Read this before you accept an equity offer at a startup

Hi! Alexey here, one of the founders of Eucalyptus.

I designed the employee equity plans for Canva, Koala, and of course did the same here at Euc. These ranged from Australia-specific plans to ones across many countries.

This is what I learned:

🤷‍♂️ What is equity?

Equity is ownership of a part of the company, in addition to your regular salary. Unlike cash, it comes in the form of a contract known as an ESOP (employee share option plan).

📈 Equity matters. Why?

Having been a beneficiary of Canva’s equity plan (for work that I have done in my mid twenties), I can say that it is a great thing, in two ways:

1 – It’s rare in your life to be able to receive a significant lump sum beyond an inheritance, lottery, crypto (which is again a lottery, plz don’t hate on me).

2 – The lump sum allows you to make choices that are not available to you ordinarily like:

• Put funds into a business, while also expecting your first child
• Put down a deposit on a property and have a buffer to meet your mortgage fees
• Pass on a job offer that is not quite right
• Join a startup at a lower salary level and participate in an equity plan yet again
• Have a head start in your retirement portfolio

Taking on an equity offer (especially if you are getting a lower salary) is a lottery in many ways as there are a lot of factors beyond your direct control.

BUT since you get to choose what lottery you join and if you go about it in a smart way you can avoid sure fails and tilt the odds in your favour. So do it right, dig into the details, and ask the questions! I hope I can help with that a little bit.

😕 Comparing equity offers from two different startups should be easy, right?

Unfortunately, in practice, it’s not so easy. Equity has a lot more dimensions to it than a simple cash offer would, so the best way to group these points of comparison is along these lines.

1. Type of equity offered
2. The company's momentum
3. Features of the equity plan
4. Tax considerations
5. Capital structure of the company (I saved the most technical till last)

1. 🍎 Type of equity offered

I won’t lie, I have written on this topic quite a bit, so if you prefer to dig into this area with a lot more detail, here is a deeper article that will scratch that itch (written by moi of course). But in short, equity can be provided in a few ways:

• Shares
• Options
• Restricted Stock Units

Which type of equity offered depends very much on the tax legislation in a particular country, as well as the size of the company and the stage in the company's startup journey. (We’ll dig into it a bit more under the tax considerations section of this article).

Nevertheless, understanding what’s on offer and mechanics of that particular instrument is an important first step in being able to compare the offers like for like.

Questions to ask the company:

1. What type of equity is offered?
2. Do I have to pay for the equity upfront?
3. Is equity on offer liquid? If not, what’s an estimate on potential liquidity timeline?

2.🚀 The company's momentum

This isn’t really a financial concept per se, but the greater the success of the company = less chance of downside scenarios playing out, and a higher chance that the equity gets to a stage of unlocking the significant economic benefits it is capable of.

So what should I be looking for? 

To be honest this is highly subjective, but this is what I looked for when joining Canva and Koala as employees 28 and 21. Let's use the example of someone looking at joining our own startup, Eucalyptus.

(We are hiring BTW, so plz have a look).

Do customers love the product?

That means doing the research on the product the company makes, and whether they are on to something. In the case of Eucalyptus, our brand Kin has 3k product reviews and is at 4.9 stars, for a long while there we were at 5 star streaks that lasted for 100’s of reviews. Software is at 4.7 which is respectable and has glowing efficacy testimonials. Pilot is a tougher crowd with 4.6 but is still solid.

Which way does the talent flow? In or out?

Again, to use our company as an example, we have 200+ amazing humans now, up from 50 a year ago. The list of places these people come from is long and star studded Canva, Atlassian, Optiver, Google, McKinsey and many more with special mention of course to Bain (we love your work Bain Talent team!)

Are people excited to work there?

We are tackling difficult problems in a highly impactful area and hyper growth is hard! We have multiple brands and are a hyper-connected organisation. That said, the pace is fast so it’s not for everyone. Have a look at what our people say. Better yet, hit them up on LinkedIn and have a chat!

Am I actually tackling a new frontier?

Pushing loans that people can’t really afford is cool and all, but is there really a spark of innovation in what you do that improves the lives of everyday people? We’re helping over 300k people engage with healthcare, often for conditions that they felt uncomfortable talking about before our brands came along.

Will I learn something new? Can it accelerate my career?

I’m a big believer in leaning towards areas that push you to learn. If you do this enough times, it becomes part of how you think and view the world.

