nonsolicitation provisions, which are clauses that prevent a departing worker from recruiting former colleagues to join a competitor, remain permissible. This assumption is incorrect, or at least highly precarious.

California courts have increasingly treated employee nonsolicitation covenants as restraints on trade that fall within the ambit of Section 16600. The reasoning is straightforward: If a former employee cannot contact or recruit colleagues they previously worked with, their ability to engage in their profession is meaningfully restricted. They cannot freely build a team, they cannot leverage their professional network, and they are placed at a competitive disadvantage relative to others in their field who are not subject to such restrictions. While some practitioners still debate the outer boundaries of the holding (for instance, whether a narrowly drawn “no-raid” provision aimed at preventing the mass departure of an entire team might survive scrutiny), the prevailing trend in California jurisprudence strongly disfavors employee nonsolicitation covenants of any kind.

For startups, this has significant implications. It is common in the technology sector for key engineers, salespeople, or executives to depart and bring colleagues with them to a new venture. While this can be deeply disruptive to a young company, attempting to prevent it through contractual nonsolicitation provisions is unlikely to succeed in a California court and may expose the company to counterclaims.

Customer Nonsolicitation Covenants: An Equally Hostile Landscape

Customer nonsolicitation provisions - clauses that prohibit a former employee from soliciting or doing business with the company’s clients or customers - face a similarly difficult road in California. The California courts have confirmed they are just as much a restraint on mobility as an employee noncompete.

Some California courts have drawn a distinction between clauses that prevent a former employee from soliciting customers and clauses that merely prevent the misuse of trade secret information (such as confidential customer lists) to solicit those customers. This distinction brings us to one of the most important, and most misunderstood, issues in this area of law.

The Trade Secret “Workaround” That Isn’t

Precisely because California’s prohibition on restrictive covenants is so broad, creative drafters have long sought workarounds. One of the most common is to frame a restrictive covenant not as a restriction on competition or solicitation, but as a restriction on the use of the company’s proprietary or confidential information. Under this approach, an agreement might provide that the employee or consultant “shall not use Company proprietary information or trade secrets in order to compete with the Company,” or “shall not use Company confidential information to solicit Company employees or customers.”

The logic behind this formulation is superficially appealing. California law does, after all, protect trade secrets through the California Uniform Trade Secrets Act (CUTSA) and does permit employers to require employees to maintain the confidentiality of genuinely proprietary information. If the clause is framed as a trade secret protection rather than a restraint on competition, the argument goes, it should survive scrutiny under Section 16600.

The critical question is whether the clause, as drafted and as applied, operates as a genuine trade secret protection or as a de facto restrictive covenant dressed in the language of trade secret law.

Consider a clause that states: “Employee shall not use Company proprietary information in order to solicit Company’s customers.” On its face, this appears to be a narrow, information-based restriction. But in practice, a former employee who spent years managing a portfolio of customer relationships will find it nearly impossible to demonstrate, to the satisfaction of a litigious former employer, that their solicitation of a customer was based entirely on publicly available information and not, in any respect, on knowledge acquired during their employment. The clause effectively gives the former employer a veto over any customer solicitation by the departing employee, because the employer can always allege that the solicitation was informed by proprietary knowledge. The practical effect may be difficult to distinguish from a customer nonsolicitation covenant.

The same analysis applies to clauses framed as restrictions on using proprietary information to compete. A provision stating that the employee “shall not use Company trade secrets in order to engage in a competing business” may sound like a reasonable trade secret protection, but if the employee’s general knowledge of the company’s business strategies, product roadmap, or market positioning is broad enough, the clause effectively prevents the employee from working in the same industry. At that point, it is a noncompete in all but name. The important takeaway is that the inclusion of trade secret language does not immunize a clause that functions as a restrictive covenant.

This does not mean that employers cannot protect their trade secrets. They absolutely can, but they must do so through mechanisms that California law actually recognizes. A well-drafted confidentiality and nondisclosure agreement that identifies categories of protected information and prohibits its disclosure or use is generally enforceable. An employer can also bring a claim under CUTSA if a former employee actually misappropriates trade secrets to gain a competitive advantage. What an employer cannot do is use the specter of trade secret protection to achieve what amounts to a blanket prohibition on competition or solicitation.

Practical Implications for Consultants and Advisors

Much of the foregoing discussion has focused on employees, but the same principles apply with equal force to independent contractors, consultants, and advisors - relationships that are ubiquitous in the startup ecosystem. Technology companies frequently engage advisors under advisory agreements that include restrictive covenants, sometimes imported wholesale from templates designed for jurisdictions where such provisions are enforceable. In California, these provisions are no more valid when imposed on a consultant than when imposed on an employee.

