WTF is an ESOP?

Jason Atkins: Hello, everyone. Welcome to today's Startup Equity Matters. Today, we're going to dig into the employee side of things. How do we help our team members understand their equity? And as a team member in a startup, how do you know what you own? How do you know that your startup cares about your equity? How do you know what it's worth? Do you have a tax bill? You know, like it is pretty complicated. At Cake, when we're hiring, we work super hard to educate and give people time to think it through and ask questions. And there are a lot of questions. People don't just automatically understand this stuff. So today's episode, we're going to dig into that. It's the employee side of things. And specifically, I'm going to be going through Cake's employee guide. It's called WTF is an ESOP. It is a little bit of an Australian guide, so it's specifically very cool for Aussie startups and their teams. But a lot of these things work all around the world. There will be some little differences on tax and some of the really technical elements. I'll try and call them out as I go along. Yeah, it's a really great report. We've had some awesome feedback on it. It's the second time we've done it, so we just really upgraded everything. The whole idea is that it's just to try and simplify this as much as possible for you all. Cool. So let's get into it. 

Jason Atkins: What is an employee share option plan, eh? So it's kind of a win-win for you and the company, right? If you're a team member, you get a slice of the equity, which ideally keeps you motivated that the company's a success, right? Because you've got some ownership. You want to see that ownership worth as much as possible, and the company wants to see the value of equity worth as much as possible as well, because the founders have equity. The investors have some and the team all have some. So we all have a piece and we're all working together to make it worth as much as possible. So it's good for everyone. Yeah, so this guide has a little glossary. There's a good 20 odd terms there that we explain really briefly. Exercising, exercise period, exit event, grant date, all that kind of thing. So if you're looking for a really quick overview, check that out. But we're going to dig into all those things in a little bit more detail now. I'm going to take about another 20 to 25 minutes to just talk you through all the most important elements of what is an ESOP, including what are the benefits? Let's talk through some examples like granting, vesting, exercising, what happens when you leave, all these kinds of things. All right. 

Jason Atkins: So what's in it for you? What are the benefits? Why, as an employee or a contractor or an advisor, why do you want equity in a startup? So the first thing, obviously, is ownership. You're owning a piece of the company. If you're an advisor, you could be getting somewhere between 0.1 and 1% over two years, really, really early. Team members could be getting up to a percent ownership in the company, normally earned over four years and everything in between, so it's just cool to have ownership in the company where you work because you're working hard to build that company. And then if it's super successful, then you can really increase your personal wealth. And we're going to dig into that a bit more as we go. There's also tax benefits. Certain ESOPs attract substantial tax concessions. Usually, what that means is that you don't pay tax when you get the options. You only pay tax when you sell them, which can be years down the track. And normally, when you sell them, it's when the company is sold or it lists on the stock market. And so you've got the cash to pay the tax bill. That's great because you don't want to be getting equity and then having to pay tax upfront because you haven't got any cash. So, yeah, some good tax benefits. And, yeah, like it's a financial asset. So it's just really great to be gaining a financial asset on top of your salary. And there's some really potential great financial rewards from being an owner in these startups. And while not every startup is successful,  quite a lot are. Whether it be like a huge big exit is one way, but some of them have smaller exits, medium-sized exits, some of them make a profit and pay dividends. And as an owner, you get access to some of these financial benefits, which is great. How can your options grow over time as a team member? So here's an example. So you're granted, say, $30,000 worth of options when you sign up to a company. Normally, that's over a four year period. So what's that? Roughly seven or $8,000 per year. So that's not a huge amount. It's a regular amount that a lot of people would be getting. So you're getting 30K upfront. You're earning it over four years. So you can't, like, if you leave in the meantime, you may not earn the whole amount, but just say you do stay for the whole four years. In year one, the company might be valued at 5 million. That's a pretty standard kind of seed stage valuation in Australia, and you've got $30,000 worth of options. So in year two, if the company does well, the valuation can go to 15 million. I mean, it's totally normal. We say that all the time. So you might get like your angel round done, and then you get like a VC round done in year two at say seed stage, $15 million bell, maybe seed series A, depending on the company and the revenue. And that's tripled the value of the company, which means it's tripled the value of your shares. 

