The key balance in secondary sales is to allow for such transactions to occur without impacting a company’s 409A valuation for common stock strike price. The 409A is an analysis you do to set the price for your stock options. If large, company-sanctioned common stock transactions occur at high prices, you will need to reset your common strike price upward, impacting your ability to reward employees.
You should talk to your legal team about the right approach to secondary sales and 409A. In addition, you should consider moving to restricted stock units (RSUs) instead of options once your valuation is over $1 billion and you are within 18–36 months of going public.
Moving to RSUs
At some point it makes sense for most companies to move to RSUs. Early on, RSUs tend to be less tax efficient for employees than early exercise of options and holding stock for capital gains tax treatment. However, once your strike price is high enough, the early exercise cost to an employee is so high that most do not do it—or it wouldn’t be wise for them to do so. (The ’90s saw a number of examples of stock options that were exercised, followed by a big tax bill, and then there was no upside on the actual stock. As a result, employees paid all the downsides of taxes without the upside of stock valuation increases, or in some cases without the cash to pay the tax bills.) Or, they will need to do a secondary sale just to generate enough cash to cover the exercise of all their options.
Eventually, when your company valuation is high and you are within a few years of an IPO, RSUs have equivalent tax efficiency to options. RSUs allow both the company and its employees to avoid the complexities of trying to cover the exercise price of stock, as well as avoid the potential loss if the stock price drops over time.
RSUs also are never “below water,” because they are effectively equivalent to shares of stock, not just options to buy that stock at a certain price. While a stock can end up trading below the option price an employee received, RSUs always have a value equivalent to the value of the stock. This means that “equity” granted to employees as RSUs will always have some value. Stock options, by contrast, may end up with zero value for very late-stage companies, if the strike price is at or below the current stock price.