A primer on the basic parameters to consider when establishing a startup in Israel
This handbook was written for you: the entrepreneur with a dream. We want to help you turn your dream into a thriving reality by sharing our expertise with you.
Throughout our years practicing law in Israel – law with a focus on startups and venture capital – we have gained a vast amount of experience-based knowledge. And we want to share our knowledge with you to help your business get off to a strong start. To do that, we have compiled a handy and handsome handbook outlining the basics you need in order to start a startup in Israel; it contains terms you need to know, steps you will have to take, and considerations to ponder when making choices about how to run and grow your company.
Keep in mind that the summaries and explanations contained in this booklet are based on the (extensive) experience of a handful of attorneys in Yigal Arnon & Co.'s corporate law practice; it's possible that experts in a different firm (or even a different department within the same firm) would see things differently. So while we would be happy for you to rely on us with blind faith, it is still best to seek legal advice that is tailor-made for your particular venture, whether from us or from any other attorney with whom you feel comfortable. We're hoping that this handbook will give you a strong foundation to know the topics on which to seek advice.
1.Making it Official: Incorporation
You've been thinking about starting your startup for a while, right? You've got an idea and you think you know how it's going to work. But before you make it official, you want to test out your idea. So you start developing your product. You ask people for their opinions. Maybe you even try to get a buzz going. You figure you'll do the technical step of creating a company when you're about to see the dollars roll in.
Hang on a minute.
You might want to incorporate a bit sooner than that. First of all, one of the legal advantages to incorporating is that if you have a company doing the work, you can "hide" behind it. Your company creates the product. Your company signs the contracts. And if your company messes up and someone wants to sue it – you're not on the hook, the company is (unless you intentionally do something particularly malicious). Secondly, there are serious tax advantages to creating a company before it has any value. If you establish a legal entity and it has nothing (no intellectual property, no revenues, no product), and you get shares in that empty, nothing-in-it company, then your shares are worth nothing. So if you pay nothing for nothing, you don't owe taxes. But – if your company has value right from the start and you pay nothing to get shares that are worth something – well, you've made a profit and the government will want a piece.
Even more important: If you've been working on your product before you set up your company, and it's been out in the world and has value – transferring it to your company (in exchange for shares) can have negative tax ramifications. Sometimes, you can get an exemption from the tax ramifications, but there will be a catch or two. You'll have to apply for that tax exemption from the authorities. And if you get it, it will impose limitations on your company. For instance, you won't be able to go ahead and sell that valuable intellectual property for at least two years from the "transfer". This includes selling off pieces of your company and diluting your holdings below a certain percentage. In turn, this will get in the way of accepting equity investments and prevent the growth of your company (see Section 6 for more about getting investments).
The actual process of incorporating a company is pretty painless. If you decide to incorporate in Israel, you choose a name and who will hold shares, sign a few forms, pay a fee of approximately NIS 2,500, and a few days later – you have an official company. If you decide to incorporate in a different country, the process tends to be similar, with the fee being the main variable. Reasons you might want to incorporate outside Israel can range from having an investor on the line who will only put his money in a US company, to tax incentives (you've heard of offshore companies, right?), to proximity to a certain industry, to regulatory constraints (some businesses are illegal in one place and legal in another). Your legal advisor can help you decide on the right jurisdiction for your company, and can introduce you to local counsel in the jurisdiction of your choice in order to get the company up and running.
2. Who's Who
And now - you're the founder of a company. Great! What does that mean? Who is the CEO? What is a director? Here, find a brief job description of each of the common, important roles in a company.
Founders. The term "founders" is used to describe the people who started a startup. Founders are usually the people who came up with the idea for the company, who have the basic technological knowledge to create the product or service, and who run the business side of the company. A startup typically has anywhere from one to five founders.
Contrary to popular belief, the term "founder" does not actually carry any legal weight. Normally, when founders start a company, they sign a founders' agreement, which sets out the division and treatment of equity, who will be responsible for what jobs, and how the company is going to be run. For more about founders agreements, see Section 8.
CEO. The term "CEO" is short for Chief Executive Officer. The CEO is typically appointed by the Board of Directors (more about that later). The CEO is the most senior officer of the company. He or she makes many of the day-to-day decisions, oversees the operations of the company, and often has the power to sign various documents on behalf of the company, including employment agreements and investment documents. Many times in a startup, the CEO is also a member of the Board of Directors and one of the founders of the company.