Indeed, the case for enforceability may be even weaker with respect to independent contractors and advisors, who by definition maintain their own businesses and serve multiple clients. A nonsolicitation or noncompetition clause imposed on a consultant who advises several companies in the same sector would directly restrict the consultant’s ability to carry on their independent business and be squarely at odds with Section 16600.

All parties should review their advisory agreements, consulting agreements, and independent contractor agreements to ensure that they do not contain provisions that California law would render void. The inclusion of such provisions does not merely result in unenforceability; under the 2024 amendments, it can result in affirmative liability.

A Word About Choice of Law and Forum Selection

Some parties sometimes attempt to circumvent California’s restrictions by including choice-of-law provisions that designate a more permissive jurisdiction, for example, specifying that the agreement will be governed by the laws of Delaware or New York. This strategy is largely ineffective for individuals who work in California. California courts have consistently held that Section 16600 reflects a fundamental public policy of the state, and they will apply California law to restrictive covenants affecting California-based workers, regardless of the contractual choice of law. Furthermore, it is unlawful to enforce a void noncompete in California even if the agreement was signed outside of California.

For investors conducting due diligence on California-based portfolio companies, this is an area of particular concern. A company whose key employee agreements rely on restrictive covenants (whether styled as noncompetes, nonsolicitation clauses, or trade-secret-based activity restrictions) may have a materially weaker competitive moat than its cap table suggests. Diligence should specifically address the enforceability of employee and consultant agreements under California law and should flag any provisions that may expose the company to liability under the current statutory framework.

Many private companies are having to grapple with the realities of lower valuations. When a new Section 409A valuation values the company’s common stock at a lower price than any past Section 409A valuations relied on to grant prior stock options, the company may want to consider repricing the stock options held by its service providers. Where an existing stock option has an exercise price higher than the company’s current valuation, the result is an “underwater option.”

While repricing can restore some of the incentive and retention value of employee equity, it raises a host of valuation, perception, legal, tax, and accounting considerations that a company must manage.

Is a repricing necessary?

If the decreased valuation is a temporary situation that is expected to shift and change in a short period of time, or the long-term value is expected to be significantly greater than the current price, a repricing may not be necessary. This is particularly true if the value that is added to the option as a result of the repricing is not significant from a long-term perspective (i.e., the adjustment in price is relatively small). For example, if an employee held 1,000 company stock options that were currently priced at $2 per share, but that could be repriced to $1 per share, it may feel like making this change would be a significant repricing. However, if, a few years later, the company were to have a liquidity event where the shares were sold at $100 a share, this repricing only added an additional $1,000 to the total sale amount of $99,000, which is an increase of only 1 percent. Contrast that to a situation where the shares are ultimately sold at $3 a share. Repricing the options to $1 a share would still only add $1,000 to the total sale amount, but that would effectively double the holder’s total sale proceeds from $1,000 to $2,000.

While companies may not be able to predict the ultimate sale price, it is useful for a company to look at what a healthy potential exit will look like and how significant this repricing would be in that context, to ensure there is material value being added as a result of the repricing.

Negative Aspects of a Repricing

At first blush, most people would expect employees would be happy to have their options repriced as it gives them additional potential equity value; however, repricing options can introduce worry about the long-term value and prospects of the equity and, as a result, impact employee morale. Repricing can, and often does, have a positive impact on employees, but employees may also interpret it to mean the equity they hold is decreasing in value and that they are less likely to get the hoped-for. This can be particularly true where there are multiple repricings over a period. Repricing can also impact employees’ trust in management, especially if the message coming from management is about how well the company has been doing during that same period. If the future value of the shares is perceived to be weak, it creates jitters among the service providers and can negatively impact retention and hiring. The impact is exacerbated if the company is in an industry where most companies are doing well, as opposed to general market downturns impacting all similar companies. Finally, a company repricing can be a signal to investors that the company does not perceive as much long-term value in the shares and can actually lead to low-ball investment proposals, creating a self-fulfilling prophecy. Companies need to carefully weigh both the long-term and short-term impact of a repricing and its perceptions by service providers and investors.

Repricing Terms & Participation

If the company has decided that a repricing is necessary to properly incentivize its employees, the next consideration is what terms the company should offer in connection with the repricing. While a private company may be tempted to use the repricing as a chance to add vesting or other terms favorable for the company, anything other than a simple repricing (e.g., changing only the price) adds considerable cost and complexity for the repricing and could trigger the tender offer rules as discussed in more detail below.

