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Startup Stock Options: When Companies Block Employee Sales

In the world of startups, stock options have long been heralded as the golden ticket that transforms employees into owners, aligning their interests with the company's success while providing a path to potential wealth creation. To take one example (of the hundreds we could have chosen from), when Cisco acquired AppDynamics for $3.7 billion in 2017, approximately 400 of the company's employees became millionaires through their stock options. The founder, Jyoti Bansal, stated that "dozens of employees" had outcomes of $5 million or more, calling these "life-changing outcomes." That’s the basic power of equity… 

Yet beneath this promising surface lies a complex and often frustrating reality: companies occasionally block employees from selling their common stock in their private startup, even when they have legitimate buyers lined up. This has happened to us as syndicate leads and other investors looking to purchase secondary shares all too often, where boards will allow preferred shareholders (e.g. investor shares) to transact, but block employees (who hold common stock) from selling. 

This practice creates a painful paradox where employees who have earned their equity through years of dedication find themselves unable to realize its value. It’s also been painful for us as potential buyers of these common shares, as it distorts the price of the share by limiting supply (as common shares are now untradable) or outright makes shares inaccessible for a company on secondary markets or elsewhere.  

The Fundamental Structure of Startup Stock

At its core, startup stock typically comes in two primary classes: common stock, which is held by employees and founders, and preferred stock, which is typically held by investors. This distinction is crucial because preferred stock usually comes with special rights and privileges that common stockholders don't enjoy. When employees receive stock options, they're being granted the right to purchase common stock at a predetermined price, meaning employees actually need to put up capital to convert their options to actual shares, and this amount could be substantial, and which they may face a tax bill on despite actually not actually receiving cash (just their earned equity).

The real complexity that thousands of employees face emerges when employees decide to leave a company. Most face a critical decision point: exercise their options within a limited timeframe (usually 90 days) or lose them entirely. This "use it or lose it" scenario creates immense pressure, particularly when the exercise cost is substantial. Imagine working at a company for years, earning your equity, only to face the prospect of either coming up with significant capital to exercise your options (which may end up being worthless if the company goes bust) or watching your options expire worthless (and in doing so potentially leaving millions on the table).

To use an example - let's say an employee joins a startup in 2024 and is granted options to purchase 50,000 shares at a strike price of $1 per share (the fair market value when they joined). After 4 years of vesting, the company has grown and the most recent preferred round values the common stock at $5 per share (determined by a 409A valuation).

Here's the math if they leave the company today:

1. Exercise Cost:

   • 50,000 shares × $1 strike price = $50,000 cash needed upfront to exercise

2. Tax Bill:

   • Paper gain = ($5 current FMV - $1 strike price) × 50,000 shares = $200,000

   • This $200,000 is treated as income for Alternative Minimum Tax (AMT) purposes

   • Assuming a ~28% AMT rate, they would owe approximately $56,000 in taxes

   • This tax bill is due in the year of exercise, even though they can't sell the shares

Total Upfront Cost to the Employee:

• Exercise cost: $50,000

• Tax bill: $56,000

• Total cash needed: $106,000

Potential Outcomes:

1. Good Case: Company gets acquired or IPOs at $20/share

   • Value: 50,000 shares × $20 = $1,000,000

   • Profit after exercise = $894,000 ($1M - $106K)

2. Worst Case: Company fails

   • Shares become worthless

   • Employee loses entire $106,000 investment

   • No tax deduction for regular income tax purposes

   • Can only claim AMT credit in future years

How Corporate Justifies This

Companies and their boards often justify blocking stock sales through a series of interconnected arguments. At the forefront is the issue of cap table management. Companies argue that allowing free trading of common stock would create a fragmented ownership structure that could complicate future funding rounds and make regulatory compliance more challenging. While this concern has merit, it often overshadows the legitimate needs of employees who have earned their equity, and in my opinion is pretty undermined given preferred shareholders may be able to transact without these same transfer restrictions. 

Valuation control represents another key concern for companies. When private company stock trades hands, it can influence the perceived value of the company. Boards worry that unofficial secondary markets might create price discovery mechanisms that could impact their ability to control the narrative around company valuation. This concern extends to potential conflicts with 409A valuations, which determine the strike price for new option grants.

Perhaps most significantly, companies view stock sale restrictions as a powerful tool for information control and employee retention. By limiting stock sales, they can better contain sensitive information and maintain leverage over their workforce. The theory goes that employees who can't easily sell their shares will remain more committed to the company's long-term success. However, this approach can backfire by creating resentment and mistrust among employees who feel trapped by golden handcuffs.

