This alert is the third in a three-part Goodwin series regarding double-vest restricted stock unit awards (Double-Vest RSUs).  As discussed in Part I and Part II of our series, many mature start-up and other high value pre-IPO companies have shifted away from granting stock options to awarding Double-Vest RSUs.  Many of those same companies may be navigating challenging waters at this time or in the near future because Double-Vest RSUs potentially are approaching the end of their term/expiration date without a liquidity event on the horizon.

A critical concept that we covered in Part II (that is a baseline issue to be mindful of in this Part III) is that if a Liquidity Event ¹ does not occur prior to the term/expiration date of a Double-Vest RSU, the Double-Vest RSU must be forfeited because the term/expiration date likely cannot be extended under U.S. federal tax laws.  

With that foundational baseline established, Part III of our series suggests some primary mitigation strategies for companies to consider to prevent grantees from forfeiting their Double-Vest RSUs.  None of these mitigation strategies are a perfect “one size fits all” solution to this problem, and a strategy that is workable for one company may not be a great fit for another.  As explained in greater detail below, most of the proposed strategies will likely require significant advance planning as they will involve delicate employee communications, potential cash outlays, and/or support from investors and external advisors, all of which are context-dependent factors to be taken into account in crafting the best program for a particular company.²

Mitigation Strategy #1:  Waive the Liquidity Event

Companies could waive the Liquidity Event vesting condition and settle outstanding Double-Vest RSUs (that have satisfied the Time Condition³) by issuing shares.  While this approach prevents forfeiture of an outstanding Double-Vest RSU, it does not address the resulting “dry” tax issue, which is that an RSU holder will be taxed on the value of the settled shares, but may not have a source of liquidity to satisfy the resulting tax obligations that must be paid in cash.  Furthermore, RSU holders who received Double-Vest RSUs in connection with their employment are subject to tax withholding on settlement of the RSUs.  Although a company could require employees to pay cash from their personal funds to satisfy these tax obligations, in reality, many employees may not have sufficient savings and disposable income to shoulder this expense, and companies therefore would typically prefer to prevent the cash burden from falling on employees without arranging a funding source.  

For that reason, companies could permit the tax withholding obligation to be satisfied by “net-settling” a Double-Vest RSU (e.g., where the company holds back shares with fair market value equal to the applicable tax withholding amount and then remits its cash to the relevant taxing authorities to pay the applicable withholding taxes).  By net-settling the award, however, a company would take on the burden of using its cash to fund payment of withholding taxes to the relevant tax authorities.  For some companies, this may not be a viable solution as the cash outlay may be too significant and/or they may be in the midst of a cash preservation phase.  Even for companies that have sufficient cash resources to fund these payments, there often remains an open question of whether it is prudent financially for the company to use its cash resources to alleviate the employee tax burden.⁴

Even if a company is willing and able to use its cash resources for these tax withholding obligations, waiving the Liquidity Event potentially carries additional tax risk.  As described in Part II, Double-Vest RSUs are typically structured so that the Liquidity Event constitutes a “substantial risk of forfeiture” for tax purposes, which, among other things, involves consideration of the likelihood that the company will enforce such forfeiture conditions.  If a company were to establish a regular pattern or practice of waiving the Liquidity Event for its Double-Vest RSUs, such a practice could cause a lapse in the substantial risk of forfeiture for other outstanding Double-Vest RSUs and potentially jeopardize the tax position for future Double-Vest RSU awards (even though such awards did not directly benefit from the waiver).  Further, the decision to waive the Liquidity Event condition must be made in the Company’s sole discretion because giving the choice to an RSU holder also could be deemed to be a lapse of the substantial risk of forfeiture potentially resulting in immediate (or earlier) taxation.  As a result, a company choosing to use this strategy will want to plan ahead to the extent there are multiple Double-Vest RSU expiration dates on the horizon, and likely will need to use this approach sparingly. Further, we recommend companies involve their tax counsel and audit firms in decision-making related to this strategy to ensure tax reporting and accounting treatment is properly handled.