My own personal example: I came in as an assistant accountant to Canva and left as a Financial Controller (2.5 years later), then from Koala I took up a CFO role at EUC (2 years later). Seems like 4.5 years on paper, feels like a long career with over 10 fundraising rounds, 4 market launches, 20 or so companies created, sooooo many people interviewed and hired, and a couple of mistakes made along the way (no getting away from those we all make them).

I’m not unique in this, that’s what high growth startups provide if you lean into the learnings. If you look across our team you will find countless examples of people leading teams for the first time, tackling new challenges unique to their craft, making mistakes and learning. We all remember that $50k oopsie – we've had several – and those people will remain unnamed here but are very much still with us 😉. 

3.🕹 Features of the equity plan

These features are often referred to as 'Plan Rules'. There are a number of features within equity plans that are pretty standard, like:

Vesting

This is how long it takes for the options grant to become 'unlocked' as you work day-to-day at the company.

For example, a very standard vesting period is "4 years with a 1 year cliff". It takes you 4 years to unlock your entire options grant. The cliff means at the end of 1 year at the company, you can exercise 25% of your grant (this is designed so people who don't stay very long don't end up as shareholders). After the cliff, vesting switches into monthly intervals until the grant is fully-vested 4 years after the start vesting date (which is usually your start date).

Requirement to exercise options

Many ESOP plans require employees to 'exercise' their employee options shortly after leaving the company (in the US, this is 90 days).

What does exercising mean?

Exercising options means converting them into shares. Essentially, that means buying them at a pre-determined price known as a 'strike price'. In the early days of a company, a strike price is very low (often $0) but can become several thousands of dollars after Series A.

What are the implications? Well, if you have to exercise your options quickly after leaving, you may have to pay (often thousands, or tens of thousands of dollars) to hang on to them.

So short exercise periods is a considered harsh practise and can be used by the companies to "lock in" employees beyond 4 year vesting period since many can't afford to pay that lump sum.

At Eucalyptus we don’t have this clause.

If you vested the option you can leave and keep it. We do this because we think it’s fair and because we were personally burned by this clause in the past (the person reading this knows who they are. Please know that I consult your competitors free of charge).

Good Leaver/Bad Leaver provisions

A 'leaver' is someone who departs the company. Just like in the army, at a company you can be honorably discharged (good leaver), or dishonorably discharged (bad leaver).

In the most fair ESOP clauses it says that if you do something bad (theft, sexual harassment, work for a competitor) then you may lose your equity even if it is vested. The key here is to make sure that the threshold is fair and the term 'competitor' is well-defined.

Procedure on 'exit event'

An exit event is when the company gets sold. Usually this means acquired by another company, or lists publicly (IPO) on a stock market (ASX, NASDAQ etc).

There are a lot of things that can happen, so just make sure you read this portion of the plan rules carefully.

Questions to ask the company:

1. Can I please have a copy of the plan rules? 
2. What happens to my options if I leave the company?
3. Do I have to exercise my options within a period of time after my departure?
4. Does the plan specify good leaver/bad leaver provisions?
5. When do vested options expire?
6. What happens to the unvested options if the company is sold part way through my vesting period?
7. When will my vesting date start?

4.💸 Tax considerations

Firstly, nothing in this section should be interpreted as personal tax advice.

It’s a bit difficult to write because tax depends on the tax rules of the country where the equity plan is offered, the size of the company, and personal aspects like citizenship(s) held.

I’ll do a quick overview of what these are for Australia, but do note that rules change and even as I write this there is legislation under consideration that will change some information covered here.

Australian Tax Office (ATO) has a lot of information dedicated to employee share scheme (ESS) regime. We are most interested in a subdivision of this regime that came into effect in 2015 called ESS Startup Concessions. These concessions allow for taxation points to coincide with the eventual sale of the equity and most early stage startups issue equity by means of options for this reason.

TL,DR;

Let's look at an example timeline of tax considerations:

Before 2015

1. You got options with the strike price equal to market value of the Share
2. Stayed with the company for 4 years
3. Fully vested your grant
4. Exercised the grant (paid to convert your options into shares)
5. Got shares (starting the clock on eligibility for capital gains discount)
6. And sold shares the same day, and since you did not hold them for 12 months, no capital gains discount for you

After 2015 (under ESS startup concessions)

1. You got options with the strike price equal to market value of the Share at the time
2. Stayed with the company for 4 years
3. Fully vested your grant
4. Exercised the grant (paid to convert your options into shares)
5. Got shares
6. And sold shares the same day, and since the holding period includes your holding period of options, you receive the capital gains discount.

