Breaking The Wheel

A picture of guest post author Tom Ketola

Real World Contract Law

If you’re both the entrepreneurial type and the game developer type, then Tom Ketola is your guy. Tom and I were brothers-in-arms at Wideload Games, where we shared a love of profanity, terrible fashion sense, and a complete disregard for status quos. Tom’s career includes stints at Activision, Jaleco, Konami, and Midway. And that’s just his career in the games industry. He’s also been involved in a number of start-ups, and seen the good, the bad, and the ugly of contracts. After reading my post about conversations for studio co-founders, Tom had a, shall we say, voluminous round of comments on the nuances of shares, acceleration, and vesting. Rather than abandoning me to badly interpret his thoughts, he took pity and offered to share his experience with all of you. I leave you in his capable, knowing, manly hands. Enjoy!


By Reading This Post, You Will Learn

  • What “Acceleration” is
  • The meaning of “Change of Control”
  • How a contract can either incentivize or discourage your employer to terminate your employment during a change of control
  • How you can use contractual Acceleration terms to protect yourself financially
  • The distinction between single- and double-trigger acceleration
  • What a “look back” provision is
  • How vesting works and why having a stock option is distinct from having owning shares of a company

Before You Begin

Before you go any further in this article, I do want to mention that I am not a lawyer. This article is only based on my own experiences and understanding of legal issues. I hope my advice is useful. But you should treat the article as a starting place with your lawyer, and not as legal advice.

The In’s and Out’s of Acceleration

Justin wrote a great high-level overview of contracts and terminology in his post on starting a video game company. I have been working as both an entrepreneur, contractor, and employee at a number of companies through out my career. Based on that experience, I’m going to supplement his article with some real-world examples, why these terms matter, and additional details to look out for.

Justin only briefly touched on Acceleration, so I wanted to go into some more details on how it works. I also want to show you how you can help protect yourself around Acceleration terms.

A Primer on Acceleration

Acceleration is the catchall name for the terms in  contracts that dictate what happens with unvested shares or options that you have in a company. The Acceleration terms normally only kick in during very particular circumstances, what is typically called a “Change Of Control“.

A Change Of Control happens when the majority of shares in a company are sold to an outside party. Or, alternatively, when an IPO (Initial Public Offering) occurs. These terms are often mentioned only briefly, and are not always reviewed carefully. But they may substantially change the outcome for you and your financial interests if a Change of Control happens.

Scenario #1: No Acceleration Terms

Scenario

To help illustrate Acceleration, I’m going to start with an example of what can happen *without* acceleration terms. You join a new startup we’ll call MoonShot. MoonShot has a great business, and you see a lot of potential there. But they’re a startup, so they can’t pay a normal market salary. Or maybe they want to incentivize you while you work long hours trying to get the company running.

In either case, MoonShot issues you 100,000 options, with a 4 year vest and a 1 year cliff. In other words, you will have no options in the company until you have worked for 1 year. At that point you’ll immediately vest 25,000 options. The remainder will vest proportionally each month for the following 3 years, until you’ve vested the entire amount.

You take the job and work long hours for 11 months, and everything goes great. You worked long hours, but the MoonShot’s product has been a knock-out hit and is taking the world by storm. It has destroyed the market for the incumbent player, MegaSoft, as customers flock to MoonShot.

Change of Control

MegaSoft isn’t run by dummies though. It recognizes the threat. Unbeknownst to you, it approaches MoonShot’s founders and offers offers them $50 million dollars for the company.

The founders recognize that the software they’ve worked so hard to create at MoonShot will probably disappear if MegaSoft’s acquisition goes through. But it will provide a nice exit for them, so they take deal, and everyone gets a nice pay day. Everyone, that is, who has vested options. You just need another month and then you’ll get your 25,000 options and your own nice payday.

MegaSoft acquires the company. And on your first day of work at your new employer, you receive immediate notice and MegaSoft terminates your employment. You see, MegaSoft bought MoonShot with the intention of shutting it down and taking a competitor out of the market. If they terminate you, then they also won’t have to let you exercise your options. And, since your work is no longer necessary, it’s far cheaper for them to terminate you (even at the cost of their reputation). And so they make the rational choice and let you go.

The Sad Reality

If this scenario seems like a long shot, you may be surprised. I haven’t had any exits in my career that were life-changing, and I’ve run into similar issues for far less money. It’s never a good idea to incentivize anyone to terminate you. Looking back at our example, Acceleration terms would have prevented you from losing your shares in MoonShot.

Acceleration terms can be written as either “single-trigger” or “double-trigger”. As soon as the company was acquired by MegaSoft, your Acceleration terms would have kicked in (the first trigger). If your contract is written as “single-trigger”, you would have immediately vested some number of shares as soon as the company was acquired.

On the other hand, if your contract is written as “double-trigger”, then you could have remained employed for another month and vested your options. If in this case, however, you are terminated or laid-off (the second trigger), it’s that action that causes the immediate vesting of your options.

Using Acceleration As A Shield

You can add Acceleration-like terms to protect you and the company in different ways. For example, normal acceleration terms do not protect you if there isn’t a change of control. Or there may be cases where 100% acceleration of options may not be realistic. Further, you can have a lawyer add limited acceleration terms. One example: the company can lay off employees, but if they are terminated without cause they automatically vest the next 3 months worth of shares. This still gives the company the option of having at-will employees that are easily terminated. But the employees do get a little extra in shares if they are.

