One of the common remuneration mechanisms in startups and
technology companies is the granting of options to employees in
addition to or, sometimes, in lieu of, the traditional remuneration
component – the cash salary.
The practical meaning of granting options is that employees are
granted a right to purchase shares of the company at a fixed price
at some time in the future.
Options enable startups to compensate for their inability to
offer attractive salaries and recruit a top-tier workforce (due to
the lack of available funds in the initial stages of a
start-up's lifecycle) and, at the same time, the grant of
options serves as an effective tool to align the interests of the
employees with those of the company.
Recently, we have been seeing an increasing number of cases in
startups that succeeded in securing investments from more than
one investor in at least two investment rounds, find themselves in
a complicated situation, whereby the company's capitalization
table following the above investment rounds does not enable the
company to effectively incentivize its employees.
How does this situation occur?
When a company raises capital from strategic investors (for the
most part, venture capital funds), it grants preferred stock to
those investors against their investment. One of the key rights
attached to preferred stock is the right to receive a certain
portion of any future proceeds distributed upon the sale of the
company, prior to the remaining shareholders (liquidation
Since every strategic investor seeks to ensure a pre-determined
return on investment, a company with several strategic investors
may find itself in a situation whereby, upon the occurrence
of a sale event, the distribution waterfall of the proceeds dries
up before it reaches the company's ordinary shareholders,
which, ordinarily, are comprised of the company's founders and
This situation poses a major challenge to the company to retain
and recruit the "best and brightest" employees,
especially since in this era employees in the field of high-tech
are well informed regarding equity incentive mechanisms and they
are looking to join a company that offers a substantive equity
incentive – and not just one on paper.
This situation is also disturbing for the company's current
and potential investors, as every investor appreciates that the
best way to guarantee that its investment will eventually reap
profits is to ensure that the company's employees are fully
committed to the company's success.
In order to create that incentive for the company's
employees, companies facing the above predicament may amend their
equity incentive plan and adopt what is known as a carve-out plan.
A carve-out plan essentially "carves out" a fixed
percentage of any future sale event and designates such percentage
of the founders or employees of the company.
The adoption of a carve-out plan requires full coordination with
the company's current investors, since they are the ones who
will be relinquishing a certain portion of the proceeds to which
they are entitled, to the benefit of the founders or employees.
The adoption of a carve-out plan also raises significant legal
considerations, such as the need to amend the company's
existing articles of association in order to create a new class of
shares which is specifically designed to provide the grantees under
the carve-out plan with the exact rights which are required to
implement the plan, without disturbing the existing relationships
between the company's shareholders. Additionally, the adoption
and implementation of a carve-out plan raises issues in the field
of taxation, due to the need to seek the Israeli
Tax Authority's prior approval to the carve-out plan before
it can be implemented.
How can companies avoid this situation?
Founders of startups need to devote considerable thought and
planning prior to raising investments regarding exactly how much
funds they require for the purpose of carrying out their business
plan, and at what company valuation.
Often, accepting a lower investment amount than the amount that
the company could raise in a particular investment round, or
holding off on raising capital until the company reaches a more
mature stage, thus enabling the company to raise capital at a
higher valuation, will minimize the dilution of the ordinary
shareholders of the company.
Of course, it is far easier to write about refusing available
funds than actually turning such funds down in reality. However,
adopting this kind of long-term thinking on the part of the
founders of startups, and taking the issue of incentivizing
employees as a dominant consideration from the company's
inception, may assist in avoiding having to face a problematic
ownership structure which ultimately requires adopting a carve-out
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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