Finance Hack of the day - Exploiting A startup's stock options Right of First Refusal
When you exercise options at a startup, there is a clause that gives the company the first right of refusal. This is the rule we aim to exploit.
As an early employee 1-7 in Silicon Valley, you are probably looking at .01%-1% in equity. A startup is usually starting out with 10,000,000 shares, meaning you are probably given somewhere in the range of 100,000 shares over a three year vesting. At the end of three years, your hope is they are worth something and more importantly that you have someone to sell them to and don’t have to wait for an IPO. But lets say you don’t want to wait. Lets say you want to sell them on the market to a private investor. Maybe you quit the company, don’t believe in the vision, or disagree with the founders. Now you just want your money. This is the target stock holder we need for this hack.
The exploit uses a little piece in at the startups stock option agreement, which will state that if you sell your shares to a third party the company has the first right to purchase those shares at the price you agreed on with that third party person. What we want (As the exploiter) to happen is to find companies that use the right of first refusal and purchase the shares. How? Well, we will simply take a no risk approach and test the waters. How? Let me explain with an example:
The first part of this exploit is finding an old employee of a startup that has left the company. This is a good sign that they don’t have a close attachment to their stock and are likely happier with cash today than holding out for tomorrow. You make an agreement with this person to purchase there stock for around 50 cents under the previous round of investment price. Lets say the person you contact owns 100,000 shares and are genuinely interested in cashing out their stock. The company within the last 12-18 months went through a Series B with shares were priced at $2. So you make an offer of $1.50 to the person willing to sell you their shares. This is fairly cut and dry. The seller is going to make $150,000 right off the bat at this price and likely paid under 20 cents per share being an early employee. You are simply giving this person the chance for an early exit and cash on their shares. There’s no scam or cheating anyone in this exploit. The trick comes next.
You (The exploiter) make an agreement with the seller that says you are going to tell the startup that you are buying the shares for $2 so the startup is encouraged for the deal to go through as it will be in line with the previous rounds investment, but it’s still probably below what the next round of investors are going to pay, making this is an attractive stock buy back price for the startup or one of its investors. If the startup decides to pull the right of first refusal and purchases the shares at the $2, then the seller pays the exploiter (the guy that put this deal together - You) the difference in the stock price. In this case 50 cents. The seller still made his original $1.50 and is happy and you the exploiter are merely asking for the 50 cent premium for the “work” you did to put the deal together and didn’t end up with any stock. The stock is never the goal. No money has transferred hands and no money is ever risked. if the startup doesn’t pull the right of first refusal, you as the exploiter simply don’t sign the agreement. The key is to push the stock purchase agreement pass the company to see what’s going to happen. If they don’t purchase, that’s the only time the seller who was hoping for $1.50 per share gets stiffed as he no longer has a buyer. You as the exploiter - walk from the deal stating something along the lines of the valuation was incorrect or some hoopla like that.
Your hope as the exploiter is to locate startups that want to keep early round stock prices up and want to keep equity in the company to be used in later rounds to give to new employees. All this comes down to getting the startup to execute its right of first refusal and you the exploiter taking the difference in price between the agreement you made with the stock seller and the price you are submitting to the startup.
This is a numbers game. You only need one employee per startup to test if a company will execute the Right of First Refusal. Once you find a company that does, you go to after every employee at that company with your stock purchase scheme. In the example above a 50 cent spread on 100,000 shares would be a $50,000 profit with $0 risked. You as the investor are experiencing zero risk. This is merely a numbers game.