Jason Atkins:So now, you've got $90,000 worth of shares and I've excluded dilution here. So just to keep it simple, but by year four, so fast forward another couple of years, the company could be worth 50 million. It's totally like a normal thing in venture for companies to go up pretty rapidly in value. Brenton Burchmore, Ph.D.:  And then, by then your equity in this instance would be worth 300,000 because you know it was worth 5 million when you got it and the company is now worth 50 million, that's 10 times, and so your equities also gone up 10 times. Again, we're ignoring dilution, but just for simplicity, now you've got $300,000 worth of equity, which is incredible, a huge amount of value creation, very difficult to create that amount of wealth. Really, there's very few other ways you can do it. So that's cool. And then, maybe in year eight, the company goes ballistic and just in the best case scenario if it hits, say, a $5 billion val, you could have a million and a half dollars worth of equity. So that's obviously like a massive outcome, a big unicorn outcome. But these things do happen. So from the original $30,000 grant that you got, you've generated a million and a half dollars worth of total wealth. So like, you know, that's a simplistic example and that's like a best case example, but I think it's just a really cool way to just to sort of explain what can happen. But even if you get a, like a medium outcome of a 50 or a hundred million dollar outcome, $20 million outcome, you know, there's still some pretty serious wealth being created from that original $30,000 worth of options. So the very first time as a team member, when you get your options issued to you, it's called an option grant and it's sent via an offer letter. So let's talk through this process. So you'll get employment, you might get an offer as part of your interview process, and then, you accept that offer. And then, the next step would be your employment agreement. I'm sure you'd be familiar with that, which sets out all the rules and what you need to do as an employee and your salary and that kind of thing. And then, there's an extra agreement that gets sent to you, which is the ESOP offer letter. And so, yeah, just make sure that you're getting an extra letter in addition to your employment agreement. Otherwise, you probably haven't really officially got your options granted to you. And yeah, if you're using Cake, this is a highly streamlined process. But of course, you can do that manually or whatever. So just make sure you get that ESOP offer letter. With that offer letter, you're going to get what's called the plan rules. So the plan rules are like the legal contract, part of the legal contract that sets out how the overall ESOP scheme runs. So for those of you that are familiar with a shareholders’ agreement, it's quite a similar document, but it's just specifically for the ESOP, for the options. So it sets out all the different things like who can participate? What happens if you leave? Can you transfer the options or shares to other people? How would a buyback occur? What happens when there's an exit? So there's all these different rules that are set out in the plan rules. It's really important that you kind of check that out. It's like signing any contract, like if a founder is going to sign a term sheet with a VC, they're going to read these rules and just check that they're fair. And so you want to be just checking that as an employee, your rights are being protected. There's obviously parts in that plan rules that protect the company as well. Right. And it does need to be in balance because the company needs to be able to control its own cap table in a fair way. But also, you know, as an employee, you need to know that you're being looked after, too. So, yeah, there's some rules in there that you should just be aware of and check out. And then the offer letter itself should have some really important information. So the number of options that you're getting, the exercise price, how it's going to vest, the vesting rules, what is the expiration date of exercising and any sort of local tax stuff. So yeah, so you're going to get two main documents when you're getting granted your options. And yeah, that's just a little bit of an overview of what they are. So make sure you check it out and that sort of works for you. Cool. So flicking on a little bit. So yeah, like after you've reviewed those two documents and you do actually sign that offer letter, and then you've been granted your options. 

Jason Atkins: And so after that, the next thing that happens is called vesting. So the vesting is kind of like earning. You can earn your options. The two main ways that options are vested or earned is based on time or a milestone. The vast majority of these investing periods are time-based. So it's like four years with a 12-month cliff, so you have to work there for a whole year normally to get that period, that percentage of your options. And then every month or every quarter after that, you get more options up until that four-year period. So if you leave within the first year, you'd normally get nothing. And that's sort of designed to protect the company. They don't want to be giving away equity to everyone, especially if there's no real commitment and no long-term sort of connection. So in that first year, you have to make it all the way to the end of the year. And then after that, every month or every quarter, you get more vested. And then, if you leave after year two or after year three, the vesting just stops and you keep the bit that you've vested or that you've earned in general terms, depending on the rules or in the plan rules. Yeah, so there's also milestone vesting. So sometimes, particularly in the case of a strategic advisor or perhaps someone senior or in sales that has a very, very specific kind of target, you could have a milestone-based vesting. So yeah, if we hit 1 million in ARR, then we get our options. Or if this particular individual hits a certain sales target, they get a specific amount of options. So you can have either time-based or milestone-based vesting, or a combination as well. Sometimes different team members might have both time-based and milestone-based vesting. The next step in the process, so the first one, remember, is granting, which is the offer letter. The second thing that happens is vesting. So after you have vested some options, you can exercise those options. So exercising is the third step, and that's converting the options to shares. So again, the rules about how and when you can exercise your options will be found in the plan rules and should be explained to you by the company. Or if you need help, you can just ask your company and they should be able to help you with that. Yeah. 

