???????? Hi friends!

It’s been a bit of a whirlwind weekend as I surprised my (much!) better half with a trip to Italy to celebrate her birthday with her family – for the first time since she moved back to the UK back in the early 2000s to boot.

We reminisced over all the moments and memories we’ve shared over the last 20 years. I’m pretty sure we made a few new ones to keep us going over the next twenty.

But, of course(!), I found the time to get a few words down and provide a bit more actionable insight and context to whatever you’re building and to your day ????

On a side note, I’m super excited to be leading the CFOs and Financial Modelling session for the EMEA cohort of Morgan Stanley’s Inclusive Venture Lab this week. It’s always such a pleasure to meet these incredible, diverse founders and learn more about what they’re building ????

In this weeks Off Balance, I’ll be chatting about:

???????? A brief word on the events in Israel
???? How to think differently about where to get your debt
???? Employee Equity Schemes – understanding the basics

Oh, and the new look Nothing Ventured Season 5 went live today!

Check out this Primer where I get to know Mark Kleyner and why he’s building Dream VC, the investor accelerator for Africa ????

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

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Now let’s get into it.

A brief word on events in Israel

Events that have unfolded over the weekend with mass devestation caused by attacks on Israelis by Hamas has been met with condemnation by leaders across the world.

I have no doubt that Israel’s response will be swift and will likely be brutal and, as the conflict escalates, will almost certainly cause more civilian casualties and losses on both sides.

I have no skin in this game and I don’t wish to opine on something where I neither hold expertise, nor where it does not immediately impact me or those around me.

However.

I do have family in the region and many Israeli and Jewish friends
I have interviewed several Israelis on my podcast, most of whom are ex IDF
I am concerned about the impact this has on innocents on both sides
I can’t assume that conflict will not spill over in impacting the rest of the world

I would love for there to be a swift and peaceful resolution to what has already been declared a war but I do not hold out much hope.

One thing I can say unequivocally is that there is no excuse for terrorism nor the premeditated and gleefull taking of innocent lives, that should be abhorrent to anyone whatever your thoughts on the politics of it all.

How can did I add value?

A couple of weeks ago, an angel I know asked if anyone could introduce one of their portfolio company founders to any debt providers.

I actually knew the company and the founder having done some work for them way back in 2019. (Side note – do you also intuitively bucket everything into pre and post pandemic eras?)

The business is already established and doing quite well and has a hardware and software element to it.

After speaking to the founder, it was clear that what they were after was a working capital facility that would help them fund inventory.

This would help them to grow further.

If you’re ever in this situation, there are a number of routes that you could consider taking:

???? Speak to your existing bank / financial institution

Pros: Should have a variety of products that you can access and there is an existing relationship which should mean a ‘quick’ decision.

Cons: Traditional insitutions are not known for having the hungriest of risk appetites so you may get to a yes but only after having jumped through a few hoops and having had to offer up a variety of different securities like personal / directors’ guarantees, a lien over the business or even a physical asset (like your home). Oh and a bunch of covenants that you have to maintain (things like interest cover, debt ratios, quick ratio and more) and report back on regularly (typically monthly).

???? Use a revenue based financing company

Pros: There’s typically a very quick turnaround once hooked into your systems. Repayment scales up and down with your revenue (i.e. if your revenue drops so does your repayment).

Cons: Restricted number of products, and although most do offer some form of inventory financing, others won’t. Fees and equivalent interest costs can be quite substantial and they may not be able to lend the sort of quantums you may need.

???? R&D Funding

Pros: Once you have a track record of submitting and being repaid for R&D undertaken in your business, you will probably qualify to secure a loan from specialist lenders specifically against the R&D due in your next claim.

Typically the lender will just add the interest to the principal loan amount and the whole lot would become repayable at the earlier of the R&D claim being paid out by HMRC or a long stop date normally set to a couple of months after you would expect to get paid out. This helps avoid the need for planning monthly payments, and if you are confident your claim will be paid by HMRC then the loan is pretty much covered.

Cons: You are likely to only be able to draw down a maximum of 80% of the total claim value, which may not be sufficient for your working capital needs. In the current environment, HMRC is pushing back hard on what qualifies for R&D, so whilst you may have claimed in the past, you are not guaranteed to qualify now. If the claim isn’t paid out, you’re still on the hook for the capital and interest.

????Venture Debt

Pros: Lighter touch diligence than traditional lenders and potential to pay interest only.

Cons: Venture debt is a specialist type of product which many institutions do not offer, so it can be hard to secure. Equally, it is often issued as part of a significant institutional equity round (so you need to raise from a VC). You may still have negative covenants (things that you are not allowed to do without specific approval) and you will likely also have to issue warrants (an instrument giving the lender the right to purchase shares in the future at an agreed price). This means more dilution – given that one of the main reasons to take out debt is so as to not dilute existing shareholders any further.

And there are no doubt other lenders and debt products out there that this founder could have looked at.

BUT

What I actually told them to think about was approaching an existing investor (especially an angel) to see if they would lend the required amount.

