Equity compensation can be confusing, especially if you haven’t worked in the startup world before. The goal of this article is to help potential startup employees understand their equity package so they can negotiate the best deal for themselves.
Remember, though the startup’s lawyers are often helpful and well-meaning, you are not their client; the company is. Therefore, they are looking out for the best interest of the company. You should hire your own lawyer to look out for your interests. If you need advice on reviewing your startup offer, feel free to contact us here.
Equity comes in different types, each with its own set of terms and conditions. Understanding different types of equity is important when evaluating a startup job offer. Equity compensation in startups can take various forms, including:
- Restricted stock (sometimes called Restricted Stock Award, or RSAs)—A grant of common stock in the company. The recipient owns the stock at the date of the grant, subject to the vesting schedule.
- Stock options—Gives employees the right to purchase company stock at a certain price (the exercise price) within a specified time period.
- Restricted stock units (RSUs)—Represents a promise to deliver company stock at a future date once certain conditions are met. Unlike stock options, RSUs do not give employees the right to purchase company stock at a certain price. Instead, they receive the company stock once they have vested.
- Stock appreciation rights (SARs)—Gives employees the right to receive an increase in the company’s stock price over a specified period.
- Phantom stock—It’s a mechanism to reward employees with the financial benefits of stock ownership without giving them actual shares of company stock. It’s not equity. These shares don’t provide ownership rights, but they do entitle employees to economic benefits since their value rises and falls in accordance with the company’s stock.
The restricted stock and stock options are by far the most common type of equity in an early stage startup. RSUs are sometimes issued in a late-stage startup. SARs and phantom stock are very rare but can be helpful in very specific circumstances.
Size of Equity Award
When evaluating a job offer from a startup, the size of the equity award is the most important number to consider. You may be willing to accept a lower salary at a startup because you’re passionate about the company’s vision and want to be part of a small team building something great. If so, equity is the best way to ensure you’re well-compensated when the company is successful.
During equity discussions, it’s important to understand the following:
- Number of shares—Ensure that your offer includes a specific number of share options.
- Cap table—Request to see the current cap table, which is the ledger of ownership in the company. It lists all current shareholders, the size of the employee pool, as well as any convertible securities or warrants that the company has issued.
- Percentage on a fully diluted basis—Startups and employees often discuss equity as a percentage, but there are different ways to calculate that percentage. Each method of calculation can result in significantly different outcomes for the employee. If you ever discuss percentages during the employment negotiation, ask: “Is this percentage calculated on a fully diluted basis?” To learn more about calculating startup equity, click here.
- Fundraising plans—Understand the startup’s fundraising plans, as each round of funding impacts employees’ stock in at least two ways.
First, it will change the market value of shares in the company. Ideally, each round of funding values the startup at increasingly higher valuations. As the value of the company increases, the value of your equity increases. The goal is for a startup to always increase in valuation each round. Unfortunately, sometimes the price from one round to the next actually decreases. This is known as a down round. It could have an incredibly negative impact on employees’ shares if the preferred shares have anti-dilution preferences. To understand more, check out this article on down rounds and this article on anti-dilution.
Second, a startup will issue more shares in the company in each round of funding, which increases the total authorized shares. By increasing the total number of shares, each share becomes a slightly smaller percentage of the company. This process is known as dilution. It’s a normal part of startup life, but it’s important to have an awareness of how your shares will be diluted over time. Knowing the startup’s fundraising plans will help you gain a general understanding.
It’s also worth checking investor databases such as Crunchbase or PitchBook to obtain a more comprehensive picture of the company’s funding history. These resources often include details on the size of each funding round, who participated and how much equity was relinquished in exchange for funding.
Most startup equity is not granted immediately; instead, an employee earns it over time through a process called a vesting schedule. There are a few key terms to understand in a vesting schedule:
- Total vesting schedule—This is the total time required for the employee to own 100% of their equity award.
- Commencement date—The date that the vesting schedule begins. The commencement date is generally tied to the date the employee first started working with the company. Since it’s common for an employee to have worked for a few months before the equity has been granted, the commencement date can precede the date of the equity grant.
- Cliff—In startup vesting, a “cliff” is a period of time that must pass before an employee becomes eligible to start earning equity. Typically, the cliff is one year from the employee’s start date. After the cliff, the employee can start vesting their equity over the remainder of the vesting schedule. The purpose of the cliff is to ensure that the employee is a good fit for the company. Hiring is a challenging process, and it’s not uncommon for a prospect to perform poorly once they join. Generally, it becomes apparent within the first year whether the employee is a good fit. If they are not, the company can terminate them without the employee taking any ownership of the company with them as they leave.
- Vesting milestones—Vesting milestones simply refer to how frequently an employee earns the equity. The milestones could be monthly, quarterly or annually. The most common milestone is monthly. So, if an employee has a four-year vesting schedule, this person will vest 1/48th of it each month.
The most common startup vesting schedule is a four-year vesting schedule with a one-year cliff that vests monthly. This means that the employee earns nothing for the first 12 months. But on the one-year anniversary, this person vests 1/4th of that equity award. Each month afterward, the employee receives 1/48th of the equity award for the following three years.
If you want to learn more about vesting, click here.
As the name suggests, an acceleration clause will accelerate your vesting schedule under certain circumstances. This clause is often included in the stock grants or stock option grants of startup employees and founders. It allows them to receive a larger portion of their equity in the event of an acquisition, and is designed to protect them from losing potential gains if they are let go during an acquisition. Additionally, it serves as an incentive for these individuals to stay with the company through its growth stages.
There are two types of acceleration:
- Single trigger acceleration—Any unvested shares become fully vested upon the occurrence of a single event or trigger—an acquisition.
- Double trigger acceleration—This requires two separate events or triggers to occur before vesting is accelerated. The first event is the acquisition of the company, and the second event is a termination of the employee without cause.
Single trigger acceleration is incredibly rare and unlikely to be acceptable to most venture capitalists. However, employees should definitely ask for double trigger acceleration, which is fairly standard. If you’d like to understand more about single and double trigger acceleration, click here.
Fair Market Value
Whether an employee is receiving a stock grant or stock option, the fair market value (FMV) will be important. The FMV is the current value of a share of stock in the company. The company will likely set the FMV in one of three ways:
- Nominal—When the company is first incorporated, the shares in the company will have a nominal value, usually $0.0001 or $0.00001 / share. Every startup is different, but generally startups issue equity compensation at nominal value in the first 12 months or until they have their first equity financing.
- Equity financing—Equity financing, often called a priced round, is a round of ifunding where the company sells preferred stock at a fixed valuation to investors. Note that issuing convertible notes or SAFEs is not equity financing. When the company sells shares to investors, the new value of the company is set to the price per share that the investors paid in that round.
- 409(a)—A 409(a) valuation takes its name from section 409(a) of the IRS code, which requires startups to set an FMV of their shares on a regular basis. The valuation is conducted by a third-party valuation firm. This valuation takes into account a variety of factors, including the company’s financial performance, market conditions and comparable transactions. To learn more about 409(a), click here.
The old adage “buy low, sell high” is applicable for employee equity. When an employee is issued an equity award, this person is essentially buying stock in the company through hard work. Employees generally want the FMV to be as low as possible at issuance. Then they want the price to rise as high as possible before they sell.
An 83(b) election is a tax election that an employee may choose to make in order to lower their personal taxable income.
Startup equity is typically granted with a vesting schedule, as noted above. Normally, an employee will report only the value of the stock that vested in a given tax year as taxable income. For example, if employees have a four-year vesting schedule, they will report the value of the stock vested in each of those four years.
However, under section 83(b) of the tax code, an employee may choose to include the value of restricted stock as income at its FMV on the date it was granted rather than when it vests. This option can be valuable for employees who believe that their company’s stock will appreciate significantly over time because they can choose to have the total equity award reported in the first year when the price is low. As a result, the taxable income will be lower.
An 83(b) election is a personal tax matter, not a company tax matter. Although the company may provide employees with an 83(b) form, it is the employee’s responsibility to file it within 30 days of issuance. If employees miss that 30-day window, they lose this potential tax savings. To learn more about 83(b) elections, click here.