CxO. In addition to the CEO, a company often has other high-ranking officers that are "C"-level. This can include a CTO (chief technology officer), a CFO (chief financial officer), a COO (chief operations officer) and even a CMO (chief marketing officer). A company can define for itself which, if any, of the C-level officers it needs. Sometimes C-level officers are founders; sometimes, they are later hires. Occasionally, and more frequently regarding a CFO, C-level positions are filled by external personnel – particularly as the company is still getting on its feet.
Directors. A director of a company is a member of its board of directors. Directors are generally appointed by the shareholders of the company. The mechanism for how directors are appointed is normally set forth in the company's articles of association; absent that, various shareholder agreements or the Companies Law govern the appointment of directors (the "Companies Law" refers to the main piece of legislation in Israel that sets out the rules for running companies; its full name is Companies Law, 5759-1999) . At first, you will likely establish your board's composition in your founders' agreement. The director's responsibility is to set the company's policies on various issues and make major decisions regarding the company's activity. For more on directors, see Section 3 below.
Advisory Board. Not to be confused with the board of directors, a member of the advisory board is typically someone with experience in the same field of business as your company. Advisory board members can provide your company with strategic advice on running your company and making it better, and can offer connections to other people that can benefit your startup. Typically, advisors advise the company on a limited, part-time basis. In exchange, they are often compensated in the form of equity (for more on equity incentives, see Section 9). Although an advisory board can be a valuable tool for a company, not all companies have an advisory board.
3. Division of Labor
The Companies Law provides the basic rules regarding the division of labor in a company. Much like a government has a system of checks and balances in order to make sure no one branch takes too much power, a company has a hierarchical system that also serves to keep the company running smoothly.
The main purpose of your company is to benefit its stakeholders, and that essentially means: to make money for its shareholders. The people entrusted with that job are the board of directors and the CEO. Each of these "organs" has a different role, and these are clearly set out so no one steps on anyone else's toes.
It is important to note that each of the organs of the company owes certain duties of loyalty and/or fidelity to the company, whereby they are expected to act in the company's best interests. Assuming they adhere to their duties, companies many times procure directors and officers insurance (commonly known as "D&O Insurance") in order to protect the directors and CEO in case they get sued for something that happened while doing their jobs.
Shareholders. The shareholders' main job in the company is related to – you guessed it – shares (and specifically, their shares). Ownership of shares is identical to ownership of the company. Each share represents a piece of the company. And each share typically comes with one vote. So the higher percentage of the overall share capital a shareholder holds in a company, the more power he, she, or it has to direct the company. The power typically comes in the form of the right to appoint a director to the board of directors, veto rights regarding certain topics, and the right to protect your holdings in the company. The power to choose the company's external financial auditor also rests with the shareholders. Additionally, each share typically comes with the right to payment if the company has an exit, or if it distributes dividends. If the company shuts down, a shareholder's holdings determine its right to receive any pieces of the company available for distribution. These rights, together, grant the shareholders the ability to determine the fate of the company.
One more role the shareholders play is to keep the board of directors in check. For example, the board can't vote to pay themselves money and grant themselves options without the shareholders' approval as well. Whenever there is a potential conflict of interest between a director and a transaction, the shareholders are called upon to cast their votes as well.
The shareholders typically vote at a meeting or in a written resolution, circulated among the shareholders for signature. Since a written resolution without a meeting requires unanimous consent, the more shareholders a company has, the more likely it is to vote by meeting (which normally requires only a majority of votes of those shareholders attending the meeting, provided it was a legitimate meeting with at least a minimum number of attendees, otherwise known as a "quorum").
Board of Directors. The board of directors is composed of individuals appointed by the shareholders. Most often, at least one founder sits on the board, as well as investors (or their representatives). Occasionally, an industry expert will be appointed to the board as well. There are normally between one and seven directors on the board. Most often, the directors are not paid for their services (although they may be paid for other roles they play in the company, like CEO).
The board's function is to direct the company. It meets frequently to discuss and decide regarding the company's plans, budgets, signature rights, potential large transactions, investments, and equity allocations. Every year, the board must approve the company's audited financial statements, and then present them to the shareholders.
