The Ins and Outs of Equity Compensation at Startups
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You may have a startup equity compensation offer if you've received an offer from a startup company. In other words, you may be eligible for vested equity after you reach certain milestones.
Whether equity compensation, also referred to as an equity grant, is reasonable depends on what's being offered and if you can live off the cash salary.
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Startup Equity Compensation
Startups often don't have a lot of cash to attract the best talent, but they might offer equity compensation, which can be even more valuable. Working for equity is a win-win for you and your employer. Your employer attracts high-quality employees, and you get the compensation you deserve, even if it's not in your salary.
When you earn equity compensation, you don't receive it upfront or on every payday. The only compensation you make regularly is your salary, which is easy to determine based on what the company offers.
You must work toward the other compensation. Most companies won't issue any equity until you've reached a specific milestone, such as working there for one year. This helps decrease employee turnover and doesn't put the company at risk of issuing more equity to employees that won't stay.
What Is Startup Equity Compensation
When you work for equity, you work for partial ownership of the company. It's non-cash compensation awarded on a specific schedule determined by the employer. Startup equity compensation makes joining a startup more attractive for top-notch, highly sought-after employees.
The most common form of equity for employees is in stock options, but other forms include restricted stock awards and restricted stock units.
The types of equity earned vary by company. Each has its own tax implications and, of course, stock value. Whether an equity compensation is worth it depends on the total package. How much is the company paying you in salary (regular compensation), and how much do you have to work towards?
Some types of equity depend on the company valuation, and others have restrictions regarding when you can sell the equity and earn the cash flow. All equity compensation has tax implications too, which you should consider as it lowers the total amount you receive.
Why Is Equity-Based Compensation Important
Startups are in a unique position. They have big goals but need talented staff to help them achieve them. Unfortunately, it can be challenging to attract the necessary talent without the cash flow to pay higher salaries.
Equity compensation, however, gives employees a stake in the company, making up for the lower salary. The ownership in the company not only compensates employees but also gives them the incentive to help the company succeed and grow and helps to minimize employee turnover. In addition, since most equity works on a timeline, offering specific ownership percentages after a certain amount of time worked can also decrease employee turnover.
How Is Equity Compensation Calculated
Calculating equity compensation can vary by company, but most companies base it on a position's seniority. For example, senior team members may earn 1% equity compensation, and management may earn 0.5%.
There's no rhyme or reason for how much equity a company pays an employee, so it's worth comparing your offers to see which provides the most significant compensation.
Ask questions if you aren't sure how a company determines how much equity they'll provide. Find out about the value of the company stock and how they decide which employees earn different types of equity, including early-stage employees.
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When Can Startups Offer Equity Compensation
Companies must pass specific legal stipulations before they can issue equity compensation. The most common hurdle is passing the 409a valuation. This process determines the fair market value of the company's stock.
The fair market value derived in the valuation determines the price you can issue your equity compensation to your employees. Without the 409a, a company could face legal consequences, and most companies must repeat the valuation annually.
How Does Equity Work for Startups
Most companies use 10% - 20% of their total shares as employee equity. This means that all employees working for equity will hold 10% - 20% of the company's shares when they are fully vested.
How long it takes to get vested and to be able to exercise your equity options varies by company. Some give a percentage of the equity in 1-year increments, with four years required for full vesting, but each company can set its own rules.
Evaluating Your Equity Offer
When evaluating your equity offer, think like an investor. If you were to buy company shares, you'd do your research, right?
The same is true of an equity compensation offer. Rather than giving money, you're giving your time and talent, which is worth just as much.
So what should you consider?
- The company's exit strategy - Startups don't always succeed. Knowing a company's strategy, whether to sell or become a public company, is essential. You could earn cash if they sell and the company has a high value. If they aren't valued high enough, though, you could walk away with nothing.
- Understand the percentage you'll own - The percentage of the company you'll own and the total percentage outstanding compared to the total shares is important. The larger the percentage owned by employees, the more likely it is you'll receive a payout in the exit strategy.
- Know the vesting schedule - The vesting schedule is most important. This states how long you must be at the company to exercise your stock options or other equity grants.
- The big picture - Always look at the big picture. How much will you earn once you're fully vested? At first, you might earn less than you hoped, but if you know once you're fully vested that your equity compensation will make up for the difference, it can be worth it.
Types of Equity Compensation Stock Options
Each company can offer a different type of equity compensation. Stock options are the most common, but there are also restricted stock awards and restricted stock units.
A common way to have a stake in the company is with stock options or the right to buy the company's stock at your strike price. When the company issues the options, your strike price is the stock's fair market value.
Most Incentive stock options have a vesting schedule you must follow. The schedule allows you to exercise your right to buy stocks at your strike price. This usually makes sense when the stock price drops, and you can earn instant equity compensation.
