In the venture capital market, the current crisis is reflected not only in the number of financing rounds, but also in the amount invested in each round. In addition, the valuations that founders can command for their companies have often experienced a sharp decline. Whether the previous valuation, which in many cases was also due to the admittedly very overheated market, was justified or realistic is irrelevant, because a lower valuation on paper alone often leads to the application of so-called down-round protection clauses.

These factors not only have a direct financial impact on startups, but also result in investors negotiating much tougher terms than, for example, in 2021, in a very founder-friendly environment. Since last year, however, the tide has turned, and deal terms have become increasingly investor friendly. In addition to the lower prices that investors are currently paying for shares in a startup due to the lower valuation, they are also obtaining multiple liquidation preferences (i.e., provisions that ensure that the respective investor receives factor X of his investment in advance in the event of an exit). Due to the greater importance of down round protection clauses, negotiations have become more challenging. In addition to extending terms beyond the subsequent financing round, the calculation methods have become more investor friendly.

What are the implications of the above changes for employee stock ownership schemes?

Startups depend on employee stock ownership schemes in the form of ESOPs or VSOPs, as their often lower salaries make them uncompetitive in a highly competitive market for skilled workers. In addition, ESOPs/VSOPs incentivize employees to drive the growth of their company by giving them a direct stake in any increase in value. Employee ownership is therefore an incredibly important tool for increasing employee retention and motivation, which is even more important for a company in times of crisis.

The developments in financing rounds may have a significant impact on the value of employee share schemes, even if it is not immediately apparent.

Why is that? There are two main reasons:

In the event of an exit, increased liquidation preferences, will result in even more money going to the investors before it is paid out to the holders of the ordinary shares - and these are the employees after they have exercised their share options. Similarly, in the case of a VSOP, employees' entitlement to exit proceeds is calculated after all liquidation preferences have been satisfied, so that the employees are economically on an equal footing with the holders of ordinary shares.
In the case of down rounds, i.e., financing rounds with a lower valuation than in the previous financing round, at least the investors in the last financing round (sometimes even beyond) protect themselves by receiving additional shares in the company at par value as compensation for the lower valuation (so-called down round protection). These additional shares result in a further dilution of the employees' stock options.

What can companies do to compensate their employees for these disadvantages? There are two main levers:

First, similar to down round protection for investors, dilution of ESOPs and VSOPs can be compensated by issuing additional option shares. This may involve an increased administrative burden, as the new issuance of option shares in most cases requires a shareholder and/or advisory board resolution, as this also leads to a dilution of the existing shares.
On the other hand, the exercise price of option shares can be lowered in the context of re-pricing, thereby reducing the financial burden on employees when they exercise their options or demand payment. Typically, the exercise price corresponds to the value of a real share at the time the ESOP/VSOP is issued, which is usually the price paid by investors in the last financing round. This prevents employees from being financially better off than other shareholders and ensures that employees only participate in the value creation of the company that occurs after they have been hired. However, the exercise price does not have to be paid in cash by the employees when the (virtual) option shareas are granted but is offset against the employee's entitlement to severance pay on leaving the company or is paid when the option to acquire the shares is exercised. If the exercise price is reduced, whether to the reduced value of the shares because of a down-round or even to €0.00, this directly increases the value of the option shares, even if this only takes effect at the time of exercise. In order to implement the repricing, only the exercise price needs to be adjusted within the framework of the grant agreement with the respective employee. Although the grant agreement is a bilateral contract between the company and the employee, one can assume that the employee's signature will not be an obstacle.

*Source: Crunchbase