/>iA recent California Court of Appeal opinion, Shah v. Skillz Inc., (2024) 101 Cal.App.5th 285, addressed two important questions relating to the valuation of stock options that have been the subject of litigation for many years: Are stock options wages? How are damages measured in a claim for breach of a stock option agreement? Although the questions might seem esoteric and of interest only to lawyers, the answers have real world consequences for companies facing claims from disgruntled former employees.
Shah’s Claims
Shah v. Skillsz Inc. involved an employee of Skillz Inc., a privately held mobile gaming company, who was terminated for cause. Because he was terminated for cause, his stock options were automatically terminated, and he was not able to exercise them. He later sued Skillz for breach of contract. Shah joined Skillz in 2015. As is true for many startups, Skillz offered Shah less cash compensation in exchange for options to buy Skillz stock at a predetermined exercise price ($0.34 per share), vesting over time. In accepting the offer, Shah was betting on the possibility that the company would go public in an initial public offering (IPO) and he would be able to sell his stock on the open market at a significant profit. In the usual course, an employee who separates from the company would have three months from his termination date to exercise his vested options. However, the stock option agreements governing Shah’s options provided that if he were terminated for “cause,” his options would expire on the date of his termination.
In January 2018, Shah spoke with the Skillz founders about leaving the company unless he received a promotion and a raise. Given his representation about leaving the company and his compensation request, Skillz suspected he might have done something harmful to the company’s interests. A forensic analysis of his emails revealed that he had forwarded a confidential business report to himself, and the company concluded there was no legitimate business reason for him to have done so. According to Shah, however, he had forwarded the email to himself only as a matter of convenience, and there was no evidence he intended to commit theft or use the report for any improper purpose. Shah was terminated “for cause” based on his purported violation of company policy on confidential information and theft. When he later attempted to exercise some of his options, he was notified that the options were void under his stock option agreement.
Skillz had an IPO in December 2020 in which other former and current Skillz employees made a significant profit. The opening price per share in the IPO was $17.89. However, current and former Skillz employees were subject to a six-month “lock-up” period during which they could not sell their shares. In the two weeks after the lock-up period expired, the stock sold for an average price of $20.01 per share.
Shah sued Skillz for breach of contract, wrongful termination and retaliation, alleging that Skillz did not have cause to terminate him and wrongfully prevented him from exercising the stock options he had earned as a Skillz employee. A jury awarded him over $11.5 million dollars in damages for his lost options, impliedly finding that he was not legitimately terminated for “cause.”
Stock Options as “Wages”
Before the trial began, the court ruled as a matter of law that Shah’s stock options were not “wages” under the California Labor Code, even though Shah had accepted less cash compensation in exchange for stock options. As a result of this ruling, Shah’s claims for retaliation and wrongful termination were dismissed, effectively eliminating any entitlement to tort damages, which otherwise could have entitled him to punitive damages and attorney’s fees.
The viability of his tort claims turned on California Labor Code section 200, which defines “wages” as “all amounts for labor performed by employees of every description, whether the amount is fixed or ascertained by the standard of time, task, piece, commission basis or other method of calculation” (emphasis added). The court agreed with Skillz that stock options “are not wages because they are not ‘amounts.’ They are not money at all; they are contractual rights to buy stock shares.” The court concurred with the Ninth Circuit Court of Appeals, which previously considered the issue, noting that the amount of money for which shares can be sold on the market varies unpredictably from time to time, so it is not “fixed or ascertainable.” The court distinguished the present facts from Schachter v. Citigroup, Inc. (2009) 47 Cal.4th 610, in which it was stated in dicta that incentive compensation, including restricted stock, constitute wages given that restricted stock units (RSUs) have an ascertainable value and are immediately issuable to an employee. Stock options, by contrast, the Skillz court held, merely grant the holder a contractual right to buy shares of stock at a later date at an agreed upon exercise price. In so holding, the Skillz court explicitly acknowledged that its ruling limited employees’ ability to recover tort damages and attorney fees, leaving employees with only claims for breach of contract to recover the value of any options that were wrongfully terminated.
The Measure of Damages
The second important holding in Skillz is that damages in a case for breach of stock option agreements need not necessarily be measured at the time of breach, as is customary with most breach-of-contract claims. Had Shah’s damages been measured at the time of “breach” (i.e. the date of his termination, before the IPO occurred), his damages would have been nominal – the difference between the exercise price of his vested stock options and the value of Skillz stock at the time of his termination, typically set by a “409A” valuation of a company’s stock. If Shah’s damages were measured at the time of breach, he would have been entitled to only $41,032 in damages due to the loss of his stock options. Alternatively, Skillz’ expert opined that the measure of damages should have been measured using the average price between the date the lock-up ended and the day before his testimony. This would have yielded about $6.7 million in damages. In contrast, Shah’s expert opined that Shah suffered approximately $11.5 million in damages by assuming that he would have sold the bulk of his shares in the two-week period immediately following the lock-up. Although the jury awarded Shah the full amount of $11.5 million, the award was later reduced to the $6.7 million alternative calculation made by Skillz’ expert.
The appellate court rejected Skillz’ argument that damages should be measured at the time of breach, noting that the goal under contract law is to put the injured party in as good a position as the party would have been had performance been rendered as promised. When there is no readily available market for the stock at the time of breach, a plaintiff cannot cover his damages by purchasing the lost shares immediately upon the breach. In such circumstances, a valuation date after the date of breach may be justified in order to reflect the arrangement that was “reasonably contemplated” by the parties at the time they entered into the agreement. “A contrary ruling under these circumstances would allow a private startup company to take away stock options earned by a terminated employee with relative impunity before the company has been sold or goes public because the financial consequences of doing so would be negligible,” the court found. The appellate court concluded that the proper measure of damages should have been the price of Skillz’ stock after the lock-up period ended, when Shah was free to sell his stock for the first time on the open market like any other former and current employee of Skillz.
Implications for Employers
The holding that stock options are not wages is good news for employers. It means that damages in a suit for breach of a stock option agreement generally will not include punitive damages or attorney’s fees that otherwise might be available if the breach were treated as a tort.
However, on a more cautionary note, although the Skillz court refused to accept Shah’s speculative assumption that he would have exercised and sold all his shares at the highest possible price, it also refused to accept the traditional measure of damages as measured at the time of breach, which would have yielded Shah a negligible amount. As the court noted, if the value of the stock at the time of termination is all that is at risk when terminating an employee, a company may decide to terminate an employee, knowing that there might be few financial consequences for doing so. In contrast, if, as the court ruled here, damages are to be measured after expiration of the lock-up period, a company seeking to void an employee’s stock options based on a finding of “cause” should proceed with caution. Finally, this case may cause employers to revisit the structure of their equity compensation in terms of RSUs vs. stock options. Although there are many considerations that come into play when determining whether to grant RSUs or stock options, the financial risk in a suit involving a breach of an RSU plan may be more readily ascertainable at the time the decision to terminate the employee is made.
