Startup Equity #4: How to Maximize Your Startup Offer and Minimize Your Risk
Welcome back, everyone! We’ve covered a lot in this series, from understanding the basics of startup equity to diving into the complexities of ISOs and AMT, and exploring the nuances of liquidity events. If you haven’t read the previous articles, I recommend doing so to get the full context of what we are talking about:
Today, we’re going to wrap up the series by focusing on how to negotiate a startup offer and what questions you need to ask to minimize your risk. Joining a startup can be a rewarding experience, but it’s essential to understand the risks and how to mitigate them through effective negotiation.
Understanding the Basics of Equity Compensation
To briefly recap what we went over in part 1 of the series, here are the 3 forms of equity that startup employees typically receive in the US:
Stock Options:
- Non-qualified Stock Options (NSOs): These can be granted to employees, contractors, and advisors and are subject to ordinary income tax upon exercise.
- Incentive Stock Options (ISOs): These are typically granted only to employees and offer potential tax benefits, such as being taxed at the capital gains rate if held for a certain period.
Restricted Stock Units (RSUs): These are company shares given on a vesting schedule and are taxed as ordinary income upon vesting. RSUs are more common in mature startups gearing for an IPO (or once they hit a 1B valuation)
Key Questions to Ask When Evaluating a Startup Offer
Unlike big tech offers that are fairly straightforward to understand since their RSUs are all liquid and can be treated like cash equivalents, with startups you have more things to consider. Here is a list of everything you should try to get answers to.
Keep in mind not every company will want to reveal all their metrics/detailed financials, but you must get these answers before joining if you don’t want to get screwed over.
How many shares outstanding?
- Why It Matters: This tells you the total number of shares, including those that could be claimed through options and warrants. Knowing this helps you understand your ownership percentage.
- You alternatively can ask for what percentage of the company this represents, which is probably fine early on. Companies after that have raised a Series B typically don’t like talking about percentages since they will be pretty small
- This is a big red flag 🚩 if they won’t tell you this. I have heard many companies tell candidates that it is confidential…
What is the current strike price, FMV, and preferred share price?
- Why It Matters: These values determine the cost to exercise your options and the potential upside. A lower strike price generally means more potential upside. Reread Article #3 if you want to understand this better
- This only matters for ISOs/NSOs, if the company is giving you RSUs you should instead clarify what the vesting conditions are — typically companies give double trigger RSUs so that you don’t vest them unless a liquidity event happens.
Do we allow early exercises?
- Why It Matters: Early exercising can lock in a lower strike price and start the holding period for potential tax benefits sooner.
- Having the option to early exercise is a huge advantage for companies that offer it. This makes equity offers much more attractive — even if it means putting money up front for the employee.
Do we have investors with liquidation preferences?
- Why It Matters: Preferred shareholders often get paid first in an exit event. High liquidation preferences can reduce the payout for common shareholders (employees).
- For those who aren’t aware of what liquidation preferences are, essentially they are clauses where preferred shareholders get paid first in the case of an exit, or bankruptcy. Usually, this is why bankrupt startups result in employees getting $0.
- If you have a company with investors that put in $100M at a 2x liquidation preference, then if the company gets bought for $500M, the first $200M will go to the investors and the other $300M goes to shareholders like employees.
- Depending on if they have participating vs non-participating liquidation preference, the investors would also get part of the remaining funds as shareholders as well
- This chart shows that liquidation preferences are more common for growth rounds. This is because there is a lot less upside when pre-IPO investing. Liquidation preferences might be the majority source of profits for financial firms.
What are the biggest issues you are running into?
- Why It Matters: Understanding the company’s challenges can help you gauge the risk and potential for future success.
- This is more of a general interview question but can help you understand if the company has product-market fit/how well it’s doing
- Generally, you want to see answers along the lines of the company trying to scale out due to too much customer demand / expand into new verticals since it has proven its core business works
What is your ideal outcome/exit?
- Why It Matters: Knowing the company’s exit strategy can help you understand the timeline and potential for your equity to become liquid.
- This is more of a question you ask executive leadership at the end of the interview process, but it can be important in figuring out how the company is trying to operate.
- Companies that are gearing up for acquisitions might be trying to cut burn and look more cash-efficient while companies looking to IPO need to get to $200–300M ARR at least and will most likely try to optimize for reasonably cash-efficient growth rates.
- In a future article I will discuss SaaS metrics in detail so please subscribe to my Substack get notified!
How do we make money?
