Hey Chris, I think you hit a nerve. Gusto didn’t respond directly to you (shocking!), but instead sent a generic, derogatory and arrogant internal email — my favorite part is about the IRS. Here is the email:
In light of this https://medium.com/@octopoedi/dear-gusto-mission-is-more-than-marketing-34340e594837#.t1p4zqg0a, a number of you asked me to clarify our stance on employee liquidity. I wanted to provide you with an overview, but also encourage you to take some time to read through Josh’s document that shares in great detail Gusto’s approach on employee equity:
When it comes to selling your stock (or what you’ll often hear referred to as “liquidity”), our approach is to restrict the transfers of stock to certain permitted transfers (including transfers to immediate family or your trust). That means all stockholders (common and preferred) cannot sell their stock to unaffiliated entities without the Board’s consent.
This approach is standard practice. During my time at Fenwick, virtually every startup I helped incorporate decided to structure themselves in this way. Other startups that restrict shares include: Airbnb, Dropbox and Tanium. Many Y Combinator startups do this as well and Sam Altman, President of Y Combinator, explains why in this http://blog.samaltman.com/employee-equity.
As legal counsel for Gusto, I’m responsible for considering what’s best for everyone who is part of our company: employees and stockholders. We’ve decided to take this approach from the start because of the many negative outcomes of allowing unrestricted transfers. While being able to liquidate stock might be advantageous on an individual level to former employees, it would be a bad outcome for Gusto and our current employees.
Why would it be a bad outcome? Well, one of the important reasons actually has to do with the IRS. Currently, the common stock price at which the options are issued (the 409A price) to employees is 30% of the preferred stock price. In other words, you’re getting a significant discount. Today, that means that preferred stock would be worth $5.02 per share to the investor, but the current exercise price for employee options is just $1.52 per share.
The IRS will honor this price of $1.52 because there is an understanding that the preferred stockholders have additional rights that common stockholders do not have and therefore the price the investors pay for the preferred stock should be higher. However, if our common stockholders start selling their shares at a price of the preferred, $5.02, then this suggests to the IRS that the 409A price is wrong and that the options that we are issuing are undervalued. In sum, the discount that our current employees would be getting would diminish greatly, impacting our new grants as well as our recruiting efforts.
Another reason is the SEC, which has started to https://corpgov.law.harvard.edu/2016/04/25/sec-scrutiny-of-secondary-market-trading/. If we allowed people to sell their shares to outsiders, we would then have to make company disclosures like a public company, even though we don’t have access to the public markets yet. That would be unnecessarily burdensome, negatively affecting our ability to operate. Additionally, allowing secondary sales can cause us to run into the issue that Facebook ran into several years back (interesting article http://www.bloomberg.com/news/articles/2011-04-21/silicon-valley-cashes-out-selling-private-shares) and force us to go public before we are ready, lowering the potential future valuation of our company as a result.
Being transparent is one of our core values, and your option agreements include a provision about the restriction in the Company’s Bylaws. In addition, we’ve provided disclosure packets which explain our approach. Here is a link to the [removed] with the specific explanation highlighted (#43 and #48).
If you want to discuss this in more detail, I will host an AMA in Farmer’s Market at 4pm today. Please come by with any questions!
Your Legal Eagle Liza :)