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Equity Clawbacks: How to Avoid a Zynga Situation

Here's how you can avoid Zynga's equity snafu if you're considering offering employees stock options.
Mark Pincus, CEO and founder of Zynga
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The dazzling prospect of the “100x” return has brought billions of dollars of venture capital—and some of the greatest minds and employees—to the most innovative and promising companies in the history of commerce. 

For investors, the risk/reward equation, short of all the complexities of negotiating preferred stock and deal terms, comes down to actual dollars invested in very risky ventures. The risk/reward equation for employees (who also make an investment, but in the form of time and talent) is more difficult to pin down. You can see this difficulty play out in the equity clawback drama allegedly unfolding at online gaming start-up Zynga. It raises a fundamental question about employee equity: What is the deal?

The two key features of employee equity—upside potential and risk of forfeiture—provide the answer.  Many employees take the plunge—and risk—to work at a start-up on the hopes of huge equity upside.  Employers (and their VC owners) expect long-term high performance in exchange, and reserve the right to end the employment relationship—and future equity participation—at any time they deem performance to be inadequate.  That is where the risk of forfeiture comes in.  Absent illegal discrimination, an employer can likely terminate an employee, denying the employee any unvested equity, merely because of a sincere belief that the employee is not worth it any more. 

In the run up to an expected multi-billion dollar IPO, Zynga apparently decided that some employees were not worth it anymore.  According to news reports, some employees held restricted stock potentially worth over $200 million, even though the same employees were considered by the CEO to be “missing in action” as workers.  Meanwhile, other, supposedly far more valuable employees, had far less valuable equity stakes than their MIA peers.  The company decided to ask some employees to give up parts of their unvested equity or face termination.

Although the vagaries of applicable state law come in to play, Zynga and companies in the same situation might well win the legal challenges (or reach favorable settlements) if they are careful and honest in their employment practices.  And since fairness or moral arguments on an issue like this are very much in the eye of the beholder, the real issues for businesses are the impact the Zynga situation will have on other companies, and the lessons that can be learned from the controversy.

By exposing the fairly harsh legal reality underlying the quasi-fantasy that equity compensation is (to both employees and employers) partially built upon, Zynga will likely cause employees to view their equity grants as somewhat less valuable.  This, in turn, might result in more demands for faster vesting of equity, up-front fully vested grants or more cash compensation.  More senior employees might also seek a specific term of employment or severance provisions. 

Employers, by the same token, will want to keep the benefit of equity compensation—and, frankly, its lure of great upside—alive and well.  Employers may consider the following: 

  • Understand from the outset that equity compensation is inherently unlimited in value—that is its attraction—and be prepared for the business expectations that, fairly or not, result from this fact.  This understanding might lead to retaining traditional equity compensation for those companies that need maximum incentive effect, or for those that fear a Zynga situation, modifying equity grant practices—perhaps using equity-linked instruments that have built in caps, or relying more on performance rather than time-based vesting.
  • If you have a Zynga situation, use competent employment counsel and make sure to obtain a full release in any negotiated settlement.  As a matter of good practice, don’t downplay what “at will” or “unvested” really mean.
  • Finally, consider enabling senior employees to invest in your stock.  While competent securities counsel will be needed to do this, giving employees the chance to invest their own cash is both a sign of respect and in many cases a more plausible basis for that coveted 100X return.

Ben Orlanski is a corporate and securities partner at Manatt, Phelps & Phillips, LLP. He can be reached at borlanski (at) manatt (dot) com. The views expressed in this article are solely those of the author and not those of Manatt, Phelps & Phillips, LLP or its clients.

IMAGE: Flickr/Joi
Last updated: Nov 23, 2011




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