Equity compensation can be a confusing topic all by itself. Combine that with the complexity of offers from a startup company and you’ve got an offer that can be hard to evaluate and much more complicated than, “I make $120k/year.” We want to help simplify this for you and help you understand how to evaluate startup offers. The first topic to cover is Equity Compensation.
Equity compensation is non-cash pay that is offered to employees of a company and is usually part of a total compensation package that can include a Base Salary and Bonuses. Equity, as compensation, can include stock options, restricted stock, and restricted stock units; all of which represent ownership in the company for its employees.
Typically, it aligns the financial interests of the employees with the goals of the company and can result in dramatic benefits for both parties. That said, equity compensation can be incredibly confusing, especially if the company offering it is still private.
With this guide, we’ll go over the basics of equity compensation, how startups evaluate equity as compensation, tax considerations, and other details to help you know what to look out for.
- Basics of Equity Compensation
- Stocks and Shares
- Public vs. Private Companies
- Basics of Startups
- Fundraising and Dilution
- Public vs. Private Companies
- Stages of Startups
- Option Pools
- Classes of Stock
- Taxes on Equity Compensation
- Types of Equity (Stock Awards, RSUs, Options)
- Vesting and Cliffs
- Taxes on Equity Compensation
- Evaluating Equity Compensation
- Offers and Negotiations
- Other Resources
Basics of Equity Compensation
Equity compensation has long been used by companies of all sizes as a way to attract and retain top talent. At its core, it’s granting partial ownership of a company in exchange for work. By tying a portion of compensation to the success of the company, many believe that it helps motivate employees, drives innovation and growth, and encourages longevity with the company.
For large public companies, equity is usually part of a Total Compensation package that includes other forms of compensation, like a base salary, bonus, benefits, etc. For cash-strapped startups, however, equity is usually the primary component they can offer, with the hope that the company will eventually grow large enough to go public or be sold for a large sum.
The term equity has plenty of meanings in other contexts, but for our purposes, we’re focusing on equity compensation in stock corporations, where ownership in the company is represented by stock ownership. It can take on many forms, including restricted stock awards, stock options, and restricted stock units.
Stock and Shares
“Stock” represents ownership of a fraction of a corporation and units of stock are called “shares.” Owners of stock in a company are called “shareholders” and they have a percentage ownership in the company.
To calculate your percentage ownership, you would divide the number of shares you own by the number of outstanding shares, which refers to the total number of shares held by all shareholders. You may also see this appear on a company’s balance sheet as “Capital Stock.”
For example, if you own 10 shares of company A and there are 100 outstanding shares total, your ownership would represent 10% of the company.
Public vs. Private Companies
A public company is a corporation that allows ownership of its stock to be available to the general public shareholders via public stock exchanges, or over-the-counter markets. With this, it’s easy to find out how much a public company’s stock is worth.
A private company, as its name suggests, is privately held and may issue stock and have shareholders, but the shares do not trade on public exchanges and are not issued through an Initial Public Offering (IPO).
You may have heard of a private company that “IPOs” or “goes public.” This is a significant step in a company’s growth and it allows investors and the general public to buy and sell stock on a public exchange. Typically, only companies with a strong history of growth and success will take this step, so it’s often a good sign of a strong company.
Equity value with private companies can be hard to know. Because of this, knowing your percentage ownership is a key in evaluating a startup offer. There are a number of factors that go into determining fair market value for a private company’s stock, but we’ll go over more on that later.
Basics of Startups
Understanding how startups operate, fundraise, and grow, is a key factor in understanding how your equity might be valued. Typically, startups rely on investors to help fund their intended rapid growth. In exchange for equity in the company, investors provide the capital needed to build or scale the business.
Fundraising and Dilution
Startups go through many stages (or ‘series’) of growth as they raise more capital to help build and scale its products/services. During fundraising, these companies will issue new shares to investors, resulting in dilution of ownership for current shareholders.
For example, let’s say you own 10 shares of Company A and, with 100 outstanding shares, that represents 10% ownership. During the next round of fundraising, company A issues 20 new shares to investors in exchange for much needed capital. Your 10 shares now represent 8.3% ownership of the company, since the outstanding shares are now up to 120.
Note that dilution isn’t always a bad thing. Although your ownership percentage is smaller, the value of your 10 shares could be worth more than before, as long as the company is continuing to grow and find success.
Since private companies aren’t publicly traded, their value is tough to gauge. Valuation is the projected worth of the company that investors believe it has. If the company is succeeding, its valuation will rise, thus increasing stock value for shareholders.
That said, what goes up can come down. If the company starts to fail, its valuation can drop with it, reducing stock value dramatically and potentially making them worthless if the company completely fails.
Stages of Startups
Understanding the various stages of startups will help you know more about how funding is raised, or how much ownership (shares) has been sold for capital.