The board typically either votes at a meeting or in a written resolution, circulated among its members for signature. As with the shareholders, a written resolution without a meeting requires unanimous consent, so the more directors a company has, the more likely it is to vote by meeting (which normally requires only a majority of votes of those directors attending the meeting, provided it was a legitimate meeting with a proper quorum). As mentioned above, occasionally the board must refer its decisions to the shareholders, when a board member has a personal interest in the matter that is up for discussion.
CEO. The CEO, as discussed in Section 2, is the person in charge of running the company on a day-to-day basis. The board typically appoints the CEO, and authorizes the CEO to carry out its decisions on its behalf. For example, if the board decides ("resolves", in legalese) that the company should raise money by the selling shares (an "issuance", in legalese) to a certain investor, it will authorize the CEO to sign the documents related to that transaction.
The CEO is typically the link between the company and the board, and the CEO is often the face of the company to the outside world. Many times, the CEO is the person entrusted to negotiate contracts on behalf of the company, hire employees, and sign checks.
4. Picking a Team
Beyond your internal team members – the CxOs, employees, board, shareholders, etc. – your company is going to need some backup. The most common external team members are lawyers, accountants, and consultants. While it can be daunting to have to shell out what feels like big bucks for these types of advisors, the stronger your team is, the better your company will be.
A good lawyer with experience with startups can provide you with more than just contracts (although you need those too). Your lawyer will help you set up the proper corporate structure for your entity, and make sure the appropriate procedures are followed on a day-to-day basis. Legal advice comes into play when negotiating terms of employment, of investments, of sales and marketing contracts, of protection of intellectual property, and so forth. Attorneys in your field can advise regarding what's considered "industry standard" and what's completely out of the norm. This can be particularly valuable when it comes to creating a company that's viable in the long run, and attractive to investors. Plus – lawyers who know the startup game can connect your company to relevant players in the field: investors, service providers, and even top-level personnel.
In addition to trying to improve the world with your genius idea, it's probably a safe bet that your company is looking to make some money. And you know what they say: you gotta spend money to make money. An accountant will not only help you keep track of what you spend and what you make; an accountant can advise on how to design your business in the most tax-beneficial way. And with taxes what they are, a competent, experienced accounting firm can make all the difference in the world. Your accountant is also necessary to help your company prepare its periodical financial reports throughout the year, plus an audited report at the end of each fiscal year (which is a legal requirement and something your shareholders expect to receive).
Your employees will probably do the bulk of the work for your company. But sometimes, you need extra hands, either temporarily or on an ongoing basis. You can think of consultants (also referred to as freelancers or contractors) as other companies or services that you hire to give you a boost. Sometimes it's just to design your webpage or logo, or to help you find new customers. Other times, it can be a programmer who contributes a critical bit to your algorithm. Two important aspects to remember when it comes to "outsiders": Firstly, they will issue an invoice to your company to pay them (rather than joining your payroll), and you will not be responsible for paying their social benefits. Secondly, unless they specifically sign a document stating that the intellectual property they create belongs to you – it's theirs. So it's incredibly important to make sure they assign their work to your company. See below for more about safeguarding intellectual property.
5. Protecting Ideas: Intellectual Property
For most startups, their most valuable asset is their idea. This idea is then translated into some sort of implementation, whether via app, website, machine, marketable code or some other form. The law recognizes this, and provides a way for your company to protect your idea and the product it yielded. We call the idea, the knowhow behind it, and its materialization into a product, "intellectual property".
IP can fall into a number of categories. The main ones are: patents, copyrights, trademarks, and trade secrets. Sometimes, to protect intellectual property (or "IP", as it's fondly known), registration with a local or international body is required. But other times, there's no need. Here is a quick look at the four main categories, and a critical tip to ensure the IP is yours. Keep in mind that IP can be a very complex topic, and it is often worth discussing with a professional in order to make sure you are maintaining your most valuable asset as your own, and to make sure you're using the IP of others in the best way, typically through specific licensing agreements.
In order for a patent to exist, it must be registered. The holder of a patent has an exclusive right to use and market the invention it covers, which can then be utilized or licensed in any number of ways. Patents do expire after a certain number of years, depending on where they are registered. In order to obtain a patent, an applicant must provide all information about the proposed patent, prove that the idea is novel and non-obvious, and that there's a use for it. The actual criteria and how to meet them vary from jurisdiction to jurisdiction. There are lawyers that specialize in patent law – look for assistance from lawyers with a scientific background of their own, as they tend to better understand the product you want to patent.
