A Deep Dive on Equity

Written by Evan Wray

A few weeks ago, we wrote about what to consider when negotiating an offer with a start-up: the most important questions to ask, criteria to consider, economic expectations and more. In that piece, we touched on how to assess equity when it’s offered as part of your compensation package.

An equity grant can represent tremendous financial opportunity; it’s also a complicated, confusing, even intimidating world to navigate. But, knowledge is power — for all of us. It’s critical that founders, as well as new hires, enter an offer negotiation with a crystal clear understanding of all the nuances. As founders, this is the best way to set both you and your team up for success. For new hires, it’s also key that you understand what equity means, how it works, its implications on your financial future and, most importantly, what is fair when it comes to the size of your equity grant. All of this ensures that both founders and new hires are aligned and enthusiastic about the agreement and the potential that comes with bringing on a new member of the team. Read on for a rundown of the elements of equity, including answers to questions you didn’t even know you had.

Why Offer Equity?

Joining a startup is a life decision: what you give up in security, you make up for in opportunity — the chance to build something new. With that risk comes upside: as a founder or employee of a startup, you are a partial owner of that business, and get to take part in the potential financial gains that come from it (which, if you hit it out of the park, can be massive). Equity is common currency in startup land.

There are several different types of equity (more on that, shortly) that may be granted as part of a compensation package. And, equity grants can serve a number of purposes: they are a tool for retention, inclusion and motivation. They help keep employees driven to work toward the company’s continued success, to compete for top-tier talent with larger companies and, potentially, to make up for a startup salary cut — which, btw, is not always the case. Let’s dig in.

Note: this information is for educational purposes only and does not constitute financial advice.

Understanding Equity Packages

If you are new to equity, don’t panic. While the concept is complicated, we’re here to give you (at least some of) the tools to understand it. The most common types of equity grants are stock options — incentive stock options (ISOs), non-qualified stock options (NSOs) — and Restricted Stock Units (RSUs.) Each has key differences in their general conditions, exercise requirements and tax implications, so it’s critical to know exactly what you’re being given and what it means financially.

Stock Options
Stock Options are the most common type of employee equity compensation. The employee has the right to purchase the stock at a predetermined strike price, which is set according to the fair market value (FMV) of the options at the time they are granted to the employee. So, for early hires, the strike will be low because the company has more growing to do. As the company’s value increases, so will the strike price. Ultimately, where you make money on your options is the spread between the strike price and the current FMV of the option when you sell. So, the higher the option value and the lower the strike price, the greater financial opportunity. When given details on your options, you should ask for the strike price, if it is not provided. (To help get a rough gauge of the market rate of your equity, we like Wealthfront’s blog and AngelList).

There are a few types of options (ISOs and NSOs), which differ primarily in terms of tax treatment. The IRS considers both cash and equity taxable income, however there are special regulations that define how each type of equity is taxed. Let’s go a little deeper.

ISOs
Incentive stock options are not subject to ordinary income tax when you exercise. They are, however, counted as income for purposes of calculating the Alternative Minimum Tax rate, (AMT). ISOs can provide several tax advantages over NSOs (profit from ISO is taxed at the capital gains rate rather than higher, ordinary income rate). Do note, however, that under IRS rules, you can’t, as an individual, treat >$100k worth of exercisable options as incentive stock options in a single year (this is to avoid abuse of the tax benefit). Finally, in order to receive the capital gains benefit, you must sell the shares more than two years after the original option grant date and have owned them for over a year, starting with the day after the exercise date.

Watch Out For…
AMT calculations and ISO tax structure overall can get complicated quickly. If you’re exercising your ISOs, we recommend consulting a tax advisor. Seriously.

NSOs
NSO’s give employees the right to buy a set number of shares at a preset price — within a specific window of time. They are subject to ordinary income tax on the difference between the original grant price and the exercise price. If your company keeps growing, exercising your NSOs gets increasingly expensive. NSOs can also push you into a higher tax bracket; remember, they count as income in addition to your base salary and other earnings.

The 409A Valuation
The 409A is an independent appraisal of the Fair Market Value of a startup’s common stock (shares reserved for founders and employees). This valuation determines the cost to purchase a share. Bottom line: if you offer equity, you need a 409A valuation, which is required once every 12 months after a company starts to issue options, after a material event (e.g., raising a round of financing) and if you’re approaching a liquidity event (an IPO, acquisition or merger). The lower the 409A, the more founders can incentivize top talent with the existing option pool. For example: a $1M share option pool for a company that just raised at a $10M valuation is far more valuable to potential employees if your 409A is $2M rather than $10M. If your 409A is $2M, your new employees already have the benefit of the $8M difference if you were to exit at your most recent valuation. This is a big upside for new hires and a key, if not nuanced, factor to point out when building out your team.

Exercise Windows
Should you leave the company before a liquidity event, you’ll need to exercise your stock options within a certain period of time (often 30–90 days, although exceptions may be granted). If you don’t exercise, you may forfeit your right to purchase the options. If this sounds risky, it’s because it is (well, it can be): you have to pay upfront for the right to sell your options later on, without knowing for certain what a liquidity event may look like or when it may occur. And, you may also have to pay taxes upfront in the case of NSOs. Many founders understand the significant risk and investment a new hire is making, and are often willing to help early members of the team by making certain exceptions to exercise windows, or even loaning them the capital to exercise. (Startups like Vested and others even help guide employees through how and when to exercise their options.) In our experience, good people take care of good people.

