Steven Johnson, author of How We Got to Now, once wrote, “The defining difference between Silicon Valley companies and almost every other industry in the U.S. is the virtually universal practice among tech companies of distributing meaningful equity, usually in the form of stock options, to ordinary employees.”
Startup compensation packages – especially those with an equity component – come in many forms, and it’s important that you understand what you stand to gain and what you stand to lose before you quit corporate.
What is Equity?
At its most basic level, equity is an “ownership share in a company.”
The Benefits of Equity
Equity is not just a potential “pathway to wealth,” as Bill Harris of PayPal fame would put it, but arguably the “most powerful tool” at a startup’s disposal when it comes to building a high caliber workforce. It has the unique ability to align risk and reward – risk assumed by those you hire on an unproven team or business model, and reward for those individuals’ performance and tenure.
Equity is attractive not only for its potential monetary value, but also for the sense of ownership it bestows in the individuals who embrace it. As venture capitalist Fred Wilson explains, “[Equity] reinforces that everyone is on the team, everyone is sharing in the gains, and everyone is a shareholder.”
Perhaps equity’s greatest issue is employee education. Equity is leveraged to recruit, retain, and reward employees for their long-term value creation, but that can only be achieved when its purpose and its value is understood.
Standard Equity Offer
The standard equity offer, especially for early hires, can be as much as 1 – 2% of the total shares of the company, along with a four-year “vesting schedule” (which we’ll discuss later) and a one-year cliff (also later).
Truly forward-looking startups might go so far as to issue “follow-on” grants, which are grants that extend beyond the full vesting of the employee’s initial grant. The purpose of this type of grant is to realign an employee’s ownership stake with their tenure and contribution to the success of the business.
Types of Equity
There are two primary categories of stock – “common” and “preferred.” If you’re an employee – not a founder or an investor – you will likely receive common stock or “options” on common stock. Common stock is different from preferred stock in that preferred stock carries “preferences,” and common stock does not. Now, while startup employees have the potential to realize significant gains should their startup go public or be acquired, very few employees realize that “common-stock holders only get paid from the pot of money left over after preferred stockholders have taken their cut.”
In some instances, common-stock holders can later discover that the preferences that accompany the preferred stock the startup has granted to its investors are so valuable, that their common stock is nearly worthless. A preference might grant a shareholder voting rights, a seat on the board, or even a liquidation preference – “a guarantee return on investment to a specific multiple of the amount originally invested.” As preferred shareholders are always paid first, some preferences might be so valuable that they drastically reduce the residual “pot of money” that common-stock holders would otherwise be paid from for their shares in the startup.
The most common form of employee equity compensation is Incentive Stock Options (ISOs). A stock option is the right of an employee to purchase a set amount of stock at a predetermined price, known as the “strike price.” An employee is deemed to have “exercised” his or her options when he or she purchases that underlying stock at strike price.
Restricted Stock Units (RSUs) are another form of equity compensation startup employees might run into. This type of stock is often directly granted to the employee without purchase, but with restrictions – vesting being perhaps the most common restriction.
To incentivize performance and tenure, equity is generally earned over time. The terms at which you earn equity is called a “vesting schedule.” As mentioned earlier, the standard equity vesting schedule spans four years, with a one-year cliff. A “cliff” is simply a period of time before which vesting will begin (i.e., you will not vest any shares prior to the cliff, but all of the shares for that same time frame will vest once it’s hit). After that point, equity typically vests on either a monthly or quarterly basis.
Let’s say you were offered 1,200 shares (representing 2% equity in the company) with a four-year vesting schedule and a one-year cliff. If you were to leave the startup before your one-year anniversary, you would leave with nothing. Why? Because you didn’t hit the cliff. Now, if you were still employed at the one-year mark, you would vest 300 shares, representing 0.5% ownership in the company. All 300 of these shares would vest at once (hence the term “cliff”). Your remaining shares would then continue to vest on either a monthly or quarterly basis such that, by the end of each of the four years, presuming you were still employed, you would vest an additional 300 shares. Once all 1,200 shares are yours, you would be considered “fully vested.”