Mitigation Strategy #2:  Grant a New Equity Award Before the Double-Vest RSU Expires

A company that is facing an expiring Double-Vest RSU could choose to grant a new equity award before expiration of the Double-Vest RSU.  If properly structured⁵, the new equity award should not be viewed as an impermissible extension of the Double-Vest RSU, however, the company would have to consider several collateral issues, including: 

1. Increased overhang on its capitalization table until the Double-Vest RSUs expire, as there would be duplicative dilution for a period of time.
2. Risk of the Liquidity Event actually occurring before the Double-Vest RSUs expire, which could create a windfall for employees.
3. Stockholder approval for any increase in capitalization and stock plan reserves may be required.
4. Limitations that may be triggered under Rule 701 of the Securities Act (Rule 701), including whether the Rule 701 volume or enhanced disclosure limits are triggered.
5. Assessing what new equity award should be granted to the impacted employee (e.g., a stock option, an RSU, etc.) and if the new award is fully time/service-vested upon grant.⁶ 

Mitigation Strategy #3:  Let the Double-Vest RSU Expire and then Grant a Replacement Equity Award

A company could allow a Double-Vest RSU to expire and then grant a replacement award.  This strategy is likely to be stressful for the grantee because of the uncertainty of whether a replacement award would be granted. Companies generally should not promise to grant a replacement equity award prior to the expiration of the prior Double-Vest RSU because that action may be called into question as an impermissible extension of the prior award for tax purposes.  Tax laws (such as the “step-transaction” doctrine, aggregation and anti-substitution rules under Internal Revenue Code Section 409A, and the “constructive receipt” tax rules in case law and under Internal Revenue Code Section 451) would need to be considered to reduce tax risk.   

Further, the Internal Revenue Service has yet to offer any guidance regarding whether a company should wait before granting a replacement equity award after a Double-Vest RSU expires.  For a company that wants to avoid the potential concern that a replacement award is an impermissible extension of the prior award, the company could consider whether to have a “cooling off” period prior to making a replacement award.  Regardless, companies granting replacement awards should involve their tax counsel and audit firms to confirm that the risk profile and tolerance of the company aligns with that timing and that adverse tax reporting or accounting treatment would not result. 

Notably, this strategy may not work well for companies who have Double-Vest RSU holders with expiring awards who are no longer providing services because most stock plans (and the typical securities law exemptions relied upon by issuers in granting equity awards) require a current service relationship.  Therefore, it is challenging (and may not be possible) to grant a replacement award to an individual who is no longer in a service relationship with the company.   

In addition, as described above in Mitigation Strategy #2, there would also be the collateral issue of what the new equity award should be, and if it should be fully vested upon grant.  Any program designed in response to this issue will be company-specific and will likely consider numerous facts and circumstances, including the company’s retention goals and expected timeline to liquidity.

Mitigation Strategy #4:  Consider Outside Funding Sources⁷ 

Companies could explore outside funding sources as an alternative solution for Double-Vest RSUs that are at risk of expiring. At a high level, this may include:

1. Structuring an investor-initiated Liquidity Program, where the company waives the Liquidity Event vesting condition and settles outstanding Double-Vest RSUs (that have satisfied the Time Condition) by issuing shares and investors increase their equity position in the company and purchase these company shares directly from employees and service providers for cash.⁸
2. Having the company waive the Liquidity Event vesting condition and settle outstanding Double-Vest RSUs (that have satisfied the Time Condition) by issuing shares and offering a Double-Vested RSU holder a short-term promissory note to help pay taxes while the grantee finds a third-party buyer on a secondary market to purchase a sufficient number of shares a short time after settlement to repay the note.  Alternatively, the grantee could instead obtain funding for taxes from another third party (such as a credit union, by taking out a loan from his or her 401(k) plan account (if available), or from an outside equity lending firm).⁹ Once a sale on a secondary market occurs or other funding is secured, the short-term note should be structured to become due and payable to the company.¹⁰ 

Although companies will likely need to retain discretion to approve or disapprove of the potential outside funding sources and liquidity mechanics, these are creative potential solutions that companies may want to explore in advance if they are willing to waive the Liquidity Event and are unable to fund the tax withholding obligations.

Mitigation Strategy #5:  Establish a Liquidity Program to Cash Out the Expiring Double-Vest RSUs

Finally, companies with a bit more risk tolerance might consider establishing a program where Double-Vest RSUs that have met the Time Condition are cancelled in exchange for a cash payment (a Liquidity Program).  The success of such a Liquidity Program is highly fact specific and must be carefully structured to navigate the complexities of U.S. federal tax and securities laws. There are a couple additional considerations that are significant:

1. Similar to Mitigation Strategy #1, a Liquidity Program may erode the tax position that the Double-Vest RSUs were or are subject to a substantial risk of forfeiture on the date of grant and should not be used repeatedly as there is a real risk that multiple Liquidity Program offerings would likely erode the substantial risk of forfeiture position.
2. The Liquidity Program’s purchase should be structured so as not to cause a lapse in the substantial risk of forfeiture for Double-Vest RSUs held by personnel who do not participate in the Liquidity Program.  Companies would need to work closely with their legal advisors to determine the appropriate terms and conditions of such a purchase in an attempt to safeguard the substantial risk of forfeiture for any Double-Vest RSUs that remain outside of the Liquidity Program.  This may involve cashing out the participating Double Vest RSUs at a price that is meaningfully less than the current value.¹¹     

Due to the aforementioned issues, companies that consider a Liquidity Program strategy should assess its viability as a solution well in advance of looming expiration dates of their Double-Vest RSUs.