I believe this is candidly unfair, which brings us to the The Human Cost

The impact on employees cannot be understated and I don’t think this is hyperbole. Consider the case of a software engineer who joins an early-stage startup, works tirelessly for four years helping to build the company's core product, and then decides to pursue a new opportunity. Upon departure, they're faced with a daunting choice: come up with tens or hundreds of thousands of dollars to exercise their options within 90 days, or forfeit the equity they've earned. 

Even if they can manage to exercise, as mentioned in the example at the top, they might face a substantial tax bill on gains they can't realize because they're unable to sell their shares.

The stakes of this decision are dramatically illustrated by real-world cases on both sides. 

Take the cautionary tale of early employees at Better.com, who in 2021 exercised their options when the company was valued at $7 billion, paying both the exercise price and substantial tax bills based on paper gains. Many borrowed money or liquidated savings to do so. By 2023, after multiple rounds of layoffs and a failed SPAC merger, the company's valuation had plummeted to a fraction of its peak, leaving these employees with virtually worthless shares and significant debt. 

Similar stories played out at Fast, the one-click checkout startup that shut down in 2022, where early employees had exercised options valued at millions on paper, only to be left with worthless shares and hefty tax bills when the company abruptly ceased operations. Or as seen by Bolt, who actually gave out loans so that employees could exercise their shares that are probably now worthless.  

On the flip side, consider the experiences at companies like Snowflake and UiPath. Several early employees at Snowflake departed between 2015 and 2017, when the exercise costs for their options were over $50,000. Some chose not to exercise due to the high cost. When Snowflake went public in 2020 at an over $30 billion valuation, those unexercised options would have been worth millions – in some cases tens of millions – of dollars. Similarly, early UiPath employees who left before its massive valuation increase faced exercise costs in the hundreds of thousands. Those who couldn't afford to exercise missed out on life changing potential gains. In the case of Snowflake, ex-employees left 72 million options worth $1.27 billion unexercised… 

This scenario plays out repeatedly across the startup ecosystem, creating a peculiar form of golden handcuffs that can trap employees in roles they've outgrown or force them to make life-altering financial decisions with limited information. The inability to sell creates particular hardship for employees who need liquidity for major life events like buying a home, paying for education, or dealing with medical expenses.

The psychological burden is equally significant. Employees must essentially gamble with their financial futures, making high-stakes decisions without the benefit of the inside information available to board members and senior executives. Those who exercise options often find themselves in a precarious position: they've taken on significant debt or depleted savings to purchase shares they can't sell, while those who don't exercise live with the constant fear of missing out on life-changing wealth.

Charting a Better Path

Companies could implement structured secondary markets with regular trading windows and clear rules similar to how SpaceX does with its ongoing tenders. These transactions would allow for controlled liquidity while maintaining necessary oversight of stock transfers.

Modified option structures could also help address these challenges. Companies might offer longer exercise windows after departure, net exercise provisions that reduce the upfront capital required, or early exercise rights with repurchase provisions. Some later-stage companies have already begun shifting toward restricted stock units (RSUs) as an alternative to traditional options, eliminating the exercise requirement entirely.

Company-sponsored liquidity programs represent another promising approach. Regular, structured opportunities for employees to sell a portion of their vested equity could provide predictable liquidity while maintaining company control over the process. This might include annual trading windows, company-facilitated marketplaces, or partnerships with third-party financing providers who can help employees exercise their options.

Building a More Equitable Future

Rather than viewing stock sales as a threat to be controlled, companies should recognize that providing reasonable liquidity options strengthens the equity value proposition and helps attract and retain top talent. This means developing clear, written policies about stock sales, maintaining transparent processes for requesting transfers, and establishing fair appeals processes when sales are denied. I don’t want more bureaucracy, just a fair, reasonable process that doesn’t screw employees while you the founders can sell millions and you the investors can also sell millions with potentially no blocking rights. 

As the startup ecosystem continues to mature with companies staying private now well into the $10B+ valuation in some cases, we must evolve beyond the binary choice between complete illiquidity and unrestricted trading. The solution lies in creating sophisticated frameworks that protect legitimate company interests while acknowledging that employees who have earned their equity deserve reasonable opportunities to realize its value. 

Will it happen? 

Probably not - those who control power like founders, investors and board members really have minimal incentive to do so, but I hope for employees’ sake we see a change. 

If you enjoyed this article, feel free to view our prior articles on related topics: 

• Why Startups Are Shutting Down in Droves

• VC SPV Trends Data → Q3, 2024

• Defending Your Pro-Rata Rights: How VCs and Angels Can Monetize Growth Rounds and Avoid Leaving Millions on the Table

Last Money in is Powered by Sydecar

Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.

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✍️ Written by Zachary and Alex