Blog Post

Silicon Valley should wake up to clawback culture

There’s been a storm around Skype ever since former employee Yee Lee let rip and accused the company’s investors, Silver Lake, of screwing employees over in its $9 billion sale to Microsoft (s msft). Specifically, Lee was upset by the discovery that his stock options suddenly become subject to “clawback” deals that made his stake in the company (which he had left before the sale) worthless.

With Silver Lake on the ropes, everyone has been jumping in to get their punches in. Michael Arrington almost popped at the prospect of such sneaky clauses; Reuters (s tri) super-blogger Felix Salmon got (rightly) angry about the way the fine print worked. All in all,this bare knuckle brawl sends a simple message: Clawbacks are bad, and they should be fought wherever possible.

A Silicon Valley state of mind

But is it possible to see this any other way? Is it possible that these arguments about clawbacks are just a remnant of Silicon Valley’s cash-rich, founder-happy culture? Evidence from elsewhere would suggest that, at the very least, the entrepreneurs just don’t know how good they’ve been getting it. Let me explain.

In the startup business, clawbacks are usually seen as a feature pushed by private equity, used by investors to exert pressure on staff and maximize returns. In fact, writing on the Financial Times techhub blog (s pso), Richard Waters characterizes it precisely this way — as a conflict between the culture of Silicon Valley venture capital and the clubby world of private equity:

If workers are tempted to cash in after a year or two to move on to the next opportunity – something more likely to happen when prices in the private market are rising quickly, as they are now – then options  contribute to an “exit strategy” culture, not one geared to building long-term value. There are always people who are tempted to “double dip”, says Christos Cotsakos, the founder of ETrade (s etfc) and now chief executive of EndPlay.

Venture capitalists frown on this behaviour but haven’t tried to prevent it. But private equity firms like Silver Lake, which led the Skype buy-out, clearly feel differently – hence the unusual and controversial clawback that caught out Yee Lee.

The truth is, however, that clawbacks are much more common than the reporting may suggest.

Scenes from a European startup

For starters, it’s seen as fairly typical procedure in Europe (where venture capital has traditionally been thin on the ground) and there are a large number of European startups that have clawbacks written into their employment contracts. Of course, that doesn’t mean it’s right — in fact, the terms can often be onerous.

What is certainly very common across European businesses is the so-called “good leaver/bad leaver” provision, which ultimately values an employee’s rights against the reasons they left the company. In general terms, a “good leaver” is somebody who ceases employment because of death, disability or being unfairly dismissed; a “bad leaver” is somebody who chooses to quit of their own accord, breached their contract or was legally terminated.

Doug Monro, a serial entrepreneur in Britain who’s currently working on job site Adzuna, has experience with companies based on both sides of the Atlantic. He told me these provisions, which often amount to clawbacks, were a strong European phenomenon:

“In my experience more EU startups have clawback or ‘discretionary bad leaver’ than in [the] U.S.,” he said, adding that the details of such clauses can be a “big issue for hires to look at.”

They didn’t start the clawbacks

But it’s is not just in European businesses that clawbacks are common. According to a BusinessWeek report from last year, fully 70 percent of America’s largest companies say they have clawback provisions of some form. There are also plenty of examples of other restrictions on employees who leave the business — such as being forced to sell options within a few months of leaving. British computer researcher Lyndsay Williams, who spent 11 years working at Microsoft before being made redundant in 2007, says she was surprised when she realized she had to sell her options quickly.

“I had vested stock options that I was required to sell by Microsoft within three months of being made redundant,” she told me. It turned out well, she says, since the stock value was only getting worse and it gave her money to invest in her own company, Girton Labs. “Given the very disappointing performance of Microsoft share price [being forced to sell] was not really a hardship.”

And remember, too, that this isn’t just about investors vs staff; it can be founder against founder. As British law firm Taylor Wessing outlines the argument in a a briefing document on private equity deals, not having clawbacks or bad leaver provisions can leave those who stay behind irked: “From the continuing founders’ point of view, why should the departing founder get market value if he has left the company?”