Generally, only current service providers can participate in a repricing. This is because the repricing is effectively treated as a cancellation of the prior grant and a grant of a new award at the new price. All new awards need to be granted pursuant to a valid securities law exemption; thus, the repricing is generally limited to service providers that satisfy compliance under Rule 701 (discussed more below). If a significant number of former service providers are impacted by underwater stock options, the company should consult with counsel to determine the best path forward.

Tax Considerations

Any time a company wants to do a repricing, it needs to consider Section 409A compliance and Incentive Stock Option (“ISO”) tax issues.

Section 409A Tax Compliance

Section 409A governs deferred compensation, including stock options, and imposes severe tax penalties on options granted with an exercise price below fair market value. Section 409A penalties include an immediate income inclusion plus a 20% extra tax for the option holder. Any option repricing must therefore be done in compliance with Section 409A. In practice, this means the new exercise price cannot be less than the then-current fair market value of the underlying stock as of the repricing date. To ensure this, companies generally obtain an updated Section 409A valuation before repricing options. The board will use this valuation to set the repriced exercise price at or above fair market value, preserving the options’ exemption from 409A. Furthermore, a single repricing is usually not a risk under Section 409A, but successive repricings may be. While market volatility may tempt companies to repeatedly adjust option prices, serial repricings can be seen as the company not having a fixed price for options (e.g., the repeated repricings are seen as chasing a price to the bottom), which could be a Section 409A violation. Each modification should be carefully considered and tied to a material change in value (not minor fluctuations), and any subsequent repricings should be analyzed for their impact under Section 409A.

ISOs

Repricing an ISO is deemed a grant of a new ISO. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more non-qualified stock options (“NSOs”) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (specifically, the prong requiring the ISO be held for two years from date of grant) will restart from the repricing date. Whether these changes are sufficiently material to require the consent of the option holder or a company tender offer should be analyzed by the company in consultation with its counsel under the terms of the plan (such as plan limitations on ISO grants and changes to existing grants) and applicable securities law.

Securities Law Considerations

A repricing raises securities law issues under Rule 701 and could trigger tender offer issues.

Rule 701

Rule 701 of the Securities Act of 1933 is the primary federal exemption that allows private companies to offer stock options and other equity compensation to employees without registering shares with the Securities and Exchange Commission. Repriced options count toward Rule 701 limits and disclosure thresholds. Importantly, as noted above, a repriced stock option is generally treated as issuance of a new security which must qualify for an exemption at the time of repricing. Therefore, the company must ensure that the repriced options, taken together with other equity compensation issued in the same 12-month period, do not exceed Rule 701’s size limits (the greater of $1 million, 15% of assets, or 15% of outstanding securities). Moreover, if the value of the repriced options, taken together with other equity compensation issued in the same 12-month period at the time of repricing, exceeds $10 million, the company must provide the required disclosures under Rule 701 (financial statements, risk factors) to all participants. Companies should keep in mind that, because Rule 701, by its terms, covers offers to current employees, directors, consultants, and advisors, it is generally not available as an exemption for repricing options to former service providers.

Tender Offer

An issuer tender offer under Rule 13e-4 and Regulation 14E of the Securities Exchange Act of 1934 (the “Exchange Act”) encompasses an offer by the company to security holders to exchange securities, which offer is open for a limited time and involves decisions by the holders. Importantly, a “simple” unilateral repricing that changes only the exercise price to the new Section 409A valuation while leaving the other terms the same is generally not thought to rise to the level of a tender offer. However, an option repricing where the option holder’s consent or action is needed may require compliance with tender offer rules, which are triggered because the option holder is making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company then must observe a host of requirements under the Exchange Act. Also note, if the option is an ISO, keeping an exchange offer open more than 30 days might affect ISO status, so companies with ISOs will sometimes limit the offer window to 29 days to be safe.

Corporate Governance Considerations

A repricing will also raise a number of corporate governance issues, including approval requirements and fiduciary duties.

Board Approval

In almost all cases, repricing will require approval by the company’s board of directors (or a committee with delegated authority). The board should formally approve the repricing terms (who is eligible, new exercise price, timing, etc.) via a resolution. This is both a governance requirement and a key part of the board fulfilling its fiduciary duty (documenting that it considered the repricing and found it in the company’s interest to retain talent). The board should also be mindful of any conflicts of interest that may arise, particularly if grants to the directors are implicated.

