Equity is a major incentive for employees who are joining a startup early, when there is more risk and potentially lower salary. It’s important for the business owner to set the company up for success. On the other hand, it’s important for employees to know when to exercise options, how to get paid out, how much they’ll make, and how much they’ll get taxed.
The Equity Basics
- Equity: The value of the shares issued by a company. One's degree of ownership in any asset after all debts associated with that asset are paid off.
- Exercise/Strike Price: The price at which you can purchase the stock.
- Exercise shares: To choose to buy or sell your shares in a company. You don't have to exercise your options, but if you don't, you won't actually "own" your equity.
- Fair market value: The current value of the shares.
- Equity grant: Occurs when an employer pays a part or all of the compensation of an employee in the form of the corporate stock.
- Stock options: A benefit in the form of an option given by a company to an employee to buy stock in the company at a discount or at a stated fixed price. A contract that gives you the right, but not obligation, to buy a stock at an agreed-upon price and date.
- When an employer grants 100 options to an employee, the employee does not own 100 shares; they have the option to buy 100 shares at the aforementioned strike price.
- Shares: A part or portion of a larger amount that is divided among a number of people, or to which a number of people contribute.
- Shares outstanding: The number of shares outstanding is the total amount of shares that are held by all its shareholders.
- Valuation: An estimation of something's worth, especially one carried out by a professional appraiser.
- Vesting Schedule: Employees may be given equity in a firm but they must stay with the firm for a number of years before they are entitled to the full equity. This is a vesting schedule. Most startup employees' equity packages come with a vesting schedule to protect the company from "ghosts in the cap table."
- ISO vs. NSO: High level, ISOs are for employees, NSOs are non-employees like advisors.
- Stock vs. RSU: When you're granted stock options, you have the option to purchase company stock at a specific price before a certain date. Whether you actually purchase the stock is entirely up to you. RSUs, on the other hand, grant you the stock itself once the vesting period is complete. You don't have to purchase it.
DO NOT FORGET TO FILE YOUR 83b!
- Instructions here
- This proves to the IRS that you purchased your shares/options at a super discounted price. Must be done within 30 days.
- Send it certified and keep a copy of the little green slip along with a copy of the signed form for your records. Do not lose this in case you get audited in the future!
- If you want to be thorough, include a self addressed, stamped copy and ask them to stamp and return it to you.
How do I manage my company’s equity?
One of the top cited reason for challenges fundraising, passing audits, and lawsuits is lack of transparency and compliance on the cap table. Investors have no patience for this. There is software, use it.
Cap table management software is crucial for a startup. There are many items to think about when choosing the best cap table software to fit your company’s needs.
- Will your lawyer use it?
- Most early stage companies will have their law firm help manage their cap table, and typically 100% of Series A startups enlist their law firms to do the actual cap table management. So ask your law firm which tools they are willing to use.
- Support for common securities
- You’ll need to choose a vendor who handles preferred stock, restricted stock, warrants, SAFEs, converts and options. The newest vendors may not be able to handle pre and post money notes, so make sure the vendor can deal with the types of securities you are likely to issue.
- Our favorite cap table software:
- Free plan available for up to 20 employees/investors/stakeholders and less than $1M raised
- Free plan available for up to 25 employees/investors/stakeholders and less than $1M raised
- LTSE Equity
- Built for founders by founders. Cheaper option, easy to self-setup and open protocols.
- Free plan available for up to 10 employees/investors/stakeholders and less than $1M raised
- Largest and one of the more controversial players. Closed system makes it very hard to terminate and delete data. Also more expensive and requires lawyers to setup.
- Free plan available for up to 25 employees/investors/stakeholders and less than $1M raised
- What is a 409A valuation?
- An independent appraisal of the fair market value (FMV) of a private company's common stock
- This will protect your employees and company from the IRS around stock compensation when the rocket ship takes off
- When should you get a 409A valuation?
- Before you issue your first common stock options
- After raising a round of venture financing
- Once every 12 months (or after a material event)
- If you're approaching an IPO, merger, or acquisition
- Where to get a 409A valuation?
