Closing the Information Gap on Employee Option Grants: Part One
Most people do not have enough information to properly evaluate the offer they receive, compare it against industry benchmarks, negotiate it and eventually make an informed decision. This can be mitigated by employers giving access to more information regarding ESOP grants, using an offer template proposed here, and by employees collaborating to benchmark Israeli ecosystem option grants.
In light of this, I’ve decided to write a series of posts. This is the first one. In this post, I’ll provide an introduction and focus on the Israeli tax treatment of options, which sets some of the rules of the game. My next posts are about how many options you should ask for and the issues of vesting and dilution over time.
Are options a “bonus” that should be ignored?
As a result of the opaqueness surrounding option grants and their potential value, some people tell me they completely ignore stock options when making up their minds about an offer: they can’t make an informed decision. They see options as a “bonus” that may or may not arrive. This isn’t a good result for either side: neither employee nor employer. I believe this sarcastic approach has three fundamental underlying reasons:
- The ESOP-related information that is available on the Internet and in various blogs by investors is very focused on US taxation, leaving Israeli ESOP recipients misinformed.
- There is a lack of transparency about what it is one is actually getting. To resolve this, I am using this series of posts to propose a standard addition to an offer letter. The document gives more information as to the status of the options and helps value them; I believe that companies adopting it will have an unfair advantage in hiring well informed talent.
- In many cases, employees lack the knowledge to understand the interests of their employers and the flexibility their employers have when negotiating. This knowledge can help maximize the benefit that they can get from option grants. Examples vary but include vesting terms, acceleration, post-termination exercise and others.
The Israeli 102 Plan and Option Terms
Aside from several quirks, Israel’s section 102 plan for option-based incentives is a good one. It provides for a 25% taxation bracket for option-based incentives. This is far better than the 52% marginal tax rate for wages. From the point of view of an employee, section 102 taxation for ESOP options is better than the US taxation in a few important ways:
- It leaves the exercise price open to discretion;
- It doesn’t tax short term gains at a higher rate than long term ones; and
- It defers taxation even when the options are exercised.
These differences are important. I’ll explore them below.
All options have an exercise price, which is essentially what you have to pay to convert the option into a share. For American residents, the US IRS immediately taxes any option grant that has an option price that is below the “fair market value” of the shares (FMV). The Israeli tax code doesn’t tax the grants if the exercise price is low. This means there is additional flexibility in granting options anywhere between par value (close to zero) and the FMV.
This difference in the rules governing the exercise price can be pretty major.
If a company raised funds at a $5M valuation (let’s say they sold common shares) and you got 1% of the company’s outstanding shares, the exercise price you would need to pay under US fair market value taxation would be $50,000. If the company then got sold for $10M, you would need to pay half of your 1% ($100,000) to the company to exercise the options, netting you $50,000.
On the other hand, had the options had a par value exercise price, you’d get $100,000. Sweet!.
The company’s Board can (rightly) oppose the grant of a par-value exercise price to Israeli employees in order to avoid a situation where Israeli and American employees at the same company get a different (financial) deal. That said, this tax regime offers far greater flexibility to the company and employees. For example, the company can decide to double a prior option grant to a high performing employee while maintaining the previously used lower exercise price, without creating tax issues.
The fair market value for the exercise price in the example was simple, since we assumed the investment had been made in common shares. However, most venture funding is done using preferred shares, while the employee ESOP shares are common shares. This allows companies certain flexibility in determining the fair-market-value of common shares, to benefit their employees. You can and should ask what was the “409a valuation” of the company, and compare it to the price-per-share in their latest investment round. This will provide you visibility for the potential upside.
102 Grants — Israeli Taxation Implications
The Israeli Tax Code contains various requirements for option grants to Israeli residents; in general, option grants need to be made under a plan that is filed with the tax authorities. The section 102 has two “routes” for a company to choose: capital gain or ordinary income. It’s very uncommon for a company to choose the ordinary income route (I have never seen it done), but it’s worthwhile making sure it did not.
One of the requirements under 102 is that the options be put in escrow for two years with a trustee. Option grants can be promised before a plan is approved under 102, but unless the company applied for the Israeli Tax Authorities (ITA) ruling, the 2 year escrow requirement doesn’t begin, and if an exit happens during that time, there will be a higher tax requirement or the proceeds will need to stay in escrow for the remainder of the period. Since there is a cost associated with this process some startups wait before they begin it. It is perfectly legitimate to ask employers whether the process has begun, so there is visibility as to the status vs the tax authorities.
Once a grant was made, the company has 45 days to file it with the ITA. If the company doesn’t do this on time, the options won’t get a preferred tax treatment. You should feel free to ask whether the company made the filing. This isn’t “nagging”; it’s your financial future.
Unlike US tax law, exercising options escrowed under a 102 plan does not create an immediate tax liability. This is especially important if this happens when an employee leaves the company before a liquidity event, as there is an exercise time limit, and imposed taxes could be significant in high flying companies. Even more important, in anything but very recent grants made within roughly 6 months of an exit, all escrowed options will be taxed under capital gain, regardless of vesting schedule and time of exercise. This is hugely valuable for Israeli employees, and is significantly superior to US taxation.
Using the Offer Template
My next posts — “how much?” and “impact of time” — will make more information available. Can the information in these series of posts close the knowledge gap? It cannot, but it can certainly mitigate some of it.
I believe that asking for the offer letter template can help you see whether the employer is open to sharing information and whether they are open to negotiation. Similarly, as a VC, I can never hope to understand as much about the business as the founders who run it. I can, and do, try to educate myself so I arrive at the level where I understand whether the person in front of me knows their shit. The same applies to knowing enough to understand whether the person in front of you is negotiating with a win:win or a win:lose mindset. A win:win mindset gives employees access to information that helps them understand their option grants.
Also, I strongly recommend consulting a lawyer that has had previous dealings with the startup and high-tech eco-system when negotiating your employment contract. There are unique considerations that your parents lawyer, or one specializing in maritime (true story) cannot be aware of. If you have recommended, price conscious lawyers that you’d like to recommend, add them as a comment. I’ll aggregate and publish a list.
Once you negotiate your option grant, add your equity grant to the compensation sheet of the spreadsheet so others can benefit too, by knowing what benchmarks exist in the industry.
To read the second post in the series click here