Stockholder Approval

For private companies, stockholder approval of a repricing is typically not required unless the company is contractually obligated pursuant to agreements with investors. It is crucial to review the stock option plan documents, the company’s charter or organizational documents, and any investor agreements (such as an Investor Rights Agreement) before proceeding. Credit agreements or other contracts might also restrict modifications of equity incentives.

Fiduciary Duties and Legal Risk

A company’s decision to reprice options should also be evaluated through the lens of fiduciary duties and fairness to all stockholders. While repricing is aimed at benefiting employees (and, by extension, the company, through improved retention), it does effectively transfer potential economic value from existing stockholders to the option holders. Directors must justify the repricing as a reasonable, informed, and fair decision. To withstand scrutiny, the company’s board should document the business purpose, such as, for instance, maintaining team morale and productivity during a downturn. Additionally, to the extent any holders benefiting from repriced stock options are directors, officers, or controlling stockholders of the company, the company should be mindful of the safe harbor requirements under Section 144 of the Delaware General Corporation Law and obtain the appropriate approvals.

Against a backdrop of executive orders targeting diversity, equity, and inclusion (DEI) programs, anti-DEI shareholder proposals, and the post-SFFA v. Harvard legal landscape, companies face growing pressure to reassess their DEI initiatives. To navigate this environment, companies should assess their risk tolerance relative to peers and consider a comprehensive audit of existing DEI policies with counsel. They should also tie their programs to demonstrable business rationale, understand the perspectives of key stakeholders through surveys and listening sessions, maintain a consistent tone at the top, and establish a response team for potential public scrutiny, while monitoring evolving regulatory guidance.

Qualified Small Business Stock (QSBS) has become an increasingly central focus for founders and investors, as awareness of its potential tax benefits continues to grow. If stock qualifies as QSBS, a holder may be eligible to exclude up to 100% of federal capital gains on disposition subject to a cap equal to the greater of (a) $10 million, or $15 million for post-2025 issuances, and (b) 10 times the taxpayer’s initial basis in the shares. Further, with careful structuring and planning, founders and investors can maximize the QSBS exclusion.

In practice, founders, investors, and senior executives often seek confirmation, typically in the form of a company-level analysis or determination letter, that the corporation’s stock satisfies the applicable requirements at issuance. As QSBS planning has become more sophisticated, both the importance of this analysis and the consequences of getting it wrong have increased materially.

Background

Before 2010, the Internal Revenue Code Section 1202 generally provided individual taxpayers with what was, in most cases, a very small tax rate reduction for gains recognized from sales of QSBS that had been held for more than five years.

That all changed significantly following the 2008 financial crisis. In the wake of the crisis, Congress passed the Small Business Jobs Act of 2010 to encourage individual taxpayers to make additional equity investments in startup corporations during the remainder of calendar year 2010. The Small Business Jobs Act of 2010 included an amendment to Section 1202 that, for the first time, provided for a complete U.S. federal income tax exemption (with no application of the alternative minimum tax) for specific gains recognized by non-corporate investors on the sale of QSBS held for more than five years but only if the stock was purchased at original issue in the limited window after September 27, 2010 and before January 1, 2011.

Although initially intended as a tax incentive for stock issued during a limited period, the 0% rate for gains on QSBS became so popular that Congress began expanding it. Congress repeatedly extended the applicable window for issuance of the 0%-eligible QSBS in successive one-to-two-year tranches. In 2015, the Protecting Americans from Tax Hikes Act of 2015 made the 0% rate for specific gains from sales of QSBS a permanent tax benefit. The tax benefits of QSBS have significantly increased in both value and accessibility. In 2025, the One Big Beautiful Bill Act (“OBBBA”), which applies to issuances after July 4, 2025, raised the “cap” on tax-free gains and introduced more flexible holding periods for new investments. The following table highlights key differences between the pre-OBBBA rules and the new rules:

Several requirements must be satisfied before those benefits can be realized and, even if those requirements are met, there are important limitations on the amount of gain that can qualify for the 0% rate. These requirements and limitations are further discussed below.