Generally, you may see startups in various stages below:
Bootstrapped: This is the earliest stage of a startup, before investments even come into play. Usually self-funded, businesses in this stage are still figuring out what to build and how to model it.
Pre-Seed: This is also a very early stage and some might not even consider it to be a “funding” round at all. Usually self-funded by a business’s founders, they may reach out to close friends/family to invest as the company continues to figure out the product and market.
Seed ($10k-$2M): This could be considered the first official funding stage, that really helps the company get off the ground. This will be the opportunity for the company to show it’s growth potential and get the foundation set.
Series A ($2M-$15M): This is the first larger-scale funding stage, where a business has a consistent track record of success and they may be looking to optimize and scale. For this round, it’s imperative to have a long-term business plan for profit generation. Typically, Series A funding raises between $2M and $15M, based on data
Series B (Tens of Millions): This stage continues to raise funding for scaling and taking a business to the next level. Companies approaching Series B have proven themselves capable of succeeding on a larger scale, often raising tens of millions of dollars to help expand market reach and match demand.
Series C, D, E, etc. (Tens to Hundreds of Millions): These stages are for continued scaling and are for companies who have proven to be incredibly successful. Averaging tens to hundreds of millions in funding, companies often use these stages to help develop new products, expand into new markets, or even acquire other companies.
Note that with each progressive series, lower risk and increased dilution happens, however very few companies make it that far.
Early on, generally before employees are even hired, a company will set aside a number of shares for an employee option pool. This may also be known as an equity incentive plan, as a way to attract high-talent employees to join the company. Once they do, the company will grant stock from the pool to the employee.
There are many factors that go into deciding how large the pool is, but as a job seeker, you’ll mainly be concerned with your share of the pool. Earlier employees in earlier stages of the company will often receive more stock, as the company is dependent on the capital to continue growing.
Classes of Stock
Early investors may ask for the first chance to be paid back on their investment if the company does well. Since the investment is usually capital in exchange for stock, companies will often award early investors a preferred stock, as opposed to a common stock.
A preferred stock usually does not give shareholders voting rights and often has a liquidation preference. This means that owners of preferred stock will be paid before common stock owners, in the case of a liquidity event (ex: Company is sold or IPOs).
Common stock is what people generally know when they think of owning stock in a company. It usually gives the shareholder voting rights and represents a claim on profits.
What you need to know As an employee of a startup, you’ll more than likely receive a common stock award. If the company is set to do well in the long term, then you won’t have anything to worry about. However, there are rare cases where the stock may not be worth what investors initially put into it. Because of that, preferred stock owners are usually first in line to be paid back and, depending on a company’s valuation, common shareholders may receive little or nothing at all.
Equity Compensation in Practice
Now that you know the basics of equity and startup funding, we’ll cover more practical information on how equity is granted in various forms.
Generally, larger companies will grant restricted stock units (RSUs), while startups prefer to grant stock options and, in rare cases for executives and founding employees, restricted stock awards.
Types of Stock
Restricted Stock Units RSUs are probably what you think of when you think equity compensation or “getting paid with stock.”
In short, RSUs are company shares given to employees as part of their compensation. However, these shares aren't transferred to the employees right away: employees are vested in these stock options. Once they satisfy certain conditions (usually a term of employment), the RSUs are transferred to them. Employees are often able to elect whether or not they want the stock or a cash award based on the value of the stock, instead, or even a combination of both.
Since startups do not typically grant RSUs, we’ll keep this section light. You can find more information on RSUs with our post here.
Restricted Stock Awards RSAs differ from RSUs primarily in that RSAs are granted immediately. They are probably the most direct form of equity compensation, but they are also rare and typically reserved for startup execs or very early hires.
Although they are granted immediately, RSAs carry a “restriction,” often with a similar vesting schedule as an RSU. The difference is that once the RSA vests, the employee is granted the stock, with no option to take a cash award instead.
Additionally, since RSAs are usually only granted to execs or early hires, their growth potential is massive and the tax burden may be too great for most people, hence why companies switch to stock options or RSUs for most employees.
Stock Options Stock Options, with regard to compensation, are contracts that allow an employee to buy a specified number of shares for a fixed price. They are also the most common way startups will offer equity compensation.
An employee with a stock option grant will not be a shareholder until they exercise the option, which means purchasing their shares at the strike price. The strike price is the fixed price-per-share set in the option agreement.
With this in mind, if the company continues to do well and grow, the actual value of the stock could rise, which means you could sell your stock for a profit down the road. We’ll go over an example later.
Vesting and Cliffs
We’ve mentioned vesting a few times earlier, but what does it actually mean? In our context, vesting is the point at which you gain the right to use your RSUs, Stock Awards, or Stock Options.
In most cases, vesting happens over a set period of time, also known as a vesting schedule. Many vesting schedules also have a cliff, which is the amount of time before the first vesting opportunity.