This is something that the founder had not considered, but realised that it made sense. They also had individual angels who had invested 7 figure amounts into the business and had the ability to write large cheques.

Overall there are several pros to going to an existing investor:

➡️ They have an existing relationship with you and the business.
➡️ They are able to make decisions quickly.
➡️ They are incentivised for your business to succeed.
➡️ They are also incentivised to not have further dilution.
➡️ They are less likely to insist on further security.
➡️ They are more likely to negotiate a good interest rate.
➡️ They are more likely to renegotiate in good faith in the event of trouble.

The biggest con would be a potential falling out with the investor should you become delinquent with the debt.

With that said, and having done and seen this done in a number of business, given the fact that your investors want your business to succeed, there is already huge alignment and a great opportunity to strengthen your relationship with them.

I’d love to hear if anyone has done this themselves and what your experience was. Drop me a message!

Off Balance

Most people involved in the startup and venture ecosystem will almost certainly have come across the notion of employee equity schemes and options at one time or the other.

In recent months there have been lots of articles about employee options being ‘underwater’ as valuations have cratered and I’ve no doubt that people have legitimate questions and concerns about how options work – whether you’re a first time founder or have just landed your first role in a startup.

In this Off Balance article, I’m going to try and give you a quick and dirty run down so that the next time you run into the issue of employee options you feel like you’ve got a base understanding you can build further on.

As always, you should always seek advice from your lawyer, whether you’re a founder or an employee, as every scheme will have variations and complexities that will be very specific to the particular company issuing the options.

With that said, let’s get into it ????????

Employee Equity Schemes

Why do companies have Employee Equity Schemes?
Equity Schemes are a way of incentivising employees and will often form part of their total package alongside salary, bonuses and other benefits they may receive such as gym memberships, health insurance or a company car.

They allow employees to participate in the future upside the company might have in a way that allows both the company and the employee to protect themselves from potentially negative outcomes.

For startups who often lack the cash to be able to pay full market salaries, allowing their employees to participate in the equity of the business helps to make up for the potential shortfall in salary and, because the employees can become future shareholders (owners) of the business one could argue that their incentives align more closely with both the founders as well as other investors and shareholders in the business.

One of the main ‘instruments’ that companies use for employee schemes are called Options.

So what’s an Option anyway?
When we talk about an Option in a business or finance context, we are talking about a contract between two parties giving them the option to buy or sell something at a future date and at a pre-agreed price.

In the context of startups especially, we are usually talking about the Option to purchase shares in the business at a future date at a pre-agreed price which is normally at a discount to the last traded share price (normally defined as the ‘price per share’ offered during the last funding round).

We’ll get into some of the details shortly, but for now just think of an option as:

A contract to purchase a defined number of shares in the future either defined by a date or on completing certain milestones, for a pre-defined price.

Why use Options over straight equity?
There are a few reasons why issuing straight equity may not make sense either to the company or the employee”:

Firstly, if equity were to be simply given to an employee in lieu of salary, there would be an immediate tax consequence – especially to the employee. The tax man would essentially argue that the equity is equivalent to the cash value it is being provided in lieu of and will charge personal income tax on that value.

Secondly, from the company’s point of view, if it has issued equity to an individual, it is pretty unlikely that that equity can be clawed back in the event that the employee ends up not adding value – or worse, is actively toxic.

Thirdly, most widely used Option schemes have had legislation drawn up around them which means that there are other tax benefits to using them. In the UK, for example, under the EMI scheme, if you have agreed a valuation with HMRC, even if the valuation has increased by the time an employee exercises their options (see below), they won’t get hit with any kind of tax bill. Instead, the tax impact only comes when there is an exit event. And, at that point, again on the assumption that the correct process has been followed with HMRC, you’ll be taxed on a capital gain rather than as personal income tax*.

Finally, from an employees perspective, there may be a reason they don’t want equity in the business after they have been issued the options (rare, but it can happen i.e. if the company behaves unethically). If they had been issued straight equity, they would be stuck on the cap table, unless they were able to find a buyer for their shares (which in early stage companies can be very difficult).

*In the UK, and indeed the US, there are various actions that must be taken to make sure that the option scheme is approved by the tax man and that the tax impact is minimised on the employee. These range from getting the valuation agreed in the first place, to only being able to issue the options within a specific window after the valuation agreed, to reporting back to the tax man on a regular basis.

Always take external legal advice and set up your scheme in the most sensible way for your company and employees.

Glossary of Terms

As with most contracts, the devil is in the detail. Thankfully there tends to be some pretty standard terminology used when setting up a scheme and in Option contracts specifically, here are the main ones:

Option Pool: A number of shares (often expressed as a percentage of the total shareholding) that are agreed to be set aside for issuing to employees, contractors, advisors or other external supporters of the business.

Scheme Rules: The overall rules that govern the option scheme irrespective of individual terms in individual options.

Option / Option contract: The commercial contract that specifies the terms by which the option holder must abide.

Vesting: The process by which options become available for purchase.

Vesting Schedule: The contractual timeline over which options vest.

Cliff: An initial period that must be completed before any options vest at all (thereby allowing for the eventuality that an employee leaves the business after a short period of employment).