General Requirements

The general requirements for qualifying for the 0% federal tax rate on gains from the sale of QSBS include the following:

1. Original Issue. The taxpayer must still be a non-corporate entity (individual, trust, or estate) and acquire the stock directly from a U.S. domestic C corporation.
2. Tiered Holding Periods. For stock issued after July 4, 2025, a taxpayer can now receive a partial exclusion earlier: 50% after three years, 75% after four years, and the full 100% after five years. Pre-OBBBA stock still requires a strict five-year hold to receive any benefit.
3. Gross Assets Test. For stock issued after July 4, 2025, the corporation’s aggregate gross assets cannot exceed $75 million (up from $50 million) at the time of issuance. Importantly, the amount of a corporation’s assets at any given time is generally measured by the corporation’s adjusted tax basis in those assets, except when any property is “contributed” to the corporation. In that case, for this purpose the property must be taken into account based on its fair market value at the time of the contribution.
4. Active Business Test. During substantially all of the taxpayer’s holding period of the stock, at least 80% of the issuing corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses. This includes assets used in furtherance of a prospective active business, i.e., startup activities, research and experimentation, and in-house research. It also includes working capital, investments expected to finance research and experimentation or increased working capital within two years, and computer software rights that produce active business royalties. However, after the corporation has existed for two years, no more than half of its assets can be working capital or investments held for future research or working capital. Although many types of trade or business should qualify for this purpose, the following are specifically excluded: any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Also specifically excluded is any trade or business for which the principal asset is the reputation or skill of any of its employees.
5. No Significant Redemptions. The issuer of the stock must not have engaged in specific levels of buybacks (redemptions) of its own stock during specified periods before or after the date of issuance of the stock to the taxpayer.

Exclusion, Limitations, and the Rise of Structured Planning

A non-corporate taxpayer who recognizes gain from the sale of stock meeting the above requirements can thus generally qualify for a 0% federal income tax rate. However, the amount of gain eligible for this 0% rate is subject to a cap. Section 1202(b)(1) states that the aggregate amount of gain for any taxpayer regarding an investment in any single issuer that may qualify for these benefits is generally limited to the greater of (a) $15 million (Post-OBBBA), or (b) 10 times the taxpayer’s adjusted tax basis in the stock. For a taxpayer who invests cash in the QSBS, the basis would generally be equal to the cash purchase price. However, there is a special rule for when a taxpayer instead purchases the QSBS for in‑kind property (that is, other than cash). In those cases, the taxpayer’s basis in the QSBS, solely for purposes of these Section 1202 rules, is deemed to be an amount not less than the fair market value of the property transferred for that QSBS as of the date of such transfer (often referred to as the basis-is-not-less-than-value rule). The general purpose of the basis-is-not-less-than-value rule is to ensure that inherent built-in gain for any property contributed to a corporation in exchange for QSBS does not qualify for the Section 1202 benefits. Only the gains from the sale of QSBS that are attributable to appreciation in value of the QSBS occurring after the date of issuance are potentially eligible for the Section 1202 benefits.

These new rules now theoretically allow for exclusions of up to $750 million for certain large-scale investments and certain other circumstances. As a result, taxpayers increasingly employ planning strategies, such as “stacking” QSBS across multiple taxpayers (e.g., trusts), and “packing” assets into QSBS-eligible entities. These strategies can be effective but require careful implementation and are subject to scrutiny. In May 2026, the Treasury Department signaled that it will be issuing guidance addressing what it sees as abuse of the QSBS “stacking” strategy.

The IRS has shown growing interest in QSBS claims, particularly in large exit transactions. Areas of focus include active business qualification, asset valuation (especially for contributed property), and related-party and restructuring transactions. QSBS remains one of the most compelling tax incentives available to founders and investors, but its benefits are not automatic. As the regime has matured, so have the expectations around compliance, documentation, and planning. For those who get it right, the rewards can be substantial. For those who do not, the cost of missed qualification can be equally significant.

State Conformity

While federal benefits are permanent, state treatment varies wildly. As of 2026, many states, including New Jersey and New York, now align with federal Section 1202 rules, while Alabama, California, Mississippi, and Pennsylvania continue to tax QSBS gains at full state rates. Residents in certain states, including Texas, can achieve a true 0% effective tax rate on QSBS gains by combining the federal exclusion with a lack of state income tax.

Rollover of Gain

A taxpayer other than a corporation (i.e., individuals, partnerships, S corporations, estates, and trusts) may elect to roll over capital gain from the sale of QSBS held for more than six months if QSBS is purchased by the taxpayer during the 60-day period beginning on the date of sale. Accordingly, gain is recognized only to the extent that the amount realized on the sale exceeds the cost of the replacement QSBS purchased during the 60-day period, as reduced by the portion of such cost, if any, previously taken into account. To the extent that capital gain is not recognized, that amount will be applied to reduce the basis of the replacement QSBS. The basis adjustment is applied to the replacement stock in the order in which the replacement stock is acquired.