- Why It Matters: Understanding the business model and revenue streams can help you assess the company’s financial health and growth potential.
- As an employee, you should always try to understand where revenue comes from in any business you work on, and then make sure that you are working in a part of the business that helps bring it in
- For early-stage companies, you will run into very amature founders who don’t have great business sense. If they do not know exactly how they expect to generate revenue — I would run
(If early) Can I talk to an investor who led a round?
- Why It Matters: Talking to an investor can provide insights into the company’s valuation, growth prospects, and overall stability.
- At the end of the day speaking to an investor won’t reveal any red flags that you didn’t already notice yourself, but it can still be useful to get insights into why an outsider found this business enticing to invest in.
My Startup Offer Experience
Let’s use my initial offer out of college in San Francisco as an example to illustrate how to approach these questions:
Offer Details:
- Cash Compensation: $120k in base salary
- Equity: 10,000 ISOs
- Benefits: Healthcare and other standard benefits
Questions and Answers:
How many shares outstanding?
- Answer: 12,000,000 shares.
- This tells me I own approximately 0.08% of the company, a common percentage for junior engineers at a series A company, albeit not very high.
What is the current strike price, FMV, and preferred share price?
- Answer: The strike price is $1.15, the FMV is $1.15, and the preferred share price is $7.50.
- This gives a significant potential upside and the total cost to exercise was under $12k which for a tech employee making six figures is not a a tremendous financial burden.
Do we allow early exercises?
- Answer: Yes, the company allows early exercises, which means I can exercise my options early and start the holding period for tax benefits.
- This was good to hear, not every company wants to deal with the additional paperwork of supporting early exercises, but it is very beneficial for me.
Do we have investors with liquidation preferences?
- Answer: Yes, our investors have a 1x liquidation preference, meaning they get their money back first before common shareholders are paid.
- This was a minor red flag for a company this early to have a liquidation preference, but at least it is not a very high one
What are the biggest issues you are running into?
- Answer: The company is not able to onboard customers fast enough and is trying to double the size of the workforce over the next 3 months
- This is the signal I was looking for and ultimately played a huge role in my decision to accept this offer. This told me the company has found product-market fit which is a very strong indicator it will be able to reach the next round of funding (Series B)
What is your ideal outcome/exit?
- Answer: The ideal outcome is to go public within the next 3–5 years, but an acquisition is also a possibility. The company had been around for 3 years already, so an exit at that range is pretty reasonable
- This chart shows the percentiles of companies getting acquired, so generally anywhere from 3–8 years is very normal and a good target.
How do we make money?
- Answer: We generate revenue through a subscription-based SaaS model targeting B2B clients.
- I generally like B2B SaaS due to annual recurring revenue, high margins, and easy scalability. So this is what I was looking for
(If early) Can I talk to an investor who led a round?
- Answer: Yes, you can speak with the lead investor from our Series A round to gain more insights.
- Talking to their investor was very insightful and gave me other reasons to be optimistic about the company’s chances of success.
Minimizing Your Risk
1. Diversify Your Investments:
- Don’t Put All Your Eggs in One Basket: While equity can be lucrative, it’s also risky. Ensure you have other investments to balance your portfolio. You should save money from your base salary to invest in public equities. Private markets are a lot less regulated and opaque.
2. Understand the Risks of Early-Stage Companies:
- High Risk, High Reward: Early-stage companies have higher risks and higher potential rewards. Be prepared for the possibility that the company might not succeed. Remember, if you spend a ton of money on an expensive early exercise and the company fails — you will be out of your job, and all the money you put in to buy your stock
3. Regularly Review Your Equity Position:
- Stay Informed: Keep track of the company’s performance, any changes in valuation, and the status of your equity. Good companies should be sharing financial metrics with their employees at a regular cadence. Companies that don’t are huge red flags and usually go the way of Fast API
4. Be Cautious with Secondary Market Sales:
- Discounted Prices: Secondary market sales often happen at a discount. Understand the terms and potential impact on your overall equity value. Getting to the point where you can sell any shares for real money is great, but make sure you get a fair valuation for your hard-earned equity.
Conclusion
Negotiating a startup offer requires careful consideration of various factors, from understanding the types of equity to knowing the right questions to ask. By preparing adequately and staying informed, you can maximize the benefits of your startup equity and make informed decisions that align with your career and financial goals.
In this series, we’ve covered the essentials of startup equity, from understanding the basics to navigating liquidity events and negotiating your offer. Stay tuned for more insights and strategies to help you succeed in the dynamic world of tech and startups.
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