April 14, 2023
When Employee Equity Goes Underwater: Repricing, Refresh Grants and Carve-Outs
For most of the last fifteen years, the working assumption at private companies was that each round would price higher than the last. Flat was the bad case. That assumption broke, and down rounds returned at levels not seen since the global financial crisis. The consequences land hardest on the part of the package employees understand least well — their equity.
What a down round actually does to common stock
A down round means this round’s pre-money valuation comes in below the post-money valuation of the last one. The mechanical consequence is not just a lower share price. New preferred investment arrives with liquidation preferences attached, and those preferences sit above common. The result is that common stock becomes a smaller share of any eventual outcome than it would have been, on top of the ordinary dilution.
For an employee holding options, this shows up twice: an exercise price set when the company was worth more, and a claim that now sits further back in the queue.
Repricing underwater options
After a down round, a company will typically commission a fresh third-party 409A valuation, and that valuation comes in lower. Lower valuation means lower exercise prices on future grants — which raises the obvious question about everyone holding options struck at the old, higher price.
Repricing those options is one of the standard responses, and it has become considerably more practical than it used to be. The old approach required waiting out a six-months-and-a-day window; that constraint has eased. It is not free — repricing has consequences across the whole cap table — but it is now a genuinely available tool rather than a last resort.
Refresh grants have two different causes
It is worth separating them, because they call for different fixes.
The first is positional. Someone was granted appropriately for the role they held, then grew into a materially larger one. Or the reverse. Either way the grant no longer matches the job.
The second is dilutive. Successive financing rounds — particularly a down round that compresses common — leave a correctly sized position badly out of proportion. Nobody did anything wrong; the cap table moved underneath them.
Refresh grants are rarely budgeted in advance, which is precisely why they become a scramble when a round closes.
Management carve-out plans
When common stock is buried under enough liquidation preference, a perfectly respectable acquisition can deliver nothing at all to the management team holding it. That is a serious problem, because those are the people who have to negotiate and close the deal.
A carve-out plan solves it directly. A defined percentage of the proceeds from an M&A event is set aside and paid ahead of the equity waterfall. It functions as promised compensation rather than as stock, so it sits above the preference stack rather than behind it. Allocation within the management group is generally settled around the time of the exit, weighted toward who actually drove it.
These plans are usually drafted to prevent double-dipping. If the deal is strong enough that liquidation preferences clear and someone’s equity would pay more on its own, they receive that instead of the carve-out rather than both. Where equity is deeply underwater, the original equity percentage often becomes the reference point for what the carve-out should pay.
More complex variants exist — portions structured as preferred stock, or tranches paying at different points — but the straightforward version is a slice of net proceeds off the top.
Extending the exercise window, and the ISO trap
Layoffs have produced a lot of requests to extend post-termination exercise periods, sometimes dramatically. This is where a well-intentioned accommodation can quietly destroy the benefit it was meant to preserve.
Incentive stock option rules require exercise within ninety days of termination. That is why the standard exercise window is ninety days for essentially all options, incentive or not. Extend an ISO’s window beyond three months and it is disqualified — it becomes a non-qualified option.
The practical consequence: at exercise, the spread between exercise price and fair market value is ordinary income, with capital gains treatment applying only to appreciation after that point. Anyone accepting an extension should understand they have traded tax treatment for time.
A related trap catches people who assume an IPO will let them capitalise on their ISOs. Incentive stock options require holding for a year after exercise. Exercise late, and you face a large AMT bill; sell shares to cover it inside that year, and the disposition is disqualifying. The favourable treatment required action well before the liquidity event, not at it.
In practice most exits are acquisitions anyway, and in an acquisition option holders are typically just cashed out on the spread — ordinary income, no holding period, no election to make.
Two things not to do
Do not grant RSUs at a private company unless you are confident about going public. RSUs vest into a tax liability with no market to sell into. Doing this before an IPO has produced large, difficult, expensive tax problems at well-known companies, and it requires a very strong cash position to absorb. Time-based incentive stock options remain the dominant instrument in private companies for good reason.
Do not put a value on equity in writing. Candidates ask for it constantly, and it is tempting to help. Offer scenario guidance instead — what the position is worth under various outcomes — and never commit to a value statement. In a market where valuations move week to week, a written number is a liability.
Benchmark against capital raised, not valuation
This is the single most durable point from the session. Valuations move too fast and, after a down round, tell you something misleading about the company’s actual stage. Total financing raised to date is the more stable comparison, combined with industry.
It also resolves a question that comes up constantly: whether lower cash correlates with higher equity. It does not reliably. You might hope the trade-off is being made deliberately, but plenty of people end up with both below market — and the pattern is most common among founders who are least inclined to advocate for themselves. Data gives you the speed limit; it does not tell you how fast to drive.
The related discipline is to resist exceptions. Set a compensation philosophy, build bands from the data, and fit people into them. Past roughly fifty to a hundred employees, accumulated exceptions become genuine operational and legal overhead.
Sizing the option pool
When a new investor comes in, the pool almost always gets expanded as part of the round. The number that matters is not the total size of the plan but how much remains reserved and unissued.
The way to argue it is by runway. If the round is expected to last around eighteen months, budget the hires you plan to make in that window and the equity each will need. That produces a defensible reserve. Refresh grants, being unpredictable, tend not to make it into that budget — which is worth correcting for deliberately.
A note on QSBS
Qualified small business stock remains one of the most valuable planning tools available. The core test is that the company holds under fifty million in assets or capital raised. Hold qualifying stock for five years and a substantial amount of gain — the first ten million — is exempt from federal tax, with meaningful additional planning possible through gifting and trusts, since the exemption applies per company and per taxpayer.
Two caveats. Early exercise starts the clock, but it is a real cash outlay and a real risk, and not every employee is offered the option. And the provision has moved in and out of favour in successive tax bills, so it should be treated as a current opportunity rather than a permanent fixture.
The recurring theme across all of it: knowing what you own is only half the problem. How you own it, and when you act, determines what you keep.
Adapted from the J. Thelander Consulting Private Company Compensation panel webinar (March 2023) with Jody Thelander, Melissa Taunton (NEA), Mark Fitzgerald (Wilson Sonsini Goodrich & Rosati), and Christine Connors (Epic Capital Group). Nothing here is legal or tax advice.