A copyright is an exclusive right to use and distribute an original work in a specific territory. Copyrights can apply to written works, artwork, musical compositions, film, broadcasts and software, among other things. Like a patent, a copyright can only exist for a certain length of time – typically the length of an author's lifetime, plus an additional number of years. Unlike a patent, a copyright does not always need to be registered. In many places, the protection is automatic; even in these places, it is often possible to register a copyright anyway, which makes enforcement easier.
A trademark is a symbol or words used to represent your company, service or product. A logo is a common example of a trademark. It is used to differentiate you from others and helps to create your "brand"; if someone else uses your trademark or another symbol that is similar to yours, it would cause confusion and could potentially hurt your business. Consider the knockoffs you've seen floating around, which are often of lesser quality than the brands they imitate. A trademark can be registered, or can be established through use in the market. The trademark expires if it stops being used for a certain amount of time. Like with copyright, even if you can establish a trademark without registering it, a registered trademark is easier to enforce if someone tries to copy you.
A trade secret is just what it sounds like: It is a bit of information that gives your product its value by virtue of no one else possessing that information. The most famously known example of a trade secret is the recipe for Coca Cola. If any other company had that recipe, it could copy Coke and there would be no difference between the brands. A trade secret cannot be registered; rather, it should be closely kept and only divulged to those who need to know it. Typically, companies protect their trade secrets by requesting that anyone with access to such confidential information, or who might have access, sign a non-disclosure agreement (see Section 8 below). As long as you can manage to protect your trade secret, it remains in force and retains its value; there is no expiration date to a trade secret.
Ok, so you know what type of IP you have and how to protect it, legally. But are you sure it actually belongs to your company? Start with any of these questions: Who came up with the idea for your patent? Who wrote your source code? Who designed your logo? Who fixed your algorithm when it was bugging out? Assuming the answer to any of those questions is a specific human being, or any number of specific human beings, then why would you think that the IP they helped develop belongs to your company, and not to the person or persons whose brain is responsible (your own brain included)? If you said, "Because we all assigned it to the company", you'd be right. An IP assignment is essentially a covenant (embodied in a document) whereby an employee, advisor, consultant, subcontractor or even graphic designer confirms that any IP they develop or help develop while working for your company belongs to the company. Ideally, the assignment will be signed before the person starts to work for your startup, and is often incorporated into an NDA (read more about that in Section 8). However, even if they didn't sign up front, you can get them to confirm it after the fact, and it will still work.
Note that some IP assignments are much broader than others. For example, employees who work at government institutions like a university, hospital or even the army often sign documents that essentially say anything those employees dream up belongs to that institution. For this reason, your company needs to be very careful when hiring people who are affiliated with such institutions. Because if they've already promised their creative works to someone else, that someone else will have a claim to what you thought was yours. Thus, before you bring in that brilliant professor for some moonlighting project or side job with your team, ask her to clear the IP assignment matter with her institution. Many times, institutions will be willing to carve out certain types of IP that the employee can assign elsewhere – provided it doesn't overlap with the work they do for that institution, and sometimes at a cost (like royalties). Believe it or not, sometimes this will be a no-go, and you would be better off finding a different team member without a complex affiliation. In the case of institutional workers – get the IP assignment before any ideas happen. Slip-ups in this area can be complete deal breakers for potential investors (really, one of the "legal" items that can botch a deal), because if your company isn't the sole owner of its IP, and thus doesn't have the rights to market and make money off that IP, the value of the company can drop all the way down to nothing in the eyes of a high risk investor (and that's ignoring any potential lawsuits from institutions that think they own your IP).
6. Money, Money, Money: Funding
Most likely, a new company requires capital in order to get started. The amount of funding necessary depends on the needs of the company, and its business plan. And depending on the amount of funding necessary, there are different ways to raise that funding. Below are a handful of the most common ways startups raise money at the beginning of their paths, along with brief descriptions and factors to consider (including the infamous "finder").
Many times, the people who start the company kick in a little of their own money in order to get started – whether it's a few hundred dollars to pay incorporation fees, or thousands of dollars to get the business rolling. If a founder decides to provide the initial funds for his new company, he should make sure he has a simple loan document signed between him and the company that specifies how much money he lent the company, and how and when he expects to be paid back. Be prepared for the possibility that future investors will ask for this loan to be written off, or to postpone repayment of the loan.