It is likely that there is no perfect solution to the problem of expiring Double-Vest RSUs for many companies.  In our experience, many companies let impacted awards lapse and grant replacement equity awards to current employees, but that approach may not work well for all companies. We recognize that there are unique challenges and risks that apply to each company’s situation.  

Going forward, we are interested in seeing the preventative strategies companies may adopt to avoid the expiring Double-Vest RSU problem making headlines today, including whether companies manage a pivot to RSUs in a different manner, based on the lessons learned by earlier Double-Vest RSU adopters.  For example, private companies may choose to pivot to Double-Vest RSUs later in their growth stage, choose to avoid a pivot to RSU awards until they are publicly-held while continuing to utilize stock options, but with longer post-termination exercise periods, and/or pivot to Double-Vest RSUs on a partial basis and continue to grant stock options on a smaller scale (e.g., 80% Double-Vest RSUs and 20% stock options).  

Double-Vest RSUs were first introduced in the Silicon Valley to solve a multifaceted legal and employee retention issue facing large pre-IPO technology companies following the Great Recession. They were essentially “born” at the intersection of capital and innovation.  We look forward to the next phase of innovation in respect of these awards, and are hopeful that this three part Goodwin series has contributed meaningfully to the conversation and to the innovation process.  

^[1] A Liquidity Event generally refers to a performance-based condition tied to the occurrence of a liquidity event that must occur prior to a specified expiration date.
^[2] The mitigation strategies identified herein are not exhaustive and are focused on holders of Double-Vest RSUs in the United States. The tax treatment, securities laws and other local requirements for Double-Vest RSU awards outside of the United States vary and may apply differently than as described herein, and are not discussed in this article.
^[3] A Time Condition generally refers to a service-based condition tied to the grantee’s continuous service or employment with the company for a specified period.
^[4] The settlement of RSUs also will trigger the “employer portion” of employment taxes.  As a result, if a “net settlement” is utilized by the employer, a company would owe the “employer portion” of the employment taxes in addition to the employee portion of any applicable tax withholdings.  It is important to note that, in the United States, the employer portion of employment taxes is a tax burden that may not be shifted to the employee.
^[5] For example, it likely does not work to have the new equity award be explicitly conditioned on  the expiration of the Double-Vest RSU.
^[6] One potential alternative would be to grant a fully-vested RSU that settles only on a qualified change of control of the company or, subject to the grantee’s continued service, the expiration of any underwriter’s lock-up period following an IPO.
^[7] These alternative funding strategies carry many of the same risks described in the first four mitigation strategies, but they do potentially reduce the company’s burden in funding the cash that is needed to pay and remit taxes.
^[8] This may give rise to the tender offer concerns described in Footnote 12 below. There may also be corporate accounting implications to any investor-initiated Liquidity Program.  For example, if the shares are purchased at a price above fair value on the transaction date, the company may need to recognize the excess as compensation cost.  Further, if the transaction involves a current investor and “immature” shares, depending on the facts and circumstances, the company may need to reclassify both the shares that are sold and other outstanding awards with similar features from equity to liabilities for accounting purposes. As a general matter, shares are considered immature if they haven’t been held for six months or more from the exercise date for options and the vesting date for share awards.
^[9] There are several outside third-party businesses that will provide “liquidity advances” against Double-Vest RSUs on a non-recourse basis.  In addition, this approach may potentially involve the third-party placing a lien on the holder’s shares as collateral, which typically requires advance approval by the company.
^[10] If utilized on broad-based basis, state lending laws may apply and should be consulted. Further, a loan between an employer and an employee should still bear the indicia of bona fide debt, including necessary interest, a fixed term, commercially reasonable repayment terms, among other factors.
^[11] Additionally, because a Double-Vest RSU is a security, a Liquidity Program that is broad-based would typically trigger tender offer rules under securities laws.  A tender offer is a highly complex legal arrangement that will require significant advanced planning, external advisors, and additional expense.

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