Restricted Stock Units (RSUs)
Restricted Stock Units are another type of compensation issued in the form of company shares. RSUs are typically issued to employees through a vesting plan and distribution schedule upon completion of designated milestones or tenure at the company. RSUs give employees interest in company stock, but no tangible value until vesting is complete, at which time the shares are assigned a Fair Market Value. Once vested, RSUs are considered income, and a portion of the shares is withheld to pay income taxes. The employee gets the remaining shares and can sell them, (or not), at their discretion.

RSUs are often given to late-stage hires, but are growing in popularity for early hires as well, as they put less of a financial burden on employees and create less risk. Unlike stock options, which can lose all tangible value with a falling stock price, RSUs almost always maintain some value, even if the stock price takes a sharp drop. RSUs are often issued instead of options as companies grow, with shares given to employees as certain restrictions are met. This switch is often made to reduce equity dilution.

Founders and hires, remember: RSUs come with certain limitations, which can be time-based, (employee must remain at company for a specified period of time), event-based (company must IPO or be acquired), or a combo of both, (most RSUs issued at startups have time-based and liquidation conditions).

When it comes to RSUs (Restricted Stock Units), the employee is taxed upon receipt of the shares. The taxable income = the market value of the shares at vesting. And note: unlike stock options, the entire value of RSUs must be reported as ordinary income (in the year of vesting) for tax purposes.

Percentage of Ownership

Equity grants will depend on your individual job level and the stage of the company. Early hires often see larger equity grants, because they’re taking a greater risk and playing a key role in building the foundations of the business — this is also a way for early-stage founders to preserve capital. As a new hire, one of the most important pieces of info to know about your equity grant is your percentage of ownership in the company, which determines the amount you’ll receive in a liquidity event or exit.

When evaluating your equity package, ask about the number of shares outstanding so you can do the math on how much of the company you would own if your shares were fully vested. Example: if there are 15,000,000 shares outstanding and you are receiving 1,000 shares, then you only own .007% of the company. However, if there are 1,000,000 shares outstanding, you own .1% of the company. Needless to say, this is a big difference, despite the same amount of awarded shares.

Remember that your percentage of ownership will likely be diluted over time. Depending on when you join the company, it could be anywhere from 10–50%. The upside: there are plenty of opportunities to gain additional equity over time, e.g. promotions and bonuses.

I’m a Founder. How Do I Know How Much Equity to Grant?
Accurately proportioning equity can be extremely challenging, especially when you’re a first-time founder. Equity grants represent a meaningful part of the offer: as a founder, you’re giving your employees partial ownership of your business — the ultimate incentive. How much stake in the company an employee should receive depends on a number of things: time of hiring, skillset, experience, contribution to the company’s mission, risk tolerance, cash vs. equity preferences. And, it’s industry-dependent, so it’s important that you consider each scenario individually.

Often, the timing of an employee’s decision to join a startup has a disproportionate impact on how much equity is offered: with the exception of key executive hires, it’s customary to offer the early team more stock. Example: If a key hire is the third person joining a team of two, they could be considered a co-founder and receive as much as 10% of the company. But if a head of sales or VP of marketing joins once a startup has achieved product market fit, they may receive between 1% and 2%, depending on experience. Consult references and benchmarks for your industry, your stage, and the individual hire to make sure that you’re in the right ballpark: from there, it’s a question of cash vs. equity, which should be a conversation you have with your potential employee.

Vesting Schedules
Since most employers leverage equity as a retention tool, it rarely all vests at the same time. You’ll want to fully understand the particular vesting schedule of your equity package. While it varies, a common approach is a 4-year vesting schedule with a 1-year cliff, (i.e. none of your equity vests in the first year, and a quarter of it vests upon your 1-year anniversary of employment with the company). From there, equity vests on a customary schedule, (e.g., monthly, quarterly). Some companies have accelerated vesting options, which means that in a liquidity event, vesting of some or all your shares is accelerated, but these terms are usually reserved for early hires, founders and executives.

Employee Options Pools
At each round of financing, it’s customary to carve out an employee options pool to compensate employees hired following the raise. The size of the pool (anywhere from 5–15% is customary) depends on the number and level of hires you’ll bring on: you and your lead investor will decide this together in the terms of the round. Employee option pools are critical: they allow you to set aside equity at key milestones in your business to compensate and incentivize the next group of key hires which as discussed, is crucial for bringing on top-tier talent. Something to watch out for: at each new round of financing some VCs will ask that you “top off” the employee options pool, which can dilute founders. Example: if you have a 10% options pool, but only use 5%, the remaining 5% goes to all shareholders versus back to the founder(s).

Equity: The Bottom Line for Founders and Hires
Equity is a fundamental piece of the startup equation, and it’s one of the most important concepts for both founders and employees to understand. Employees: joining a startup comes with risks and rewards; it gives you the chance to build something new, to innovate, and to play a key role in paving your own path forward. And, in exchange for taking a chance, you become a partial owner of the company, which is not only a great incentive to hustle, but also offers the potential for tremendous financial upside. Founders: remember to be strategic about how you structure your equity grants, compensate people appropriately, and keep your investors in the loop. For both sides of the table, don’t be afraid to ask questions until every detail is 100% clear. Trust us, you may save an extraordinary amount of time and headache in the long run.

About TMV
TMV is an early-stage venture firm that invests in purposeful startups reimagining the future.

If you are building an innovative business of the future or if you are an investor who believes in the power of community and operational commitment, we want to hear from you. Find us at hi@tmv.vc

The contents of this article are intended for educational purposes only and do not constitute financial advice.

TMV is an early-stage venture fund investing in purposeful startups reimagining the future.