One other thing to keep in mind when you are looking at Acceleration, is a “lookback” provision.

Scenario #2: The “Lookback” Provision

You join a new company after MoonShot called The Mars Project, and this time, you argue for, and get, all the terms I’ve advocated. Because you are such an amazing employee, The Mars Project goes even better than MoonShot. 11 months after you start, The Mars Project gets an acquisition offer from MegaSoft for $200 million, and you’re finally going to get your big pay day.

Unfortunately for you, the founder of the Mars Project are not nearly as honest as the founders of MoonShot. Before the acquisition completes, the founders lay you off to prevent your shares from vesting. Since you were terminated before the acquisition, your normal Acceleration terms do not apply. Your limited acceleration moves you up the vesting schedule by a few months, but you are only earning roughly 25% of what you could have made.

What Can You Do?

You can make sure your contract has a “lookback” provision. In simple terms, this provision should stipulate that, if your company terminates your empoment, and an acquisition or other major event occurs happens within some limited window of time (like 60 or 90 days), then the acquisition has to “lookback”. In this case, the company has to offer give you what you would have earned had they not terminated you. This ties back to the theme of making sure no one is incentivized to terminate you if things go well.

Vesting

Finally, the last term I wanted to make sure to mention is vesting. I’m not going to spend a huge amount of time discussing this, if you want more detail on this, then follow some of the links I’ll mention to read more.

When options vest, you are not actually receiving the shares. Instead you are incrementally earning the “option” to buy them at an agreed-upon price guarantee. That price will be a part of the options that are issued to you, and will generally be based on a discount on the Fair Market Value of the company’s stock at the moment your shares vest.

“Fair Market Value” is a legal term, and so you can lookup (or ask a lawyer) for the precise legal definition. But it works to set the price of the stock to something legitimate, like the price of the last investment round. If you buy the stock at the price guaranteed by your options, also known as exercising your options, then you own the stock. And if you quit or lose your job, that stock cannot be taken away from you.

If you have not exercised your options when you are laid off (or soon after), then your options will generally “expire”. This means that the ability to buy the stock will no longer be available to you. Traditionally, this period of time after termination is between 7 and 30 days.

Having A Vested Option Is Not The Same Thing As Holding Shares

If you do exercise those options, you’ll have to pay for your stock. If your options for MoonShot let you buy the stock at $1, you would still need to be able to pay $25,000 to buy your options. Coming up with that kind of money quickly after you’ve quit or lost your job won’t be easy for most of us.

If you can sell your stock in a public market, then you may be able to get a bank loan to buy the shares. But the company might not be public yet, or there may be restrictions on how long you have to hold on to your shares. In that case, this won’t be an option for you in all likelihood.

There is good news on the solution. This is a rare case where incentives for venture capital firms and employees line up quite nicely. There has recently been a movement to push for much longer periods during which you can exercise your options. Advocates argue for timelines as long as 10 years after termination. The VC firm Andreessen-Horowitz even has a blog post discussing it, and giving their recommendations. I highly recommend reading more about it. The nice part about advocating for this position is that you can do it strongly without turning confrontational because of the aligned incentives.


Further Reading If You Enjoyed This Post

Strong Fences Make for the Best Neighbors: Conversations for Co-Founders

Business School Mini-Lesson: What Is A Synergy?

The Law of One Price – A Business School Mini-Lesson


Knowledge Is Power

That’s it for this article, I hope some of the tips here end up being useful. If possible you should consult a lawyer for all of these terms. But any due diligence and effort you put in before talking to legal council will only serve you.

My lawyers have been helpful when I had specific questions, but I did not always know which questions to ask. And your lawyer probably won’t know enough about your agreement or your knowledge level to explain everything to you.

Again, I’ve run into each of these terms at least once. My knowledge has saved me on more than one occasion. I wish the best to each of you, and I hope you’ll never need to exercise any of these terms. But, for those of you who do end up in a situation where you have to start involving lawyers to resolve a situation will also have the incredibly rewarding experience of seeing your due-diligence pay off.


Key Takeaways

  • “Acceleration” is a catch-all term that encompasses contractual terms dictating what happens to an employee’s stake in a company during a “change of control”
  • Acceleration terms dictate what happens to any shares or options you hold in the company which have not vested
  • “Change of control” refers to scenarios in which majority ownership of one company changes hands, for example through acquisition, hostile takeover, or IPO
  • Depending on how an employment contract is written, it may incentivize or discourage termination of your employment during a change of control
  • “Single-trigger acceleration” means that acceleration occurs during the change of control
  • “Double-trigger acceleration” means acceleration occurs if there is a change of control and  you are terminated without cause
  • A “look back” provision means that if you are terminated without cause within some period of time before a change of control, the change still triggers acceleration
  • Vesting typically happens over years
  • Holding a stock option is not the same thing as holding a share; a stock option gives you the option of purchasing shares at some point in the future at a pre-determined price
  • Longer windows to exercise stock options can serve to align employee and investor interests

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