Friends and Family.
Sometimes, instead of – or in addition to – a founder loan, a founder's friends and family will invest money in the new company in order to help it get started. In total, these types of loans can amount to tens of thousands of dollars, if not more. Most often, in exchange for the investment, the friends and family are granted equity in the new company – normally in the form of ordinary shares.
Other times, investors (friends and family, or outsiders) will choose to put money into a new company in exchange for a promise of future equity. This type of investment can take the shape of a CLA (convertible loan agreement), a convertible note, a SAFE (see section 8), a KISS (keep it simple security) and other types of agreement. If a loan or other form of convertible investment is given, instead of getting repaid, the investment is used to buy shares of the company later down the line, when the company undergoes a more significant financing. There are typically conditions in this type of investment regarding what class of shares it will convert into, when, and at what price (often, the company will offer a discount on the price per share to investors, in return for them taking a chance on the company, and a maximum valuation upon which the price per share can be based, called a "cap"). There are also terms regarding what happens if the company runs out of money, or if it has an exit before the investment can convert.
An equity investment is normally what people mean when they refer to a "round" or a "financing". In an equity investment, investors invest in the company in accordance with an agreed-upon valuation of the company, from which a price per share is derived. The shares purchased may be ordinary shares, or they may be preferred shares. Negotiations will typically revolve around what extra rights the investor will receive in the company in exchange for its money. These rights normally have to do with the ability to invest more money in the future, the right to receive, before other shareholders, any profits in an exit or dividends when distributed, and the power to direct – or at least have a say in – the company's future. Many times, investors will receive a seat on the company's board of directors, either as directors or non-voting observers. Additionally, investors will most likely conduct due diligence on the company (commonly abbreviated to "DD") during which they will ask questions and request all of the documents the company has, in order to make sure it is being run legally and wisely, ie. their money is not being thrown down a hole. This is one of the reasons it's so important for startups to keep good, clean records from day one – to make the company more appealing to investors.
Venture lenders are somewhat of a hybrid between investors and a bank. They will give a company money in exchange for repayment with interest, and in exchange for a warrant (or option) to purchase shares. The venture lender will also require the company offer securities for the loan, typically in the form of a pledge over all of the company's assets. Because a venture lender tends to have more power than a startup, the terms are not always negotiable to the extent a company may want. But a venture lender has the ability to put forward millions of dollars without taking too large of a stake in the company.
One of the ways companies locate and snag investors is through contractors often referred to as "finders" or "brokers". These kind folks will provide you with a list of people or funds they can introduce you to, get your ok, set up a meeting, do some more liaising – and in exchange, they'll take a cut from the investment they brought in. Note that this cut can be in cash or in equity, or a combination of the two. Sometimes the cut is only demanded for the first investment, but other times, it includes future investments made by that same investor the finder brought in. Sometimes the "cut" is from friends of the investor. Sometimes the "cut" is not only from investments, but rather from revenues, loans and even the proceeds of an acquisition of the company by such introduced person. You should always strive to create incentive for the finder to go and get only the deal that you need (usually it's just a straightforward financing) from only people that you want approached (and not their friends or contacts), and as quickly as possible (no fee should be paid if a deal is closed only years later). The size of the "cut" can be anywhere from 2%-7% of the investment amount (this is just a general range), with industry standard firmly hovering around 5% (very few deals with a lower or higher fee). Be cautious and firm when negotiating a finder agreement: Investors don't like to see a company's money "wasted" on these types of services, and it's pretty painful for you, as a founder, as well. (As a side point, similar concepts can be found in companies seeking potential customers.)
7. Making it Work: Employees
As your startup moves forward, it will need to expand its manpower in order to meet its growing needs. Typically, this is done by hiring employees. Israel has some pretty strict rules regarding employment, and it's in your company's best interests to adhere to these laws. These rules relate to the hiring process, the employment period, and the termination.
One of the most basic laws regarding employees is: They need to get paid! There is no such thing as an employee working on a volunteer basis. The laws regarding minimum wage are non-negotiable. Don't forgot that out of an employee's salary come funds for pension, for health insurance, for Bituah Leumi... funds that cover your employee during and after his employment. Keep in mind that this means that when you promise a certain gross salary to an employee, your actual cost may be about 1.35 times that gross salary.