Jason Atkins: So the third step is exercising. And so that's where a payment is made from the employee to the company, which is the exercise payment. And that's the exercise price multiplied by the number of options that are being exercised. And once that payment is made and the company proves the exercising occurring, then, yeah, then the options change from options to shares. So then, you become a shareholder. There is a difference between an option holder and a shareholder. And while none of this is financial or legal advice, I guess in simple terms, a shareholder would have the ability to vote at meetings of shareholders and approve things when it comes to shareholders resolutions, and also has the right to dividends when they happen. Whereas an option holder doesn't have the right to vote or approve things or get access to dividends. So yeah, just good to be aware of those things. And the normal time when an employee would exercise from an option to a share, especially in Australia, would be when the company exits or if the company is paying dividends because you don't want to be kept as an option holder when the company is sold because you want to convert from options to shares, and you want your shares to participate in the sale, so that you get the cash as part of the exit. And similarly, if the company is paying a dividend, you don't want to have options because they're not going to get any of the dividend. You most likely would want to convert your options to shares so that you get access to the dividend. An important consideration here is how much do you have to pay to convert your options to shares? For the most part in Australia, the exercise price is very, very small. It's a nominal amount. It's normal. This is a really tricky thing to try and explain the exercise price. So the price that you pay per share in Australia is normally cents on the dollar to what the company is actually worth, like one cent or two cents or three cents, like max, is normally the exercise price. I won't go into the details of why, but that's kind of how it is. But you do need to check that because in certain circumstances, it could be, just say that the share price is currently a dollar, your exercise price could be 50 cents or 80 cents or a dollar, or in the worst case, it could actually be $2. Just if, say, for example, your exercise price has been set at a really high valuation, and then the company maybe does a big down round, you do need to check the exercise price and the exercise payment and make sure that that's balanced to the amount you're going to get in an exit or a dividend. But for the most part, the exercise price is something like a cent or whatever, because the options are normally issued very early in the company's life when its taxable value is nice and low. And yeah, so it's a really awesome thing to exercise because you're normally participating in an exit. And that's quite often a really, really fantastic moment where a lot of value is realized. And that's quite often, hopefully, a really, really exciting part of the journey. So here, we have a couple of examples, because some of this stuff is just going to sound like mumbo jumbo jargon. I'm sorry about that. It is a little bit of technical stuff. So let's try and simplify it a little bit. Let's use Kelly as an example. So, and this is all in the ESOP guide. So if you need to reread it or read it, or if you want to ask the Cake team, read these examples, talk about it with your advisors and mentors, it's probably a good idea. So Kelly has joined a Series B FinTech startup. Kelly's starting package is made up of 100K base salary with a hundred options issued at a company valuation of $50 per share with a strike price of one cent. So there, you can see the company share price is $50, but the strike price, the exercise price is only one cent. So the other $49.99 is value that Kelly's getting. Now on the current valuation, if Kelly exercises her options to purchase shares, she can realize just 5,000, just shy of $5,000. If she, three years later, if the company value has increased by 5X, her options will be worth 25,000, but she still only has to pay $1 for exercising because she's got 100 options and the strike price is one cent. So here's another example. Peter joins a seed stage marketing tech company. His starting package is made up of a 200k base plus 20k in options issued at a share price of $2.27 with a strike price of $1. So you can see there, even though the company share price is worth $2.27, he's getting a strike price of a dollar. So he hasn't got it for one cent like Kelly did. It's a dollar. So it's probably a little bit more of a substantial company. That's a bit further down the track in its journey. He's still getting a big discount. Right. He's still only paying a dollar when the company is worth two dollars twenty seven, so that's great. So if Peter exercises all of his options, he can gain up to twenty five thousand four hundred in addition to his base salary, and this value will continue to grow as the company value increases. Three years later, if the company value has increased by 10x, his options will be worth $254,000. But he would still only have had to pay $20k for those 20,000 options times a dollar. So, it’s a really nice upside there and a couple of practical examples. I hope that helps to clear that up a little bit. 