And let’s not imagine this is brand new, either. Two years ago, Fred Destin, a partner at Atlas Venture who was based in Europe at the time (he’s now in Boston), highlighted such clauses as a potential minefield for startups and founders. Although he said he “would not do a deal without some form of reverse vesting,” he suggested the details are something founders should watch carefully, and be prepared to negotiate hard over.

“Make sure there is a good leaver/bad leaver clause,” he wrote. “You get fired for cause, you lose some [stock options]. You decide to leave, you lose some. The company decides it does not want you around any more, you keep it.”

That’s just the way things are

So there you have it. Clawbacks are not new, not rare and not necessarily about screwing over founders. The real difference is that they are new to the Valley, so some people are being exposed to them for the first time.

Whether it’s restrictions on bonuses paid to executives at failed banks, or a stick that encourages employees to stick with a business, clawbacks are less unusual than you may have been led to believe. In fact, it’s worth considering that Silicon Valley is the exception rather than the norm — that its tendency towards founder-friendly terms means it has been largely insulated from what’s commonplace in the rest of the world. Are clawbacks right or not? That’s for entrepreneurs and investors to argue between them, but perhaps they should start by realizing it’s time to wake up to what’s really going on out there.

14 Responses to “Silicon Valley should wake up to clawback culture”

  1. Good article. You lay it out clearly.
    The main problem with Skype is that it appeared to obfuscate the claw-back. If option holders knew what the terms were, they’d have no reason to gripe but it does seem that the terms were unnecessarily obscure.

    From what I’ve seen in discussions of the Skype claw-back, the people most outraged are those who have never had their own company and had to deal with these issues from the other side of the table. As a founder/entrepreneur, you’re taking the big risks and putting your life on hold to create your business. When you offer options as enticements to employees, the expectation is that if the company succeeds, the employee will benefit. But if the option holder leaves before putting in their due, why should they benefit at the same level as someone who sticks it out? They shouldn’t, and that’s what the claw-back is for. It’s more fair for everybody.

    Without claw-backs, you’d have companies filled with mercenaries. They’d get their options, work a bit, then leave to pick up options elsewhere.

    Don’t get me wrong, if Skype fired a bunch of people just so they could grab back their options, that’s clearly immoral and they deserve to be slapped for that. But for people to get indignant over the concept of claw-back just shows their selfishness and naivety.

    • I sympathize with your point about mercenaries and wanting to encourage the right behaviors? Why can’t this be achieved through vesting schedules and supplemental options grants?

    • Melinda Byerley

      If the employee added value during the year they were there, why are they not entitled to get the value of the vested shares? Why not change the cliff to 2 years instead of 1?

      • Let me play devil’s advocate for a minute more: if an employee was fairly compensated during the period of their employment, why are they entitled to any added value? Right now, people want it both ways – the security of a salaried job AND stock options. Upside benefit with minimal risk.
        If they were compensated well below market value, gambling on the upside value of their options, that’s a different story.

      • @Ted-san, options are part of the compensation package. When you are hired, you given the option to buy shares that you work to increase the value of. When they revoke the options, you are changing the compensation that was agreed upon. Who said there is minimal risk? And who says what they are getting paid is fair?

      • KenG – that’s why I said ‘if’. There are lots of unknown if’s. Stocks/options in a privately held company typically have no real value until a liquidity event – i.e. the company is sold. Buying the shares back at the initial option price is making the initial purchaser “whole.” and that’s what the shareholder agreements with claw-back clauses stipulate.
        Nobody is entitled to options. If the option recipient does their homework, they should understand the legal details and, if they’re not comfortable with the clause, they can either negotiate a different contract, or forego the risk of the options and work elsewhere. Claiming ignorance, as Lee did, shows that he didn’t do his homework.
        All that said, I personally don’t conduct my business in this manner. Prior to selling my last company, I distributed the outstanding stock to the employees so that they could share in the rewards for the company they helped to build.

