Equity Compensation

Whether a company is gearing up for an acquisition, a growth equity financing, or an IPO, a due diligence review will be an inevitable part of that transaction, and that review will test not only the current business but also the integrity of a company’s historical records. Readiness for that review is critical, as once a diligence process begins, gaps in corporate approvals, equity records, contract management, intellectual property ownership, and regulatory compliance can quickly become leverage for purchase price adjustments, closing conditions, and/or special indemnities. At best, diligence gaps can consume management attention at a time when a company has little bandwidth to spare. At worst, they can detract from a company’s credibility and can have a meaningful impact on deal speed and certainty. Most issues are fixable, but the available solutions often narrow after a deal is already on the table. This article provides an overview of actionable steps leadership at mid- to late-stage private companies can take to make transaction readiness an ongoing discipline rather than a pre-signing scramble.

Set Up and Maintain a Virtual Data Room

Rather than waiting until a letter of intent is signed, companies should stand up and maintain a virtual data room (VDR) early, using records they already keep locally, and treat it as a living repository of critical corporate documents. Management teams that prepare to address anticipated diligence focus areas and maintain organized virtual records early are better positioned when a process launches than teams that start flat-footed. Companies can get a head start by asking outside counsel for a standard due diligence request list, which serves as an organizational and gap-identification tool, as well as an organized table of contents for their VDR. This ensures that documents are comprehensive and indexed by categories prospective investors and acquirers will expect.

The VDR should contain current, fully executed, and dated documents together with all amendments, statements of work, and side letters. Superseded and terminated agreements should be archived, not deleted or mixed with operative versions. One small but time-saving step in setting up a VDR is using a consistent and intuitive naming convention as documents are uploaded, which will help not only management but also third-party reviewers quickly navigate the VDR’s contents. Once a diligence process begins, access should be staged and subject to tiered permissions, with additional controls for competitively sensitive information, compensation data, and litigation files; privileged materials should be withheld or handled through a process designed to preserve privilege. Particularly when a potential buyer is a competitor, or when the underlying material is subject to confidentiality restrictions that do not permit sharing with a potential acquirer or investor, counsel should advise prior to upload and contemplate redactions, clean-team arrangements, and restrictions on downloading or printing. When in doubt, leave it out; it is easier to pause early and evaluate permissions and other protections than to pull back a document after it has been shared.

A word of caution: prospective investors now run AI review tools that can scan an entire data room in minutes, and while that process can generate false positives, it can also magnify every internal inconsistency across the VDR, including in the cap table, contracts, and other materials. As a best practice, keeping the VDR updated quarterly helps identify issues early and positions the company and management to earn credibility from the moment that transaction diligence begins.

Maintain a Corporate Record Book and Organizational Documents

M&A buyers and growth equity investors will expect clean and current corporate governance records. This means prospective investors will review: current versions of the certificate of incorporation (including all amendments) and bylaws; board and stockholder minutes; and fully executed, dated written consents. An improperly compiled consent with a missing signature page or date can cost the company meaningful time and resources to track down or, worse, require corrective action to cure. Every material corporate action should tie out to a corresponding board and/or stockholder approval, including equity issuances, option grants, director and officer elections, and subsidiary formations.

Companies should also at least annually confirm good standing in their state of incorporation and in every jurisdiction in which they are qualified to do business. Outside counsel can obtain verbal good standing confirmations from third-party service providers, often for a nominal or no cost to the company. Good standing lapses can trigger fees, taxes, and penalties and, in many states, can bar the company from bringing suit in local courts until the lapse is cured, although a lapse does not typically invalidate contracts executed while the company was not in good standing. For an additional layer of caution, companies can consider ordering lien and litigation searches from third-party service providers in the same set of jurisdictions.

Ensure Vigilant Capitalization Table Hygiene

The company should expect buyers or investors to request a current copy of the capitalization table and, in the case of an equity financing, a pro forma cap table reflecting the completed round. Most cap table hygiene issues exist well before a contemplated transaction and surface in the diligence process. Common hiccups include unsigned option grants, undocumented stock issuances, unrecorded convertible note draws, and inconsistencies between vesting schedules and employment terms. Cap table accuracy is key: a company’s representations about its capitalization are often treated as fundamental representations, giving buyers or investors the ability to claim breach even for minor discrepancies. Moreover, a messy cap table can be perceived as poor ownership discipline by the company or its management.

With assistance from outside counsel, the company should reconcile the cap table against the stock ledger and equity grant documentation, ensuring that every stock and option issuance is supported by board resolutions, grant agreements, evidence of payment of the exercise or purchase price, and, if applicable, an approved, unexpired equity incentive plan. Each option grant should also be supported by a current 409A valuation that supports the board’s determination of the fair market value of the underlying shares.

Importantly, companies should develop a clear understanding of how antidilution provisions operate and how change-of-control acceleration clauses (single-trigger and double-trigger) may affect the equity/distribution waterfall in a transaction. Modeling these scenarios in advance allows management to communicate the deal economics clearly to all stockholders and avoids last-minute surprises that can derail negotiations.

Understand Key Provisions in Material Contracts

Counsel for buyers and investors will expect the opportunity to review each contract that is material to the business. These typically include: contracts with key customers and suppliers above certain revenue or expense thresholds; license agreements; leases; employment and severance agreements with key personnel; and other contracts that are important to the business. These contracts often contain change-of-control consent triggers, rights of first refusal, out-licensing restrictions, most favored nation provisions, exclusivity, non-solicit, non-compete, and other restrictive covenants. In certain circumstances, a counterparty may have a notice, consent, or termination right in connection with a transaction. Accordingly, with the help of outside counsel, a company should be generally aware of which key agreements contain those provisions and should have a plan for obtaining consents or providing timely notice in advance of entering into a transaction process. Seeking consent late in the process can give leverage to the counterparty, which can increase overall costs and decrease deal certainty.

Confirm Intellectual Property Ownership and Assignment of IP

Depending on the company’s core business, clean IP title is often a significant driver of the diligence process. One consideration that comes up time and again is whether every founder, employee, and contractor who contributed to the company’s IP portfolio has executed an invention assignment agreement that assigns all intellectual property rights to the company. It isn’t uncommon for advisors and early contributors in early-stage companies, often compensated in equity, to miss the assignment paperwork altogether, or to execute, but not date, the assignment. Any gaps in assignment should be addressed ahead of the buyer or investor diligence process, which can be done with the help of outside IP counsel. Companies should also routinely conduct an audit of open-source software usage to confirm compliance with applicable license terms.

Maintain Compliance with Industry-Specific Regulatory Requirements

Companies operating in regulated industries, such as healthcare, financial services, energy, and government contracting, should confirm that all material licenses, permits, and registrations are current and in good standing. Identifying regulatory approvals or notices that would be required in connection with a change-of-control or assignment of a license can avoid an additional layer of investor diligence caused when gaps are identified later in the deal negotiation process. Regulatory non-compliance discovered during diligence can significantly delay closing or reduce deal certainty.

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.

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.

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.