Periodic Vesting: The process by which options may vest over a certain period (monthly, quarterly, annual etc).

Milestone Vesting: The process by which options only vest on completion of certain targets. Often used with sales teams and tied to revenue targets, however could even be used to incentivise a CFO to source and close additional investment etc.

Exercise: The act of purchasing options that have been issued to you.

Strike Price: The price at which the option can be exercised.

Exit only options: Options that can only be exercised at the time that a company goes through some form of a liquidity event (sale, IPO or orderly windup).

Good / Bad Leaver Clauses: In some instances, employees may be allowed to exercise options even though they have left the business – often before their options have fully vested, and normally at the discretion of the board of director. The terms of their rights to exercise will be defined under a good / bad leaver clause. As you would expect, a Bad Leaver would unlikely be allowed to exercise their options.

Approved / Unapproved Schemes: In the UK, an Approved scheme is one that can be issued to employees after having been agreed with HMRC and provides the tax efficiency I’ve mentioned earlier. An Unapproved scheme simply means that there won’t be any tax efficiency and these schemes are typically used to issue options to people who are not employees of the company.

Fully Diluted Equity: Whilst this isn’t a term that is used ****in**** options contracts, it is a fundamental concept to understand when talking about equity. Fully diluted equity is the ownership of existing shareholders, expressed as a percentage as if all options (and any other instrument such as share warrants) have been exercised. It essentially tells shareholders what their minimum ownership sits as as of right now.

Being ‘Underwater: An option is underwater when the exercise price exceeds the current price per share of the company (i.e. the company is valued lower than the option would suggest). This is obviously a critical issue for employees who have a large part of their compensation made up by the option scheme they participate in.

A word of caution

When talking to employees about options, never discuss it in terms of a percentage of equity (as this moves every time new shares are issued). Rather talk about it in terms of value, or preferably an absolute number of shares over which the options are being issued.

Wherever possible you should refrain from putting these things in writing until you are ready to issue the options. This is to protect the company as far as possible in the event that someone mis-speaks.

Types of Employee Equity in the UK and USA:

Right, we’ve got the basics covered, so et’s take a quick look different types of Employee Equity schemes in the UK and across the pond in the US.

UK:

Enterprise Management Incentives (EMI): These are a tax-advantaged share option scheme specifically designed for smaller companies and hence widely used by startups. There are certain conditions, for example a £250,000 limit on the value of shares over which options may be granted to any one employee. But it is quite flexible and relatively easy to set up and implement.

Company Share Option Plan (CSOP): This allows companies to grant options to selected employees who can then acquire shares at a fixed price. CSOPs offer tax advantages if certain conditions are met.

Share Incentive Plans (SIPs): Use in more established companies, employees can buy shares out of their pre-tax salary, often at a discounted rate.

Unapproved Share Options: As discussed earlier, these don’t have the tax advantages of the schemes above but are more flexible. They’re also relatively easy to set up and issue.

USA:

Incentive Stock Options (ISOs): These are exclusive to employees and come with tax benefits, but they must meet specific IRS requirements.

Non-Qualified Stock Options (NSOs or NQSOs): Unlike ISOs, these don’t have the same tax benefits but are more flexible and can be granted to anyone – similar to unapproved share options in the UK.

Restricted Stock Units (RSUs): Used in established (and often listed companies), employees receive shares once they vest, without needing to buy them. They’re taxed as income when vested.

Stock Appreciation Rights (SARs): Employees benefit from the increase in share price without having to purchase shares. They receive the appreciation amount in cash or shares.

How the Schemes Work:

EMI & CSOP (UK): Companies grant options to selected employees at a fixed price. When the options vest, employees can exercise them, purchasing shares at the previously set price. If the company’s share price has risen, employees stand to make a gain.

ISOs & NSOs (USA): Similar to the UK schemes, companies grant options at a set price. The main difference lies in the tax treatment upon exercising the options and selling the shares.

Impact on Valuations, Shareholders, and Accounts:

Valuations: Employee equity schemes can dilute the ownership percentage of existing shareholders. However, they can also align employee interests with company growth, potentially driving up the company’s value.

Shareholders: Dilution can be a concern, especially if a significant number of options are granted. However, motivated employees can lead to increased company performance, benefiting shareholders in the long run.

Accounts: Companies need to account for share-based compensation. In the US, for instance, the Financial Accounting Standards Board requires companies to estimate and report the fair value of stock options they grant. And given the reality of most early stage businesses where fair value can be very hard to define, this leads to using pricing models like Black Scholes to arrive at a price. This may lead to a charge to the income statement as equity is credited.

To really bring it home, check out this worked example based on a (simplified) UK Unapproved vs Approved EMI Scheme.

Hopefully this has given you a good primer in the basics of what you need to know about Employee Equity Schemes, whether you’re the founder responsible for issuing them, or the employee being granted them. And, of course, this is non exhaustive, not only are there other types of equity products out there (like Growth Shares) but legislation will also move over time.

Make sure you know what you’re getting and what it’s going to cost you!

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you would love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish