Most people understand that equity is generally a good thing, but have little idea what the numbers actually mean or what processes will lead them to holding value. I’d like to try and clear some of that up today.
When considering a job offer from a startup you may be more interested in the role, the culture and your base salary than the equity compensation they’re offering. But if you’re working at a fast growing startup, with a little luck and the right strategy you could walk away with massive financial rewards.
This guide intends to explain in plain English the stock option process so you can are able to make informed decisions regarding equity.
Shares
Shares can be seen as a form of virtual currency. Shareholders speculate on the value of that currency and companies do their utmost to increase its value. Businesses can inflate or deflate the currency through their performance, perceived market potential or by issuing new shares.
When companies are formed they typically issue ~ 10 million shares, which are divided between members of the founding team and diluted in subsequent investment rounds. Some of these shares are put aside into an “option pool,” a group of shares dedicated for employees. Any shares you receive will probably come out of this pool.
Stock Options
When you join a company, you probably receive the option to buy shares. This is a contract which dictates you have the ‘option’ to buy shares at a predetermined price over a specified time period.
Stock options are really similar to futures. The expectation is for their valuation to increase, which means that in future you’ll be able to buy shares at the price when you joined and make a tidy profit when you decide to sell the shares.
Vesting Schedules
Option agreements typically have a four-year vesting schedule, with a one year cliff. In plain English this means that you will receive all your stock options over a period of four years, but if you leave the business in less than a year (or if you are “let go”) then you won’t receive any options at all.
Usually the shares are broken up into 48 pieces. You get a quarter of your shares after 1 year, and then each month after that you’ll vest another 1/48.
Questions you should ask
When discussing your equity compensation there are some very important questions you should ask:
- How many shares will I have the option to exercise?
- What is the total number of shares?
- What price can I buy my shares for?
- What have investors paid for their shares?
- What does my vesting schedule look like?
- What is the potential tax liability?
These questions should let you figure out how much it would cost to buy the shares and the current valuation of the company. More importantly, you’ll be able to know what percentage of the company you’re shares would represent if they were all vested today. The company is likely to grow and issue more shares - therefore diluting your shares and the percentage of the company you “own” - but it’s still good to have a rough idea of your percentage from the beginning.
If the company seems reluctant to answer these questions, keep pushing. If equity compensation means anything to you (and hopefully it now does!) you deserve to know what percentage of the company you “own” and its value.
I’d question any compromise on salary for shares, unless you’re one of the first employees or a co-founder. It’s a red flag if the founders are willing to give up a big portion of their company when they should be able to pay you. If they are offering a lower salary than you’re comfortable with, try negotiating a tiered offer but stick to the ratio of salary to equity that feels right for you.
Valuations & Tax
A 409A valuation is a fair market valuation of a company that’s made by an accountant and then reported to the IRS. The valuation usually increases at every investment round as investors become more optimistic about the company’s future and speculate on its potential. As the company approaches an IPO, the gap between the two valuations shrinks and finally disappears.
By comparing the company’s 409A valuation when you were granted the stock options and the valuation when you purchase the stock, you can get a pretty good idea of your tax liabilities. If you’ve only been at the company for a year – or if the company hasn’t grown – the 409A valuation may be the same. If you decide to buy shares at this point you’ll have no tax liability.
But if there’s a significant difference the IRS will treat the gain as an “AMT preference” and tax you on the increase. The tax bill can sometimes be bigger than the amount you have to pay to your company. And if the company fails then you don’t get the tax refunded; you only receive credit that goes towards you next tax return. This can increase the risk on the investment.
If you’re buying vested share before you leave the company, you should definitely look into filing an “83(b) election,” which can decrease the amount of tax you have to pay. Basically, this lets you pay all of your tax liabilities for vested and un-vested stock early at the current 409A valuation so if the valuation subsequently increase you won’t be adversely affected.
Sounds a bit complicated? It is! But the more you know about your equity offer up front will help you understand its value, allowing you to make an informed decision as to whether the risk of joining a startup is worth the would-be reward.
Written by Izzy Griffin-Smith
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