A Brief Overview Of Equity Compensation At Startups
Welcome to Unicorn Startup Co.
Congratulations, you just earned a job at one of the hottest tech startups in Silicon Valley, Unicorn Startup Co!
I know the main reason for taking the job is the warm feeling felt by challenging yourself, learning from the best in the world and hopefully creating a difference in the lives of millions. I get all of that.
But getting paid is also a big incentive too, right?
Chances are, compensation at your new job is a combination of a base salary and equity. But the real money incentive to joining Unicorn Startup Co. is the equity compensation (i.e. stock options) the company pays its employees.
Equity compensation is really complicated. This post will not be the exhaustive blog post to shed light on all the minutia of equity compensation.
My goal with this post is to cover the following:
- Define what equity compensation is
- Highlight some important factors underlying equity compensation
- Outline some questions for employees to ask employers
What is Equity Compensation?
“Equity compensation is non-cash pay that represents ownership in the firm. This type of compensation can take many forms, including options, restricted stock and performance shares. Equity compensation allows the employees of the firm to share in the profits via appreciation and can encourage retention, particularly if there are vesting requirements.”
Basically what this means is, employees are granted a certain amount of the company’s stock as a form of deferred compensation. If the company does well, then the employee will benefit because of their % stock ownership in the company.
Note: A very important point to keep in mind is the reality of being an employee of a very early stage business. Stock options can potentially end up worthless. The best thing an employee can do is weigh the risk vs. benefit of taking salary vs. stock options.
How Equity Compensation Works
At its core, equity compensation is fairly straightforward.
Basically, an employee is hired and awarded/granted the right to purchase so many shares of a company’s stock at a predetermined price, called the strike price.
If the company does well, the value of the employee’s shares will increase, leaving the employee with a gain. If the company doesn’t do well…then the options may be worthless.
For the sake of brevity, I’m going to list out what I think are some extremely important points to consider when thinking about equity compensation. The points below will be by no means exhaustive, but should get the wheels spinning and thinking in the right direction.
What the company is worth (i.e. valued) is what determines the price of an employee’s stock. The best way to think about this is in terms of risk vs. reward.
Pre-revenue and seed stage companies are going to be worth much less than established startups. This means the price per share of a stock option will be lower, meaning there is the potential for significant gain down the road.
The other way to think about it is very early stage companies are extremely hard to value thus their stock is also extremely hard to value. If the majority of an employees pay is tied up in stock, the employee needs to consider the very real potential for the company to NOT do well and the employee NOT getting fairly compensated for their time.
The strike price of a stock option is the price the employee pays when the option is exercised. Strike prices are usually set at the time the stock option is granted to the employee at the fair market value of the company’s stock at that time.
Dilution is what happens when a startup makes more shares available to investors thus potentially making an employee’s percentage ownership in the company less.
Most employees are going to have very little control over their ownership stake being diluted. However, dilution is generally a good thing because it means investors are interested in acquiring shares of the company and hopefully the newest shares sold are sold at a higher price meaning that an employee’s share are also more valuable.
Types of Stock
Two different types of stock are generally issued in startup companies: common stock and preferred stock.
- Common stock is issued to founders and employees of companies, with employees usually receiving stock via grants/options.
- Preferred stock is usually issued to investors in companies.
Each type of stock conveys ownership and voting rights in the company but preferred stock usually has economic advantages over common stock in events such as liquidation, new investment, board governance, etc.
Vesting is a process whereby the company allows the employee to exercise their stock options at specific dates in time. This is primarily done as an employee retention and motivation tool by the company.
The “normal” vesting schedule is 4 year vesting with a 1 year cliff. This means an employee needs to stay with the firm for at least one year before being able to exercise their options. The employee will have full access to their stock options over the four year time frame.
Employees need to be aware of the tax consequences of their equity compensation.
Taxes are broadly determined by:
- Type of option (do I pay taxes or do I not pay taxes)
- Difference between strike price and current stock value (gain/loss)
- Holding period of actual stock (short-term capital gains vs. long-term capital gains)
What Are Some Questions To Ask?
Here are some general questions to ask your employer:
- How/when can I purchase and/or sell my options, are there any restrictions?
- What type of option do I have?
- What is my strike price?
- What is my vesting schedule?
- Who is my contact to explain my compensation in more detail?