Treatment for Pass-Through Entities

Gain on qualified stock held by a partnership, S corporation, regulated investment company, or common trust fund is excludable if the entity held it for the required holding period and if the partner, stockholder, or participant to whom the gain passes through held an interest in the entity when the entity acquired the stock and at all times thereafter. However, the partner, stockholder, or participant cannot exclude the gain to the extent that his or her share in the entity’s gain is greater than what it was when the entity acquired the qualified stock.

The Bottom Line

QSBS has evolved from a niche tax benefit into a central component of early-stage investment planning, particularly in light of recent expansions under the OBBBA regime. The increased exclusion caps, more flexible holding periods, and expanded asset thresholds have made QSBS more valuable, and more widely accessible, than ever before. At the same time, these enhancements have accelerated the use of structured planning strategies and heightened IRS scrutiny, raising the stakes for both companies and investors. In this environment, QSBS should be viewed not as a passive benefit but as a strategic framework that requires thoughtful implementation from formation through exit. With proper planning, documentation, and coordination, taxpayers can unlock substantial tax efficiencies; without such planning, the opportunity may be irretrievably lost.

Successful founders often find themselves stock rich and cash poor, with most of their net worth held in illiquid shares. The usual path to early liquidity is a secondary sale, in which a founder sells a portion of existing shares to investors in connection with a financing. FF preferred stock (also called founders preferred stock or Series FF) is a class of stock adopted at formation to make that future secondary sale cleaner and more streamlined. Despite the name, it generally functions as common stock: it carries no dividend or liquidation preference, and it is distinct from the super-voting share classes sometimes used to concentrate founder control.

How It Works

FF preferred stock has a single distinguishing feature: when sold to investors in connection with a future preferred stock financing, it converts into the series of preferred stock being sold in that round. The investor receives preferred stock rather than common stock, and the founder typically receives the preferred price for the shares. The precise mechanics vary by form. Some versions convert automatically upon the sale, some convert at the holder’s option if the buyer pays the same per share price as the new round, and some require board approval; typical forms also permit conversion into common stock at any time and convert automatically into common stock in a qualified IPO.

Three practical rules follow from the tax analysis. FF preferred stock is generally adopted at formation, when founder shares are first issued; adding the class later can carry tax consequences. It is often, but not always, issued fully vested, because shares subject to forfeiture or repurchase may raise additional tax issues; as a result, any vesting sits on the founder’s common shares. And it typically covers only a modest portion of a founder’s holdings, most often 10 to 25 percent, with the balance in common stock.

Why It Exists

The structure responds to two problems with selling common stock at a preferred stock price. The first is tax. A founder who sells common stock for more than its fair market value (which ordinarily sits well below the preferred price) risks having the excess treated as compensatory ordinary income rather than capital gain, and the risk increases if the company facilitates the sale by converting the founder’s common stock into preferred stock at closing. Since FF preferred stock converts by its terms when sold, no corporate action is required at the time of sale, which is generally viewed as more characteristically the type of transaction that should result in capital gain treatment. However, that treatment is not assured and depends on a variety of factors specific to the underlying transaction; the nature of the security sold is merely one such factor. The second is valuation. A founder sale of common stock at or near the preferred price can put upward pressure on the fair market value of the common stock and, with it, the strike price of future option grants. Alternatively, a sale of FF preferred stock that converts into preferred stock mitigates the repricing effect on the common stock. Note that market practice has evolved on this point: secondary sales of common stock at no or a small discount to the latest preferred round have become customary, and selling parties have found ways to work through the issues that FF preferred stock addresses in its absence. Nonetheless, founders often view the implementation of FF preferred stock as a “just in case” move to improve their chances of a successful secondary transaction in the future.

What to Weigh

FF preferred stock is not the norm. It adds drafting complexity and cost to the certificate of incorporation for a benefit that materializes only if investors are someday willing to buy founder shares, which as a practical matter requires a strong company, an oversubscribed round, and a supportive board. Some investors also read the class as a signal that the founders expect early liquidity, and, when the shares are issued fully vested, the company gives up repurchase rights over that portion of a departing founder’s equity. However, when a secondary sale does happen, the structure may have real advantages: the founder can sell at the preferred price rather than at a discount, the company avoids facilitating a sale of common stock above its appraised value, and an oversubscribed round can be accommodated with less dilution because investors buy existing shares. Additionally, the potential tax consequences of such conversion should be addressed on a case-by-case basis.

In almost all cases, one typical feature of FF preferred stock is that it can convert to common stock at the election of its holder at any time, so founders can always elect to eliminate FF preferred stock at a later time if they find its utility no longer of value. Thus, including FF preferred stock at incorporation gives founders flexibility down the road.