Jason Atkins: So what happens if you leave the company? This question comes up a lot. There's multiple spots along the journey where you could leave and you just kind of want to know how much of your options you keep, how much of your shares you keep, what happens if the company gets sold, all those kinds of things. What happens if you leave the company? If you leave in the first year when there's a cliff, you get nothing. If you leave after two years, then you get two years out of your four years. That would be kept as vested options. And again, you need to read the plan rules. There can be differences on exactly how many you keep and what happens when you leave and things like that. So do pay attention to the exact plan rules that you know, and how it works in this particular company. But quite often, what'll happen is afte you work for two years, you'll keep that two years worth. If you stay the whole four years and then leave, you'll keep the whole four years worth. If you leave as a good leaver, then quite often the company will just let you keep all your options. They'll also let you convert your options to shares by exercising quite often. But again, check the specific rules that you're signing. And if you leave as a bad leaver, so if you leave under poor circumstances like if you're fired or if there's some sort of fraud or one of those bad outcomes, then it's possible that your options can be taken off you or bought back at a big discount. So it's much more punitive in that circumstance. So, yeah, just have a look at the plan rules of what your company says about leavers and just check that you're cool and that it's pretty fair for you. So, yeah, once you own it, you want to be able to keep it, and you want to be able to participate in the exit, if and when it ever happens, or in dividends, if and when they happen, you don't want to earn it and then realize that they can sort of be taken off you, or you might just make a little admin error and lose them for some reason. So just check those things. Yeah, and can you sell them? You know, usually not. Again, you need to check the plan rules for the company that you're signing up to. But normally, you can't really sell them at any time unless the company approves it. So sometimes, companies will run like what's called a secondary market or have a bigger shareholder that's kind of happy to buy out team members' equity after they leave. So that's kind of cool if you want to do that. And sometimes, you get a choice of selling them or keeping them. And then usually, if the company has a bigger exit or gets bought out, you're forced to sell into that sale. So again, just check it out. Normally, you can't sell your options. Sometimes, you can if the company is set up with a buyer. And then if the company has an exit, you normally get dragged in. 

Jason Atkins: Quickly on the tax side of things. So as I said, right at the start, in Australia particularly, and most countries have pretty favorable tax laws around ESOPs, so check it out in whatever country you're in. But in Australia, the vast, vast, vast majority of startups are using the startup concession ESOP. There are some rules that they need to follow. But the most important thing is if they're using the startup concession and it's done correctly, then you don't have to pay tax when you receive the options, which is great. And you only have to pay when you sell, which is really cool, really balanced. And you're probably eligible for the 50% CGT discount at that point as well. So, yeah, you do need to get your own tax advice. This is not tax advice. This is just sort of like giving you the general info so that you can be aware and make sure that you check it all out–what's important and the sorts of stuff you need to know. 

Jason Atkins: Yes, let's talk a little bit about exits. So yeah, a big part of why we own equity is like just having some skin in the game and being part of it and knowing that if everybody wins, you're going to win, right, which is super cool from a day in day out cultural perspective. But at the end of the day, it's a financial asset. And what we really want is equity for our options converted into shares. What we really want our equity for is to access an exit one day. Yeah, so if the company does an IPO, you should get a percentage of that listed stock, which then becomes something you can sell on the stock market. There's quite often a bit of a lockout period, maybe a period that you can't sell, but that's a great outcome usually, especially if you started at like seed or series A stage and IPO is normally at a much higher valuation and the company's raising a big chunk of money so that they can go on and grow and become even bigger. You know, that's normally great for you. It's normally a liquidity moment where you can take some cash out, some or all of the cash out from your options. And yeah, it's like a super exciting time. We love seeing that. Hopefully, we get more and more of this kind of thing in the industry. IPO is not the only way as well, like also an acquisition. So mergers and acquisitions, a bigger company buys you or you merge with another company. And in that case, you can end up with stock in the new company. So shares or stock in the new company or cash or both. So, yeah, like it's again, normally at a high valuation, not always, but yeah, really nice to be able to get some cash for all that hard work and reap the benefits. 

Jason Atkins: Yes, I'm just going to finish with the equity flywheel. The report finishes with that as well. You know, at Cake, we just love this concept and we see it in the market all the time where someone will come in at, say, C to a Series A. Just think of the likes of Canva and Atlassian. They come in early and go on this incredible journey. The company valuation just goes to the moon. And these early employees, honestly, make millions in equity. And that's obviously the best case scenario. But like anyone that makes half a million or a million dollars worth of equity in these startups, it's just completely set themselves off in a different financial journey. We talked to people time and time again about how much space this creates for them. It creates financial freedom, it creates creativity. So much creativity is born from this because they're freed from the shackles of day to day and month to month and year to year. Just payments. And we love seeing the freedom that this equity flywheel creates, so it creates wealth for that individual. It creates space for them to create new companies. Not always, of course, but it does for many. Many of those people go on to become angel investors or VCs themselves. And that capital goes into regenerating the next stage of founders, which is just like super, super exciting. So, yeah, we love the equity flywheel at Cake. I'm just going to finish on that high note. So yeah, that's an overview of the employee guide. WTF is an ESOP by Cake. Again, this is not all about Cake, but having Cake there is such a wonderful resource for us here at Startup Equity Matters. And yeah, we really, really hope that you enjoyed today. And yeah, good luck out there. As a founder, get that equity in your team's hands. As team members, make sure you understand your equity. Ask questions of your company. The more you understand it, the more you're going to value it and the better outcomes we're all going to have. So, yeah, keep on trucking.