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Defending Skype and private equity

June 28, 2011: 1:08 PM ET

I've spilt a lot of digital ink on the saga of Yee Lee, a former Skype employee who lost his vested options upon leaving the company voluntarily. My initial post argued that the Skype arrangement was intentionally confusing, while a follow-up suggested that private equity and Silicon Valley work together but speak separate languages.

Throughout, I've been engaged in an email conversation with an attorney not engaged by either Skype or its PE backers. He is very knowledgeable about the broader issues, and I wanted to share his most recent correspondence (upon the unfortunate condition of anonymity). He is basically defending the private equity option model, which differs significantly from the startup model. At the same time, however, he seems to acknowledge that Skype is a bit of an outlier.

His email follows below, with some of my comments in italics (although I tried to keep them to a minimum):

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Your blog said that Lee claims he was cheated. The Skype option plan and related docs (which are publicly filed with the SEC) provide for "call rights." Those call rights are more clear than you claim (see section 8.01, which says that Skype can repurchase equity of any terminated employee, with the repurchase price equal to the lesser of (x) FMV and (y) cost for people who quit within the first five years).  As a result, any notion that a departing employee was cheated is nonsense – he got his bargain. In my experience, PE firms make these terms very clear to management – after all, golden handcuffs are only effective if the executive understands the burdens of quitting and the benefits of staying. But that's secondary to the real issue you're trying to address here -- whether these types of contract terms are fair.

Call rights upon a termination of employment are standard operating procedure for most private companies, but particularly at PE portfolio companies. There are several reasons (listed below from least important to most):

1. Logistics. Allowing employees to retain ownership after departure can result in complications in restructurings or other transactions. This is a small point, but worth mentioning -- minority shareholders are often litigious troublemakers. When someone leaves your employment, you want a clean divorce with them.

If minority shareholders "are often litigious troublemakers," then shouldn't Skype have asked Silver Lake to kick out both Andreessen Horowitz and Canada Pension Plan Investment Board? Okay, I kid (sort of). 

2. Conflicts. Former employees who leave for a competitor should not retain an ownership interest and potential profit in my organization for conflict reasons. This isn't an issue with public companies, because anyone can invest in public companies -- an investment in a private company, on the other hand, is a privilege, or an opportunity (as evidenced by the rush to buy Facebook stock via Goldman Sachs). Why should a competitor have the continuing opportunity to profit from my business when he's in a position to disadvantage it?

Because options are something granted upon original employment, and only vest for as long as the employee remains with his/her original company. I stipulate that companies should have the right to buy back shares at the time an employee leaves, or perhaps freeze the value. But the employee helped create value, and should get to reap some of those rewards.

3. Replacement Employees. Someone presumably must replace the departing employee. The replacement will need an option grant of similar size (or maybe larger because the strike price might be higher because of increases in value) -- where should we find those options? Should the owners and other employees be diluted each time there is employee turnover?  No, when we repurchase (or "call") shares from the departed employee, the shares are extinguished, creating new headroom for replacement grants. This is a critical point.  You are viewing this from the departed employee's perspective only – he lost his "vested" options, but the PE firm is looking at it from a company-wide perspective – who should bear the cost of employee turnover (particularly voluntary turnover)?

Maybe I'm being dense, but this argument seems to sound better on paper than in practice. Imagine an employee is granted options on 100 shares, with 4-year vesting. Then he leaves after two years. Can't the company give his replacement options on just 50 shares, given that the company is now more mature (i.e., closer to exit)? And if exit takes longer than 4 years, it's possible the company would have had to issue more shares anyway.

4. Pay for Performance. We strive for "pay for performance" in our plans. Call rights help ensure pay for performance. If we allow a departed employee to continue to participate in increases in value AFTER he leaves, then he is profiting from someone else's hard work and value creation. If a PE firm invests in a company at a valuation of $20/share, then the options generally would have a $20 strike price. If an optionholder quits when the shares are worth $25/share, why should he get to hold the options indefinitely until the stock is worth $50 or $100? That value was created after he left. At most, he should get $5/option ($25 FMV on his departure vs $20 strike price), and that's it. This is also how public companies work – when an executive quits, he usually has 60-90 days to exercise his options, rather than hold the options indefinitely while the company's stock price climbs.

This is a key difference relative to some startup companies where options are more akin to lottery tickets and employee turnover is high as people flock as soon as a company looks like a failure to chase the next big thing. PE firms typically invest in mature companies with relatively steady revenue streams and a plan to pay down leverage. These companies typically are not boom-or-bust investments -- instead, they have cash flow models and debt repayment plans under a model that is financeable in the debt markets.  Options in a PE investment are not lottery tickets -- they are long-term investments in a class of companies with a track record of paying off very well. So why should we let someone who isn't a long-term player in the company share in that long-term value creation? This is particularly true when you consider average hold-times at PE firms are 4-6 years. That's also why you typically see 5-year vesting in PE companies, together with a class of options that only vest upon satisfaction of EBITDA/cash flow targets or IRR/multiple of money.

A weakness in my last argument above exists when the PE firm is not paying FMV for the vested tranche of options. Most PE option plans provide for call rights at FMV upon a departure -- but many provide for a "forfeiture call right" upon voluntary resignations within a specified period. Skype's plan uses a 5-year period for a forfeiture call upon a voluntary departure, which is somewhat unusual in my recent experience (it was standard practice in the "old days" of private equity in the 1980s/90s and is still used in probably 20% of transactions). I think the fact that this particular feature of the Skype contract is unique is lost in your article, which implies that all PE firms use these terms. The length of a "forfeiture call" is a negotiated term – I typically see 2-3 years, but oftentimes this type of forfeiture is a tradeoff for some other benefit negotiated by management -- (i.e. higher severance payouts or a larger option pool). Your article talks about one aspect of an option plan in a vacuum (forfeiture) – while ignoring that everything is negotiated by senior management for their team as a package.  Maybe Skype management negotiated a bigger option pool or lower IRR targets that were more beneficial than this one aspect.

In any event, the rationale for this type of 5-year forfeiture call is simple:  You're either part of the team that sticks with the company from the early stage of the buyout through the exit, or you're not. If you're not, you don't get to participate in the upside. This is the "in together, out together" mentality of private equity. For those who stick around, it can be extremely lucrative – for people who leave voluntarily, they lose out. But that's the choice they make.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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