Additional resources to learn more about equity
Equity as Compensation
Who should I offer equity to?
How to split equity amongst Founders?
This is stress inducing in every company, every time. Good luck! The answer is, there is no right answer.
- Founders tend to make the mistake of splitting equity based on early work; however, equity should be split equally because all the work is ahead of you.
- Everyone should vest for at least 4 years with a one year cliff. Even you! VCs are known to reset equity vesting at the Series A. Not guaranteed but can be mitigating to start with 5 year vesting at formation.
What is founders’ preferred stock (FF preferred)?
- FF preferred addresses certain tax and accounting issues that can arise when founders decide to get early liquidity by selling shares of their stock to investors at the same price as other preferred stock sold in a concurrent equity financing (“New Preferred Stock”).
- Founders’ preferred stock is different than common stock because it automatically converts into shares of New Preferred Stock when sold to a third-party investor in connection with a new equity financing.
- This allows the Founder to sell their founders’ preferred stock for the New Preferred Stock price without any further action by the company.
Is founders’ preferred stock right for me?
- Founders’ preferred stock is ideal for founders who think they are likely to raise venture capital and will want to get early liquidity, or at least want to leave that option open.
- Note that founders’ preferred stock may be frowned upon by some VCs since it makes it easier for founders to get early liquidity, which may not be in the VCs’ interest.
How much equity should I offer Advisors?
- Dependent on role and experience of the advisor
- Most common advisor arrangements in 2022 for pre-seed companies - here:
- Median advisor grant was 0.24% of company shares
- 70% of advisor grants were for less than 0.5% of the company
- 40% of advisory grants had a two-year vesting schedule, while 26% had a four-year vesting schedule
- Additional resource - here
- Should advisors vest?
- Yes - Make sure Advisors vest over a period of time, typically 2 years
- Should advisors have a cliff?
- Maybe - It is generally advised to make sure you are getting value out of your advisors, who typically start much more involved, and taper off over time. A 3 month cliff ensures advisors are aligned for the long term, rather than provide advice one time as if it is a transaction.
How much equity should I offer Investors?
- There is no tried and true percentage
- The amount you'd give an investor is directly related to 1) how much you value the company to be worth at the time of investment and 2) how much they invest
How much equity should I offer employees?
- Many founders leverage equity as a way to make up for the fact that they may not be able to pay employees a full market salary.
- Additionally, equity creates ownership among employees, giving them the motivation to become invested in the company’s success.
- Employers typically reserve 13% to 20% of equity for their employee option pool.
Understanding equity as a component of an offer
- When granting an employee equity as a part of an offer, there are a few key components that should be outlined
- Number of Options: The number of shares the employee has the right to purchase.
- Percentage Ownership: The percentage ownership of the company’s total outstanding equity, assuming that the employee exercises all of options. This is calculated as (number of options) / (total outstanding shares issued by the company).
- Strike Price: The per-share price that the employee will pay to exercise their options.
- Vesting Schedule: Typically an employee’s equity grant will be subject to vesting, which means that they don’t receive all options right away, but that they’ll receive them over time.
- Common Vesting Schedules: Four years with a one-year cliff. This means that if an employee leaves the company within the first year, they’ll walk away with nothing. If they stay, 1/4th of the shares will vest on their one-year anniversary, after which 1/48th of the shares will vest monthly.
- Post-Termination Exercise (PTE) Window: If an employee leaves the company, they’ll often have just 90 days to decide if they want to exercise their options. Once those 90 days are up they’ll forfeit all their options, causing many employees to find themselves in “golden handcuffs”. Be aware, though, that even if your PTE window is more than 90 days, your ISOs will convert into NSOs after 90 days.
Are there tax consequences tied to employee equity?
- Yes, there are a few different points in time where you pay taxes, depending on type and time you receive equity
- Incentive stock options (ISO’s) are most tax favorable for employees:
- Grant - Typically no taxes are owed at this time
- Vesting - Typically no taxes are owed at this time
- Exercise - Typically no taxes are owed at this time
- Sale - Yes, taxable income is reported at this time