A founder-chief executive officer (CEO) whom the board no longer trusts may still hold a board seat, meaningful equity, and a dual-class voting block. A chief operating officer’s departure may activate a key-person provision in a venture debt facility before the company has aligned on a successor or a message. For later-stage private companies, an executive transition is rarely just an employment event: it can become a governance contest, a financing issue, an investigation, a cap-table negotiation, and a litigation risk at the same time. Below is a brief summary of some (but not all) key decisions and steps to consider when leadership changes hands and how to approach such change from inside the impacted organization.

Setting the Stage: Why the Nature of the Departure Drives Everything

Start by deciding what kind of event the company is actually managing: planned succession, negotiated exit, resignation, termination without cause, termination for cause, or an asserted resignation for good reason. These are not labels reserved for the separation agreement or the press statement. The characterization can control acceleration triggers, severance eligibility, notice and cure rights, release leverage, restrictive-covenant arguments, lender or investor notifications, and what the company can say to employees, investors, customers, and the market. An orderly succession may permit a staged handoff; an abrupt exit may require immediate access controls and a parallel fact investigation. Before anyone communicates, align the board, Human Resources (HR), finance, legal, and operations teams on the factual record and decision rights. Confirm the employment agreement, equity plan and award agreements, incentive arrangements, change-in-control terms, key-person provisions, and applicable policies. Labor-law compliance remains the baseline: assess discrimination, retaliation, whistleblower, wage-and-hour, final-pay, accrued-leave, benefits-continuation, and notice requirements, as well as any works-council or collective-bargaining obligations. Honor contractual payment and notice terms, and document the legitimate business rationale and decision process.

Governance and Board Dynamics: Beyond Simple Recusal

When a founder-CEO is also a director, holds protective provisions, or controls a dual-class voting block, removing the executive from an operating role does not necessarily change board composition or voting control. Separate the board’s power to remove an officer from the stockholders’ or, where permitted by applicable law and the governing documents, the board’s power to remove a director. Confirm who can call the meeting, what quorum and voting thresholds apply, whether an investor designation or protective provision is implicated, and whether a voting agreement, charter provision, or side letter constrains the path. A clean termination process can still fail if the company treats a governance problem as an HR action.

When the departure is tied to an internal investigation, run three tracks deliberately: protect facts and privilege; decide whether interim controls or termination for cause are warranted; and assess whether a negotiated separation creates value without compromising the investigation. Use an independent committee or outside counsel when the board’s independence is in question, define the client and privilege purpose at the outset, and keep business, HR, and communications teams on a need-to-know basis.

Investor and Stakeholder Dynamics: When a Departure Becomes a Capital-Structure Event

Credit agreements, venture debt facilities, preferred-stock documents, investor side letters, and material commercial arrangements may contain key-person provisions that require notice, consent, a replacement plan, or a cure period, and may turn silence into a default. The same analysis should cover customer, regulatory, and financing diligence processes already underway.

A departing stockholder-executive may retain board-observer status, inspection or information rights, rights under a voting agreement, or a contractual right to receive notices even after system access is revoked.

Investor relations should be sequenced, not improvised. Decide which directors, lead investors, lenders, and major stakeholders need a direct call, who will make it, and what they need to know about interim leadership, business continuity, financing impact, and customer coverage. Communicate early enough to avoid surprise but only after authority, facts, and the core message are aligned. A single factual narrative is more valuable than a detailed explanation of disputed allegations; document what is being said and to whom, and avoid allowing a departing executive or an investor to define the story through a leak.

Bring the director and officer (D&O) broker and carrier into the analysis early. Confirm notice obligations, extended-reporting or tail coverage, indemnification and advancement rights, and whether the facts could trigger a conduct exclusion or a coverage dispute. An allegation of misconduct can affect both the company’s and the departing executive’s coverage, especially if the company makes admissions or settles before giving the carrier a meaningful opportunity to respond. Separation documents should preserve applicable indemnification and cooperation arrangements, allocate responsibility for notices, and avoid language that unintentionally prejudices coverage.

Negotiation Strategy: Beyond the Severance Check

Map the executive’s priorities – equity treatment, exercise window, health coverage, title or reference, timing, transition, advisory role, indemnification, and departure message – then package concessions rather than negotiating one item at a time. At the same time, separate contractual entitlements from discretionary consideration and validate every term against the employment agreement, equity documents, plan rules, wage laws, benefits rules, and tax constraints.

