They’re a way of giving employees a slice of ownership in the company they work for, and are a friggin’ incredible tool for high-growth businesses to attract top talent from traditional employers.
The thing is, ESOPs are bloody hard both to implement and understand, especially if you’re not from a financial background.
That’s why in this newsletter, Amit Majumder (VP Equity Management Product @ Qapita) and I have tried to condense the high-level basics into a cheeky guide for junior employees!
Special shoutout to Albert Patajo for early sparring on the piece 🧡
Why Employers Offer You Equity 🎁
Giving equity to junior employees isn’t something you see in big grad employers like Deloitte & PwC, so what’s encouraged tech companies to start doing this?
Here are the five biggest reasons:
Employee Motivation: Employees feel more like ‘owners’ when given a stake in the business and may be more likely to go the extra mile for the high financial upside.
Employee Retention: Equity is granted to employees over an extended period of time, giving employees a sweetener to stay longer.
Incentive Alignment: From a cultural perspective, when workers and investors alike own a piece of the pie, there’s a stronger alignment on prioritising the objective to grow and scale the business.
Protection Against Bad Leavers: Departing employees who are uncooperative with the company may lose some or all of their equity, based on ESOP conditions.
Reduced Cost of Attracting Top Talent: Companies with limited cash reserves can still provide attractive compensation packages to hire high-quality talent.
Equity Instruments 🎺
You’ve just signed a job offer at a tech company or startup that includes equity. Congrats!
Here’s the thing: you probably don’t get actual shares in the company just yet.
Instead, you get some form of ‘equity instrument’: a document serving as evidence that you own a piece of a business.
These come in several “flavours”, and the differences can be pretty important. These are the ones you’re most likely to encounter as a junior employee in Australia:
An option is a right for you to buy shares in the future at a predetermined price, known as a strike price or exercise price.
These are the most popular instrument for early-stage startups & scaleups that are not yet listed on the stock market e.g. Eucalyptus.
Rather than holding shares upfront, you are instead able to buy the shares once your options vest i.e they have surpassed a certain amount of time held and/or you have met certain performance conditions.
The action of buying shares based on this right is known as exercising your options.
Restricted Stock Units (RSUs)
An RSU is a right to receive shares in future based on certain conditions being met, without the employee having to pay anything.
These are more common in scaleups and publicly listed companies e.g. Atlassian.
Typically, the conditions are based on the duration of time held, but may also include individual performance targets, company performance or the company going public.
Loan Funded Shares
A loan-funded share means you purchase a company’s share for a certain price but receive a loan from the company to fund that purchase
These are more unique to startups in Australia, but less popular due to heightened administrative complexity for companies issuing them.
You need to repay the loan if you want to hold or sell the shares.
Phantom plans mimic another instrument with one exception: on conversion, you don’t receive a share, but a cash payment representing the value of your gain.
These are sometimes used by international companies that may find it tricky to comply with local equity rules in countries where they only have a handful of employees. Australian companies sometimes use these for employees in China & the Phillippines.
The Lifecycle of an ESOP 🌱
Let’s walk through the lifecycle of what typically happens when equity is part of your employment contract:
You get the job and on Day 1, you get allocated some value of equity through one of the equity instruments we talked about, like options or RSUs.
Let’s say your contract came with $20K worth of equity. Your employer would use the current share price to determine the number of equity units you receive.
You probably can’t sell that equity just yet! Instead, you’ll need to earn it over a period of time, known as a vesting schedule.
A common default vesting schedule is 4 years, with a 1-year ‘cliff’. Under such an arrangement, 25% of your equity would vest after spending 1 year at a role, and it would continue to vest proportionally every month or quarter thereafter. At the 4 year mark, you would have received 100% of the equity.
For some equity arrangements, you may be required to meet additional performance conditions around individual/company performance before your equity vests.
So your equity has vested. You can either sell your equity and get cash or hold onto your shares. Your ability to sell depends on a few factors:
Your company’s security trading policy: You may be in a blackout period where share sales by employees are not allowed or may need to request pre-clearance before selling.
Whether you hold shares: Options need to be converted into shares and often have an expiry date. This means you need to convert them into shares before a certain time or you lose them, even if they’re vested!
Whether your company is listed on a stock exchange or is still private: Publicly listed companies mean you can sell your shares at any time to the market provided it complies with company trading policy. Private companies are not involved in an active market, and so you will need to wait for a liquidity event e.g. IPO, acquisition, fundraising round, etc. in order to sell.
Leaving The Company
Typically if you resign, you will get to keep any vested equity when leaving a company.
If you retire, resign due to illness/injury, get made redundant, or get dismissed unfairly, you may be classified as a ‘good leaver’ and get to keep unvested equity as well.
Otherwise, if you resign voluntarily (e.g. you accept a job at another company) or are fired for failing to uphold company policies or performance targets, you are technically classified as a ‘bad leaver’, though the name is a bit melodramatic.
In the case of breaching contractual conditions like disparaging the company or leaking company information, you may be at risk of losing all equity even if vested. This depends on the clawback clauses in your equity agreement.
Risks and Caveats 🚨
All this equity stuff sounds pretty like a pretty sweet ticket to financial independence. Join rocketship. Wait a few years. Retire and dive into a large pile of gold coins like Scrooge McDuck?
Let’s come back down to earth for a second and call out some sobering truths.
Most Startups Don’t Become Unicorns
It’s easy to fantasise about the stories of early employees at Uber and Airbnb cashing out equity, but most startups do not get anywhere near this size. Be mindful that when you join an early-stage startup, you are likely joining a risky and unproven business model. There’s a good chance your equity goes to $0.
Early-stage startups usually can’t compete with big corporates on salary level, and they use equity to make up the compensation gap for attracting top talent.
From a financial perspective, are you comfortable with the risk:reward ratio of forgoing a guaranteed higher salary in exchange for the opportunity of a big equity payout if the startup works out? There is no right answer.
Just because your equity has vested, doesn’t mean you can convert it into shares or sell it.
If you hold equity in a private company, you can’t just hop on Stake or Superhero and go and sell the shares; there’s no active market for them yet.
You’ll need to wait for a liquidity event, such as an acquisition or IPO, and this could take many years. Increasingly, there are opportunities for secondary sales when a startup raises a new funding round, allowing employees to cash out their equity by selling it to new investors.
With every new funding round, more equity is issued to investors. If there are more shares on issue, the percentage of the company that you own is now smaller 😭
This may seem like a bit of a bummer, but by taking more funding, the hope is that this enables the business to grow much bigger, ultimately making your equity ownership more valuable in the long run.
You often see the news of companies raising more capital at higher valuations, but that’s not always the case.
Your company’s next funding round could be a down round: raising at a valuation that is significantly lower than the previous round. As a result, the value of your equity can go down.
The Cost of Exercising Options
If you are presented with the ability to exercise options i.e. convert them into shares, you might be faced with a challenge.
If there is no liquid market or the ability for you to sell the resulting shares to fund the option cost, you may need to pay that out of pocket.
Given you may only be given a couple of months after you leave a company before the expiry date for the options, be sure to plan ahead and be in a position to exercise your options before they lapse.
Keep in mind that you may end up being hit with capital gains tax and/or income tax on your equity.
In some situations, income tax may also be triggered before you even transact on your equity; be sure to check the specific terms of your equity plan.
When you sell your shares in a company, you produce a capital gains tax, and normally if you sell less than 12 months after owning shares, you do not receive the capital gains discount.
However, for company ESOPs that fall under the ESS startup legislation, your holding period of options counts towards this 12 month period, which is why startups tend to use options instead of RSUs.
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