Starting a Startup: Where to Start - Part 8: Equity Incentives (Options)

Shira Teger, Associate at Yigal Arnon & Co.
This series 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.

What follows is a series of articles 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. We'll add a new chapter each week – so keep coming back for more! As always, we welcome your comments below.

If you missed the previous installments of this series, be sure to check them out (along with some other stellar articles) in YTech's Pro Content section. Otherwise, we are proud to present Part 8 of this series: 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.

The content of this article does not constitute legal advice.

Shira Teger is an associate in Yigal Arnon & Co.’s high-tech practice. In her previous incarnation (before choosing a life of law), Shira was a journalist.