Also, there are stringent rules regarding how to fire an employee, in case things don't work out. It's not like on TV – you can't just tell someone he is fired and needs to pack his things. It's best to consult with your legal representative in such cases so he can walk you through the process.
8.Sign Here: Basic Agreements
During the life of a company, there will be a lot of paperwork. Unfortunately, that's the way corporate life works, and the best you can hope for is to become familiar with the agreements you'll need, how to negotiate them, and how to keep your needs for agreements to a minimum (which, of course, is relative). Below is a brief rundown of some of the agreements you'll come across at the start of your startup.
This is the agreement that you and your co-founders will sign at the very outset – maybe even before you've actually incorporated a company. It functions to set out the relationship among the founders, including ownership ratios, rights, roles, and what happens if one of you leaves the company (because you want to, or because your buddies are tired of you). Most often, this agreement is cancelled once the company has a financing, and it is replaced by elaborate articles of association (the governing charter of the company) and sometimes a shareholders' agreement and, occasionally, by something called a repurchase agreement.
One of the most ubiquitous agreements in the corporate world is the non-disclosure agreement, or "NDA" for short. The purpose of the NDA is to protect your company's confidential information. The person signing the NDA promises not to use your secret info for any purpose but the purpose you agreed to. An NDA can be a one-way agreement, where one side is the discloser of information, and the other side is the receiver. An NDA can also be a mutual agreement, or an "MNDA", where each side discloses and receives information. Depending on the nature of your relationship and how much and what type of information you expect that you'll be disclosing to the other party, you will decide which format suits the occasion. NDAs are important for commercial partners, for employees and consultants, and other service providers.
A variation of the NDA also includes provisions that guarantee that intellectual property created by employees and freelancers belongs to the company. This version not only says, "my secret information is mine", but it also says, "if you create anything new and useful while you're working for me, it's mine." This version of an NDA can be called a Proprietary Rights and Assignment of Inventions Agreement, or something along those lines. Refer to Section 5 above regarding assignment provisions.
Share Purchase Agreement.
As discussed above, one of the most common ways that startups raise money is via equity investors. And one of the most common agreements that governs such investments is called a "share purchase agreement", known as an "SPA" for short (pronounced S-P-A, rather than "spa").
An SPA typically opens with a description of the proposed transaction (for instance, who is investing, how much, and what they're getting in return). Then there is a list of deliverables: actions or documents that need to be provided or completed before the transaction can go through. The next section of the agreement is frequently the representations and warranties, or "reps". The reps are where the company (and sometimes, the founders themselves) makes a number of assertions and states facts about the company – for instance, what its share capital looks like, who owns the IP of the company, who is employed by the company, whether there is any litigation taking place, etc. This is what the investors rely upon when they make their investment. If the company provides false or incomplete reps, it can be liable to the investors for a lot of money. So the idea here is: Disclose everything. Allow your investor to make an informed decision. Don't forget that once they put money into your company, you and the investors are on the same team. After the company's reps, the investors often give a few basic reps about their ability to make the promised investment. The SPA is then signed by the company and all the investors.
Convertible Loan Agreement.
Just like the SPA governs an equity investment, the convertible loan agreement (or CLA) governs a convertible loan. The CLA sets out the basic terms of the loan: who, how much, when the loan converts or matures, and the equity into which the loan can be converted. Note that when it comes to CLAs, the latest advice is to watch out for potential tax withholding implications for the company on certain interest or interest-like components of the deal, so get your accountant or legal tax advisor involved early in this process.
The Safe is the American cousin of the CLA, and it is becoming increasingly popular in Israel, too. "Safe" is an acronym standing for "simple agreement for future equity." As its name implies, under a Safe, an investor puts money into a company, and in exchange, it has a right to receive equity in the future.
9. Equity Incentives (Options)
One of the nice things about a startup is that people are frequently willing to work for a startup in exchange for equity, or at a lower rate with equity thrown in. "Options" refer to an option to purchase equity in the company. When an employee or advisor is granted options in a company, they are being told, "hey, you're a part of our team". It's an incentive for them to work harder to make the company succeed, because they have a stake in the company, too.