The key to all of this is that the company and its equity plan needs to fall into the ESS startup concessions 'regime'. The company needs to be of the right size and age, and the plan needs to be structured correctly.

If the plan does not fall into that definition, then the timing and rate of tax paid can be very different.

At some point, if the company is large enough, it will exit this regime and will design a different equity plan to suit its needs. And there are too many equity plans out there to speculate on how they may look.

Questions to ask the company:

1. Does the plan qualify for concessional tax treatment? (Startup concessions or similar)
2. Does the plan attract tax on grant, vest, termination of employment, or exercise?
3. Are there any tax reporting requirements that I should be aware of as part of accepting this equity offer?

5.🏗 Capital structure of the company

This area is the big, big iceberg under the surface. This section is quite technical, so buckle up!

While it's great you are being offered equity and its potential upside, be aware it also comes with the baggage and history of how the company developed and manages its investment relationships with shareholders.

There could be a few things going on; founder conflict, bad investors etc, however, I think it boils down to two main things:

1. Preferential terms the company has across its share classes (wat?)
2. The vectors for dilution (woah)

You might feel that these two things make no sense, and you’d be right – these two sentences are loaded with highly-technical terminology.

I'll try to break it down by introducing the concepts of preference and dilution first, and then we’ll jump into more technical examples of how these two things manifest in practice.

Side Quest 1: Preference

It should be reasonably general knowledge that a company has shares. Shareholders hold these shares and gain proportional ownership of said company.

If one particular shareholder has 10 of the total 100 shares on issue, then that shareholder owns 10% of the company. This shareholder gets 10% of the profits, proceeds from sale, and has 10% of the votes at shareholder meetings. So far, so good…

Not all shares are created equal.

You see, some shares have extra features that cause them to be referred to as 'preference' or 'preferred shares'. The standard, vanilla shares described above are usually called 'ordinary shares'. In reality, shares can be split into many classes, and each class can have very different rights, especially over many rounds of investment.

Let's look at an example: we'll create a share class for illustrative purposes called 'Super Voting Class - SVC' that allows the holders of these shares to have more voting rights compared to holders of ordinary shares (meaning they can control the company more).

In this class we’ll just set a rule that each vote of this SVC share is equal to 100 votes, while ordinary shares still carry 1 vote for 1 share. So all of a sudden, if we have 100 shares total, 2 SVC shares, and 98 ordinary shares, then the control of the company is split in 200 votes vs 98 votes.

But the economic rights of the shares may remain the same. In this case, economic outcomes are reversed – 2% vs 98%. Strange huh? This is just one example of a preference right.

For our purposes there can be many different preferential rights in a capital structure of the company. The most common ones I’ll cover in the technical portion of this explanation in just a bit. But before that, let’s talk about the concept of dilution.

Side Quest 2: Dilution

Just like adding extra water to your cordial, dilution is the concept of decreasing percentage of ownership in your shares over time.

What is dilution?

Dilution can happen in different instances, but the most simple example is a new investment round. An example: let’s say current shareholders hold 100 shares of the 100 shares total on issue, meaning that they have 100% ownership.

Now imagine a new investor puts some money into the business and gets issued with an additional new 50 shares, bringing the total shares on issue to 150 shares. Great! The new investors now own 50/150 = 33.3% of the business, but our existing shareholders went down in their percentage of ownership to 66.6% = 100/150.

I know you’re probably thinking; “but Alexey, that sucks!”, and I suppose it does.

But that’s just the crux of VC backed startups and a reality for any company that is taking on external investment. The bet is on the fact that the new money would allow for the business to grow, and the smaller % ownership of the business is actually worth more since the total size of the business has increased. So this is “dilution”. It’s not good, but also it’s not always bad; it’s just the way the cookie crumbles.

OK, but what's that mean for me?

The sections above should give you an overview of the concepts of Dilution and Preference. If there's one thing to remember from that, it's that capital structures in companies vary quite a lot.

Could I cover every possible scenario that can arise in the capital structure of the company that will affect the economic windfall from equity? I sure can! But our content team asked me to keep this to a few pages, so I’ll clue you into the most common things you need to ask.

Questions to ask the company:

1) Are you looking at a fully diluted equity pool when making your comparison?2) What kind of liquidity preference do investors have?3) What kind of anti-dilution preference do investors have?