Once equity fully vests, you own your full stake of the company, but there might be some limitations on exactly what you can do with it. One such limitation is a “Right of First Refusal,” which gives the startup a contractual right to be given the opportunity to purchase the shares you own before anyone else can. If the startup waives this right, then you would be free to do with the shares what you wish.
Early stage hires that have been offered stock options enjoy a benefit that no future investor could ever hope to, but valuing that equity can be extremely difficult and there are a multitude of factors to consider.
I. Percentage of Ownership
As a starting point, you will want to know what your offer means in terms of percentage of ownership. Equity is distributed from what is known as an “option pool,” a predetermined amount of equity that has been set aside to be distributed to the workforce. A typical startup equity pool comprises 10 – 15% of the startup’s available equity to recruit, retain and reward employees. When it comes to receiving an offer, the percentage of your potential ownership and the sheer number of shares you’re being offered are two very different things.
If you are only told the number of shares you’re being offered (e.g., 1,200 shares), you should dig deeper. The answer you want to walk away with is the amount of equity you’re being offered on a fully-diluted basis (i.e., the percentage of ownership the offered stock options represent, taking into account all of the stock that the startup has already issued and is obligated to issue in the future as well as the stock option pool).
II. 409A Valuation
For a rough approximation of the dollar value of your equity, you might want to ask the startup about its most recent 409A valuation, a measure of the startup’s book value, typically determined by an outside appraiser. This valuation is most commonly performed to assist startups set the strike price for their employee stock options (common stock), which must be at or above fair market value. A startup’s market value, however, is often defined by its most recent round of funding. This valuation, while not an accurate representation of the value of common stock, does assist common-stock holders with an approximate valuation of their equity: market value less book value.
Remember, one difference between common stock and preferred stock is that preferred stock comes with preferences. These preferences (such as the liquidation preference discussed above) have the potential to impact the value of employee stock options. Thus, it is important that you determine how much capital the startup has already raised, and on what terms.
Finally, consider asking how much debt the startup has raised and how that debt would impact employee stock options in the event of liquidation. Debt might come in the form of either venture debt or a convertible note. Venture debt is a secured loan from an investor that must be repaid before all other debt or equity holders, including common-stock holders (you, the employee). A convertible note, on the other hand, is part-debt, part-equity. It is debt that is designed to convert into equity at some later date.
What About Dilution?
Dilution is a future-oriented concept that you should familiarize yourself with. Your ownership stake in the startup is equal to the number of shares or options you have been granted (the numerator) divided by the total number of shares (the denominator). When the total number of shares grows, such as when new stock is issued during a round of funding, your ownership stake decreases, or is “diluted.” Over a period of years, with numerous rounds of funding, ownership percentages that were once significant could be diluted considerably.
If you have ever in your life received a paycheck, you are probably painfully familiar with income tax. Well, the Internal Revenue Service (IRS) considers both your salary (and commissions and bonuses) as well as your equity compensation to be taxable income, and (no surprise here) there are a number of rules governing how equity compensation is taxed.
For instance, unlike your paycheck, Incentive Stock Options (ISOs) are not immediately taxable. Options are options to purchase stock, which is different from stock ownership. When it comes to ISOs, your most favorable tax treatment exists if you were to exercise your options and hold onto that stock for at least one year – at which point it is considered a long-term capital gain, which is taxable, just at a lower rate than your ordinary income.
When and how your equity is taxed all depends on the type of equity you receive and how you receive it. It is in your best interest to understand the tax implications of your equity offer before you accept the position.
Not all founders are experienced in the intricacies of equity compensation. Work with them, but vet the terms of your compensation package and make damn certain you understand them. When it comes to equity compensation, standard advice tells you to be on the lookout for anything not standard (e.g., a 6-year vesting period with a 2-year cliff), but warning bells should especially be ringing if the startup is unwilling to sit down with you and educate you on your offer.
Don’t allow a potentially lucrative equity stake to be the determining factor in your decision to join a startup. Understand the risks before you assume them. Often, a greater stake in equity means a base compensation well below market value and, in the end, your shares might be worth nothing. Of course, there’s always wondering what could have been.