Vesting schedules and cliffs are ways for companies to incentivize long term commitment from employees, as most common vesting schedules are over the course of 4 years with a 1 year cliff. This means that you would receive 0% of your equity compensation for the first year, then receive 25% every year after that until you fully vest 100% of your grant. Many companies have different schedules and refreshers, as well, to help incentivize loyalty beyond those 4 years.
Options, Vesting, and Cliff, example Let’s run through an example to help paint a picture.
Situation: You were awarded a Stock Option for Startup A, which gives you the right to purchase 1000 shares of Startup A at a strike price of $10. The vesting schedule is 25% every 4 years, with a 1-year cliff.
You work for Startup A for 12 months and the company sees solid growth and the fair market value of the stock is now up to $30 per share. After your first 12 months, you can now vest 25% of your total grant, meaning you can exercise the option to purchase up to 250 Shares of Startup A at the pre-determined strike price of $10 or you can wait and see if the company continues to grow.
If you exercise your option now, you would buy 250 shares of Startup A for $250 (250x$10), but the stock is actually worth $30-per share, so you now net $7250 (250x$30 - $250) if you sell them right away.
If you decide to wait for your next vesting date (24 months), you would have the option to exercise up to 50% of your grant at the $10 strike price. If the company grows beyond their $30 per share market value, then you stand to make a larger profit by waiting, but the company may not always do better and it could go down.
Taxes on Equity Compensation
The example above is simplified to help understand vesting, cliffs, and options, but something to keep in mind is tax implications on equity compensation. Options, RSUs, and RSAs are all taxed differently, so we suggest taking a look at Holloway’s Guide on Taxes on Equity Compensation.
We are not tax professionals, and if you are unsure about any tax implications with your offer, we would suggest connecting with a tax professional.
Evaluating Equity Compensation
Now that you have an idea of how equity compensation is structured, how do you evaluate all the pieces to ensure you’re set up for success?
You will have to understand, and potentially make educated guesses, on multiple factors. With regard to equity compensation, these are the big pieces to consider:
- Equity Value – Obviously, the most important piece is estimating equity value to know how much you potentially stand to gain. There are two other things to consider, as well.
a. Percentage Ownership – For startups, the number of shares you have is less important than knowing your percentage ownership of the company.
b. Risk – Startups are inherently risky; you will need to understand the risk and dilution to help get an idea for the possible future value of the company.
- Vesting and Cliffs – Know when you will receive the equity and how you will be able to use it. More likely than not, you will receive Stock Options, so understand the strike price, exercise windows, and vesting periods.
- Tax – Taxes are complex and detailed. Understand how your taxes might be affected by the type of equity grant you receive and when you may have a taxable event.
- Liquidity – We’ll go over more details in the next section, but you will need to consider when you can sell your stock and if you stand to profit from it.
Selling Private Stock
As discussed before, private companies don’t trade on public markets, so you can’t just buy/sell a private stock like you would a public stock.
For shareholders of a private stock, you would typically need a liquidity event, to sell your stock. These events are primarily only when a company is sold or IPOs, so the likelihood of being able to sell private stock is low.
There are rare occasions, sometimes called secondary sales or private sales, where a private company’s stock is sold to another private party. An example might be when an employee sells their stock to a private investor who wants to invest in the company outside of a funding round. Often times, the company has to be a part of this conversation though, as there are implications which could impact the company as a whole.
Exercising Stock Options
More likely than not, you will have gotten Stock Options as the primary piece of your equity compensation. Below, we go over a few scenarios to help you understand how best to exercise your options.
- Exercise the option and hold the stock – Your vesting date is here and you want to exercise the option and buy the stock at the strike price. You’d pay the company for the stock, pay any applicable taxes, and now you’re a shareholder of the company. Since it’s still private, you won’t be able to sell the stock until a liquidity event happens or you engage in a secondary sale.
- Wait until an acquisition to exercise – As noted above, a sale of the company would be a liquidity event allowing you to exercise your options to buy the stock. Keep in mind that if the company is not doing well and sells for less than the initial investor funding for it (liquidation overhang), they will have to pay back preferred stock holders first, so you may not make any money from this.
- Exercise and engage in a secondary sale – Again, it’s a rare situation, but you may be able to exercise your option and sell the stock to a private party, such as a private investor, a board member, etc.
- Cashless exercise – During an IPO, your broker may allow you to exercise all of your vested options and sell a portion of them immediately to cover for taxes and you will receive the rest as stock.
The first three scenarios will require significant cash up front, to cover for any tax implications, so be sure you understand how much you will owe and how best to work in these cases.
We always advocate for negotiations before accepting any job offer. This is a big commitment, so both you and your employer want to make sure it’s a good fit and everyone is comfortable with the arrangement.
Something to keep in mind is that startup salaries are often below what you might get at an established company, since they need the cash flow to help build and scale the business. Because of that, negotiating equity is a key component when considering startup offers.
We offer some valuable tips on negotiating startup offers on our blog, so we won’t spend the time in this guide.