Departure messaging is another bargaining instrument: agree who speaks, when the statement is issued, how the role is described, what reference is provided, and whether mutual non-disparagement is conditioned on performance. If the parties cannot align, have a short, factual unilateral message ready rather than letting the dispute write it.

Acceleration disputes usually turn on whether the termination was “without cause,” whether the executive established “good reason” and satisfied notice-and-cure requirements, and who had authority to make the decision. That characterization can cascade into vesting, exercise deadlines, repurchase price, dilution, withholding, and the executive’s leverage in a release. Also ask how separation interacts with drag-along, tag-along, transfer restrictions, voting agreements, and investor-consent rights. A departing executive who remains a significant stockholder may still be able to block, participate in, or complicate a sale. Coordinate any repurchase or recovery with wage laws and the governing documents; do not assume the company can simply withhold amounts otherwise owed.

Litigation Risk and Enforcement Strategy: Preserve Optionality Before You Escalate

Test the company’s legitimate protectable interest, the likelihood of irreparable harm, the evidence of competitive risk, and whether enforcement would accelerate disclosure or make the former executive a sympathetic witness. A targeted confidentiality, customer non-solicitation, intellectual-property, or trade-secret remedy – or carefully structured garden leave – may preserve more value than an overbroad non-compete.

A measured demand letter can identify continuing obligations, request return or deletion of information, preserve the company’s position, and invite a controlled resolution. A tolling agreement can protect limitations periods while the parties investigate, and targeted forensic imaging can preserve devices, cloud records, access logs, and transfer history before evidence disappears. Use legal holds, a defensible collection protocol, and an appropriate forensic vendor; overcollection, careless accusations, or an unlawful review of personal data can create the next dispute.

Before finalizing the departure, stress-test whistleblower and retaliation theories. Build a chronology of complaints, investigations, performance actions, protected disclosures, and decision-maker involvement; confirm that the stated rationale is supported by contemporaneous evidence and would have produced the same result absent protected activity. Keep the investigation independent where necessary, avoid labeling allegations as established fact, and ensure the separation agreement and communications do not restrict legally protected reporting. The goal is not merely to win the severance negotiation; it is to prevent the departure from being recharacterized as retaliation after the executive leaves.

Sequencing the Transition: Order of Operations Matters

First, preserve authority, facts, and business continuity: confirm the board action, legal hold, key-person notices, interim coverage, and immediate safety or access needs before the executive is told, where the risk profile permits. In parallel, build two calendars, one for the contested legal and negotiation track and one for the operating track, covering notice, severance and equity modeling, communications, customer and investor outreach, access changes, successor coverage, and knowledge transfer. After notice, execute access changes, device preservation, written reminders, and a controlled handoff in a coordinated sequence. Nonessential courtesy items, such as a reference format or advisory title, can wait until core rights and preservation steps are secured.

Identify mission-critical relationships, approvals, systems, customer commitments, product decisions, financial processes, and pending disputes; assign an owner and a deadline for each item. Use supervised sessions, written inventories, clean-room access, and time-boxed cooperation rather than giving a departing executive broader access simply to make the handoff easier. Decide whether a successor starts before the final day, whether an interim leader fills the gap, which board, customer, investor, and employee communications happen, and who signs off on completion. Document board resolutions, the termination or separation agreement, intellectual-property assignments, release, repayment or repurchase terms, cooperation obligations, successor agreements, authority matrices, and restrictive-covenant terms. Treat the paperwork as an operating control: it must match the actual sequence and must not promise rights the board has not approved.

Trade Secrets and Confidential Information: A Strategic Approach

When facts permit, conduct forensic triage before the departure conversation. Under an appropriate legal hold and applicable privacy and employment rules, identify high-value repositories, privileged files, source code, customer lists, pricing, financing materials, personal-device connections, and access logs; preserve targeted images and logs rather than taking an indiscriminate data grab. Build a trade-secret inventory and identify what makes each item secret: limited access, labeling, contractual controls, training, or technical safeguards. If the contract and applicable law permit, garden leave can serve as a cooling-off tool: maintain pay and benefits while suspending operational access and competitor contact instead of forcing an immediate binary choice between active access and termination.

Remind the executive in writing of confidentiality, intellectual-property, cooperation, non-solicitation, and other post-employment obligations, while preserving applicable indemnification and privilege boundaries. If the executive retains an advisory role or stockholder or observer rights, use segregated, time-limited access and a designated channel rather than blanket credentials. For a competitor departure, conduct a documented risk assessment, monitor only where lawful and disclosed, and escalate suspicious transfers; account for personal data, cross-border rules, and bring your own device (BYOD) before collecting or reviewing content.