Most often, a company will promise an employee (or other service provider) options. Then, the board of directors will go ahead and grant the promised options to the employee, formally. When the board grants the options, it will dictate how many options the employee will receive, at what exercise price, and according to which vesting schedule. The number of options is straightforward: It's normally a low percentage of the company's share capital. The more valuable the employee is, the more options he will receive. The exercise price is how much the employee needs to pay in order to turn each option into a share. The exercise price can be symbolic, like NIS 0.01 per option, or it can be a real reflection of what the share is actually worth. When granting options to US taxpayers, the options must reflect the "fair market value" of the underlying shares on the day of grant. The vesting schedule is when the options "ripen" and become exercisable. Normally, a company wants to give its employees an incentive to stick around. So when the options are granted, they can't all be exercised right away. Often, there is what is known as a "cliff" – a certain amount of time after being granted, a chunk of options become exercisable. Following the cliff, additional portions of options vest on a regular schedule. For example, a company might grant an employee 1,000 options with a 4-year vesting schedule, with a 1-year cliff and quarterly vesting. In this case, 12 months after the options are granted, 250 options will vest. Then, every 3 months for 3 years, another 62.5 options vest. Generally speaking, employees don't bother to exercise their options until they leave the company, or right before an exit.
A few other factors to take into account when considering an options plan are taxes and dilution.
Different types of options recipients are subject to different tax tracks. The most common in Israel are the 102 capital gains track and the 3(i) tax track. These numbers refer to sections in the Income Tax Ordinance (New Version), 5721-1961 – good luck trying to read through the legislation while keeping your eyes open (unless you're into that sort of thing). The former offers a better a tax break and is more desirable, but is only available to employees, certain officers and directors and is subject to strict procedure and constraints. The latter is the track for freelancers and advisors.
As would seem obvious, every time someone is granted equity in your company, it lowers the percentage holdings the existing security holders have. One way to provide stability to your shareholders is to reserve a certain number of shares in advance for grants to employees and consultants. That way, the dilution happens at once in one fell swoop and lets shareholders know where they stand. This reservation is often referred to as a "pool", or "ESOP pool". ESOP refers to an "employee stock ownership plan". This ESOP is adopted by a company's board of directors and submitted to the tax authorities, so that employees can receive the coveted 102 options.
10. Red Tape: Registrar of Companies
Speaking of authorities, the Israeli Registrar of Companies (Rasham Hahavarot, in Hebrew, or "ROC" in English, for short) is the governmental body charged with overseeing your startup. It is the authority that certifies your startup as a company, and it is the authority to which your startup must report on an ongoing basis.
At the very least, your company is required to pay an annual fee and submit an annual report to the ROC. This report is a snapshot of the company on a given date: It states the shareholders and their holdings, the directors, the address, and the overall share capital of the company.
On an ongoing basis, your company is required to report changes to the ROC. When someone new is issued shares, when a shareholder transfers its shares to someone else, when a director is appointed or removed, and when your company changes its share capital. Your company must also notify the ROC if it changes its address.
The ROC can be a true hassle, like any government authority. However, it is a necessary evil and your lawyers can help with the required paperwork. Note that if you fail to report regularly and pay your fees, the ROC will declare your company a "violating company", which will block it (and even its directors, as individuals) from taking certain actions. The ROC can also levy fines. So make sure to keep the ROC happy!
11. Head Toward the Exit
When establishing your startup, you may be thinking long-term: You want to create a company and run it for the long haul, changing the world, raking in profits and gaining fame. On the other hand, you may be thinking shorter term: You want to create a company, flaunt its potential, and then sell it to the highest bidder, either via a merger or acquisition ("M&A", where your company is folded into an existing company, or its shares or assets are purchased by another company), or via an initial public offering (an "IPO", when your private company goes public and is listed on the stock exchange). If you're aiming for the shorter term option, you're looking for what is known as an "exit".
There is no magic formula on how to achieve an exit, but there is certain groundwork required from day one to make sure you don't preclude the option. Particularly, you need to make sure your company is run well and every move it makes is properly documented over the years. Because when a potential buyer comes along, it is looking for a good, clean product. This means making sure your employees are paid and the proper deductions are made; that your board and shareholders approve all the actions that the company takes which they are required by law or by agreement to approve; ensuring that your company owns its IP – considering that it is most likely your most valuable asset; paying your taxes and filing your annual financial report; settling disputes appropriately, should they arise.
And as frustrating as it may be – we recommend that all of the above should be done in English, to the extent possible. Because if you want Apple or Google or Facebook to come after you – they need to be able to get comfortable with your documents in order to know what your company is worth and what they're buying.
So go ahead – show them what you're worth!