      • Ted, come on, buying back options at the option price is not making the employee whole. That term is used when people have suffered a loss, and a counterparty is covering their losses. Buying the options back at cost, instead of at market price, is reneging on a deal. Your point about the options having no real value until there is a liquidity event is not true, and not even applicable in this case. There are many privately held companies (Facebook, for example) whose shares are traded without a liquidity event. And in Skype’s case, there is a liquidity event, the acquisition by MS. But that is irrelevant, as the deal was the employees options were supposed to be vested. Any other compensation they received, fair or otherwise, is meaningless, as the only issue is whether or not the agreement is breached, and the only way Skype can say they are not breaching the vesting clause of the options agreement is by the fact that they tricked the employees with a hidden partnership agreement.

        Yes, nobody is entitled to options, but the issue is not about entitlement. If they are part of an employment agreement, they can’t be unilaterally revoked. I’m not convinced that the clawback clause in the partnership agreement was even there when the employees joined, and even if it was, it was in bad faith.

      • Ken,
        I suspect we could debate these points all day but I’ll try not to spend too much more time on this….
        There are a very small handful of privately held companies whose stock has real value based upon secondary market demand. For every Facebook, there are tens of thousands of companies where the stock has no value. Skype clearly was one of the exceptions.
        Keep in mind, we’re talking about options, not stocks, so they’re one step further removed from having real value. Options are a limited ability to buy stock.
        Yee Lee’s situation was unfortunate, but he left the company well before the liquidity event without exercising his options. If he wanted to share in the upside potential of Skype, he should have purchased the stock before he left. Since he was partially vested, he should have exercised his options.

        If an option holder believes the company stock has value, they should exercise the option and buy the stock. But if they decide to gamble and hold the options, then they better hire a good lawyer and understand the rules.

    • Bobbie Johnson

      Enjoying the discussion, everyone. Thanks for joining in.

      This Skype deal may be an extreme example — obfuscating clawbacks so that employees have no way of knowing that they are subject to those conditions seems very wrong indeed — but I suspect this won’t be the last time that clawbacks come up. A better understanding of them may help prevent us from simply jumping to the conclusion that they are, by their very nature, evil or intended to cheat shareholders.

    • Derek Scruggs

      The notion of vesting has no meaning if Skype-style clawbacks are in place. Period.

      BTW I’ll wager that if this is more common in non-startups, it’s because those companies are already public. The ex-Microsoft person in the article was merely forced to exercise-or-forfeit her options, not give them back. That has a very different meaning in public markets.

      Even in Silicon Valley it’s common to walk away from worthless options. Think of all the Yahoo people with worthless options. They’re vested in something with no value.

      • Good article. Some staff needed to sell stock early to support their family. I was sole financial supporter of my daughter/family for 17 years so needed to sell stock at timely intervals. I was in the good leaver category in the article.

  2. If you get fired for cause or leave on your own, then you lose some? Isn’t this already covered in the vesting schedule? A more honest way to handle this would be to offer an extended vesting schedule, not some complex clause that invalidates the schedule.

    A clawback makes sense for employees who have fraudulently, or through litigation, managed to stay past a vesting milestone, but other applications seem merely deceptive and abusive.

  3. “For starters, it’s seen as fairly typical procedure in Europe”. Maybe that’s why venture funded start-ups in Europe have traditionally not done as well as in the U.S. – the screw the employee attitude employed by investors there does not foster loyalty, innovation, or effort above and beyond the call.

    I’m also not convinced that clawback clauses are that common in US start-ups. Some options agreements I have seen have the right to re-purchase vested shares when an employee leaves, but only at market value. That’s a big difference than having the right to buy them back at cost.

    If PE (or VC) firms want to force employees to stay for the entire length of the deal, they should eliminate the partial vesting, as it is obviously fraud.

    • Bobbie Johnson

      I don’t think they’re common in US startups either, Ken — but it may be that we see a lot more of this as time goes on. But it is common in US businesses in the wider sense.

      It’s a good point about the competitiveness of European startups versus American (it’s certainly arguable that investment holds the crucial role in both ecosystems)