Let’s break down each one of these in more detail…

Fully diluted equity pool

A fully diluted equity pool is a mouthful (hey, that rhymes), but all it means: the number of shares on issue includes any options and allocations reserved for employee plans. For example, if we have 100 shares on issue, but also can issue up to 20% of the company as options in an equity plan, the reality is that the fully diluted pool of shares can be up to 125 shares (25/125=20% not 120 as 20/120=16%).

Now that’s reasonably simple, but it gets more complex sadly. The business could have instruments provided to investors like 'SAFE notes' or 'convertible notes' (these are common funding tools) that are not equity yet, but have the potential to be converted into equity.

The trick is to make sure that the number you are looking at is the right one to start with.

Questions to ask the company:

1. What is the fully diluted equity pool?
2. Does the business have any unconverted fundraising instruments and what are they (safe, convertible notes, warrants etc)?

Liquidation preference

Alright! Let’s dive into the world of liquidation preference. If the company you are joining has a venture capital fund as an investor, they'll likely have liquidation preference rights.

The devil, however, is in the detail as there are multiple versions of the clause that can exist.

What is liquidation preference?

It is a clause that gives certain investors the right to take the money they invested back, in case of a liquidity event (company sale, public listing, bankruptcy, or similar).

Why does this exist?

It's traditionally done to protect investors from examples like this: where the company gets $10 million investment for 20% of shares, and shareholders decide to close down the company and distribute the cash proceeds. 20% of $10m goes to the investor, yielding $2m, and the other $8m goes to the 80% shareholders. Not a great scenario for the investor, so the liquidation preference is put into place.

The standard clause, in my humble opinion, is the "1x non participating liquidation" preference. The Important parts here are the 1x and “non participating”.

This is how it works: the investor now has a choice between taking the original sum invested (1x which is $10m), or taking 20% of the 'proceeds' (in-line with their percentage of ownership). If the company is selling for $50m, the investor won't mind (because $10m or 20% of $50m is the same). But, if the company is higher in valuation (let’s say $100m), then the investor would convert into ordinary shares (20% of $100m is $20m which is more than the $10m option). They would be treated the same as the rest of the ordinary shareholders.

The interesting part here is; if the company does not do well and sells for $30m, and the investor still selects the $10m option, ordinary shareholders get the remaining $20m (or 66% of proceeds, even if they hold 80% of the ownership).

Liquidation preference cushions the investor against downside scenarios. Some investors take it further and ask for 2x or more participation, allowing them to take double the money they invest and effectively locking in some return on their funds, potentially at the expense of other shareholders.

Or (and this is the most mind boggling thing) they can ask for participating preference, meaning that they get to take their money back AND participate in distribution for the ordinary shareholders.

While this is really in the weeds of the investment terms, it’s important to know if this factor is at play as it makes seemingly equivalent equity offers very different in terms of risk.

Questions to ask the company:

1. Do your investors have a liquidation preference? 
2. Does the liquidation preference differ across the preference share classes?
3. Is it participating or non participating liquidation preference?

Anti-dilution clauses

Ok, we are almost through the thick of it! Let’s chat about the anti-dilution clauses. A clause is part of a shareholders agreement (a long document that lays out the rights of the shareholders).

The best way to get into this bit is to watch this segment from 'The Social Network'.

Broad based weighted average

The anti-dilution clauses can be written in many ways but the standard is the “broad based weighted average” clause.

This clause resets the price the investors paid in already-completed investment rounds if a new round of investment is done at a price lower than those investors chipped in at. The weighted average part makes sure that the price does not just reset to the new price, but takes into account the amount of new equity issued vs prior equity invested. So if only a single share is issued at say $0.01, then the price for prior investment rounds does not change much.

Full ratchet clause

If you have a “full ratchet clause”, then all the prior rounds reset to this lower price. So anti-dilution preferences cushion investors against some downside scenarios, which is fine for the lighter versions of this clause since the golden rule dictates: the one who has the gold makes the rule. But the heavier handed versions of this clause shift the risk ever so slightly to the common equity and thus employee equity plans.

Questions to ask the company:

1. What kind of anti dilution provisions do your investors have?
2. What valuations were set in prior fundraising rounds? (so you can see a trend)

Final words!

I hope you enjoyed this! I have one last great resource to share where some of these concepts are broken down in more detail. Please check it out!

But in all seriousness, if you are an engineer with React, Typescript, Apollo, Tailwind, HTML/CSS/JS or TypeScript, Node, GraphQL, PostgreSQL, AWS experience and have an equity offer on your hands, then please reach out to me or our team.

We can’t really provide tax or legal advice but maybe we can get another offer into your hands and explain how our equity plan works.