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Restricted Stock Awards
Restricted stock awards are equity shares you receive after meeting certain restrictions or requirements. The most common limitation is the vesting schedule. You must be at the company for a specific time to receive the stocks.
Another common restriction is the ability to transfer the stock. You typically have to ask permission before you can transfer ownership.
Restricted Stock Units
Restricted stock units are an equity distribution agreement that states the startup will issue stock shares on a specific date. One RSU equals one stock share or the number corresponding to the share's value. When you meet the vesting requirements, you can earn the share or the cash equivalent of the share.
As the name suggests, performance shares are an equity stake based on the company's performance. Companies set certain benchmarks, such as Earnings per Share or Return on Equity, and once the company reaches the benchmark, they issue the shares as contracted.
What Is Equity in Business: Important Terms
The stock agreement for equity compensation is a legal document that contains the important details of the stock offered as equity.
This is the number of shares the company will issue you as a part of your equity compensation.
The equity vesting schedule is the time you must work at the company to earn a specific amount of company equity. Most vesting schedules have multiple dates, usually 4, awarding you a percentage of your equity ownership at different intervals.
The 409(a) valuation is a third party's appraisal of the company's stock. Most companies have a 409(a) evaluation annually. Each new appraisal determines the stock's fair market value.
An Initial Public Offering is the first offering of a company's stock on the public market. After an IPO, anyone holding the company's stock can trade or cash out their equity in exchange for cash.
Ordinary Income Tax
Ordinary income tax is the tax you pay on your earnings. The percentage you pay depends on your earnings but varies from 12% - 37%.
Capital Gains Tax
When considering equity compensation, make sure to think about the capital gains tax. This is the tax you'll pay on any profits earned on investments. The percentages range from 0% - 20%.
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Equity Compensation Plan Examples
Let's say you have two offers from two different companies with the following conditions:
- Company A - $125,000 salary plus 15,000 shares and 7,000 options
- Company B - $150,000 salary plus 7,000 shares and 4,000 options
To figure out the value of the shares, you'll need the company's valuation according to their 409(a) and the total number of shares the company has outstanding.
- Company A has 12 million shares valued at 75 million
- Company B tells you that the fair market value of the shares is $5
For Company A, use the following:
- $75 million/12 million shares * 15,000 shares = $93,750 + $125,000 salary = $218,750
For Company B, use the following:
- $5 FMV * 7,000 shares = $35,000 + $150,000 = $185,000
To determine the stock options' value, you need each company's strike price and current FMV. You already know Company B's share price, but to figure out Company A's, do the following:
- $75 million/12 million shares = $6.25
If the strike price for each company is $2, you will figure your stock options at:
- 7,000 * ($6.25 - $2) = $29,750
- 4,000 * (5 - $2) = $12,000
Comparing the offers, you'd have:
- Company A - $125,000 + $93,750 + $29,750 = $248,500
- Company B - $150,000 + 35,000 + $12,000 = $197,000
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Joining Startups With Private Equity Compensation
The big question is, should you join startups with private equity compensation?
It depends on what you're looking for and what you can afford. If you don't need the total compensation upfront, you can help early-stage startups by accepting their equity packages and making the most of your time there.
Like any job decision, though, there are pros and cons.
- It gives employees a 'reason' to work harder and helps the company grow
- May offer beneficial tax benefits
- Can offer significantly more than a salary in the right conditions
- There's no guarantee of capital gains
- If the company doesn't have a strong exit strategy, it could hurt employees
- You must be vested to earn your compensation
Startup Equity in a Company FAQ
What's the Average Employee Equity for Startups?
The average company gives employees 10% - 20% of its total capital. This means all employees own 10% - 20% of the company.
Stock, Shares, and Equity — What's the Difference?
Equity is a measurement of how much of the company you own. For example, if you have 10% equity and the company has 10 million shares outstanding, you own 1 million shares. But shares are the unit you own and are displayed as a number, such as you own 200 shares.
How Are Taxes Affected by Equity Offers?
How long you hold the shares and if you earn capital gains determine how your taxes are affected. For example, you don't pay taxes on any equity compensation you haven't earned yet because you aren't fully vested. Once you take ownership of the equity, though, you'll pay taxes according to your earnings. In addition, if you hold onto the investments long-term (more than one year), you'll pay long-term capital gains taxes, which are lower than short-term capital gains (owned less than one year).
What Does Equity Mean in Stocks?
Equity is the amount you'd earn if the company liquidated its assets and paid its debts. It's the percentage of ownership you have of a company after it settles its debts.
Do Startups Pay Well?
Startups often have cash flow issues, so they can't reward new employees with high salaries, but they can compensate for it with startup equity compensation. Whether they pay well depends on what's offered and how it compares to the competition.
Should You Accept Equity as Compensation: The Bottom Line
Each person has different situations and requirements when deciding if equity compensation is acceptable. Do the math and make sure you understand the big picture. Sometimes a larger salary is worth less than what you could earn if you waited for startup equity compensation.