Startup Equity Part 1: Stop leaving money on the table and understand equity grants

Hey everyone welcome to the first part of a mini-series I will be publishing over the next few weeks about one of the most misunderstood and complex forms of compensation in Silicon Valley startups: private equity grants.

As someone who wants to break into startups or entrepreneurship, trying to make sense of your first offer from a startup can be very intimidating. I know it was for me. While there is great literature online around big tech compensation, especially with the amount of accurate and accessible data we have with websites like levels.fyi, startup compensation is so much less understood by people outside of the industry and it can be challenging to accurately evaluate your offer.

The example I will use in the rest of the article will be a comparable offer to what I received as a junior engineer at my first job out of college in San Fransisco:

So my initial offer was $120k in cash + 10,000 ISOs in the company + benefits (note: in the United States, benefits typically cost your employer around ~16% of your salary, what is showing up here is my healthcare premium payments they offered, not the total cost to the company which would include things like payroll taxes)

Understanding the Basics of Startup Equity:

So to dive into this, we have to understand, what even is equity?

Equity just means that you are given some ownership in the company. In my case, I was given incentive stock options (ISOs), but that is just one of many possible ways in which an employee can be granted equity.

Types of Equity:

• Restricted Stock Units (RSUs): This is the simplest one to understand so I will get it out of the way first. These are company shares given on a vesting schedule and taxed upon vesting or in the case of double-trigger RSUs, they vest after the vesting period in addition to once the company has a liquidity event. For the most part RSUs in privately-held startups operate mostly the same way as in publicly traded companies with just much more limited options for selling.
• Incentive Stock Options (ISOs): These give you the right to purchase shares at a set price after a certain period, known as exercising. Generally, because of the ability to early exercise and file an 83B Election with the IRS, ISOs carry more upside due to tax benefits at the cost of having to pay money upfront to exercise. In a future article, I will break down the ISO tax benefits, so stay tuned. Typically as companies get bigger, the strike price to exercise goes up and it becomes too costly for employees to take advantage of the tax benefits of ISOs.
• (Non-qualified Stock Options (NSOs): Will only mention these briefly but these are mostly similar to ISOs except they don’t get certain tax benefits. It should be noted that ISOs can be granted only to employees of the company, while NSOs can be granted to anyone like advisors/board members/etc. Additionally, since companies can’t authorize a grant that gives an employee more than $100,000 in exercisable ISOs in a given year, any amount over that will be converted to NSOs.

The rest of this article will focus on ISOs since these are the most complex and what is typically gifted to early-stage startup employees.

So in my example, it can be hard to understand, what it means to get 10,000 options in the company. How do you even begin to value this? What do I need to understand to begin proper negotiations? How do I calculate my total compensation?

Most startup equity comes with a vesting schedule, typically four years with a one-year cliff. This means you won’t receive any shares until you’ve been with the company for at least a year, and then the rest vest on a monthly, quarterly, or annual basis. In my case, this meant I would receive 2,500 ISOs after one year of working + around 156 ISOs every month thereafter. Note that this one-year vesting cliff usually applies to refresher grants as well. So if you are gifted a second grant say 2 years in for good performance, you would have to stay an extra year before you get 25% of that grant.

Examining an Equity Grant:

A lot of conventional wisdom that you read online will say to value the equity as 0 because startup stock is usually worthless. After all, most startups fail. The issue with this logic is that it often causes employees to fail to negotiate equity because they don’t understand or value it. I have left hundreds of thousands of dollars on the table because early in my career I didn’t realize how valuable negotiating equity was or that I could even do it.

As an aside, if you are a high-performing employee with competing offers, if you don’t believe in a startup’s ability to reach a liquidity event for your shares, then I suggest not taking the offer unless the cash portion is so much greater. Joining a startup will be miserable if you don’t believe in the company vision and will cause you to lose a ton of future earnings that you could have made working at publicly traded companies where you would be paid in RSUs that are as good as cash in the public markets.

Now back to my example with 120k base salary plus 10k ISOs, how do I value this? What is my theoretical total comp? (I am using theoretical here because my liquid TC will be 120k, there is no getting around it, that is what I will have to live on) There are 3 different numbers you will need to know when dealing with ISOs to be able to understand how much a grant is worth:

1. Preferred Share Price: This is the price of a stock in the company that investors pay. When you read a headline like “X company raised at a 1B valuation”, what that means is that you can find the preferred stock price with the following formula:

1. Fair Market Value (FMV): This is probably the hardest to understand, but this is the price of a “common stock” in the company. This number is not related to anything specifically about the company and is typically much lower than the preferred share price. It is calculated by an independent auditor through a 409A valuation for tax purposes. Over time this number will converge with the preferred share price which is a big reason late-stage startups switch to RSUs as the upside granted by ISOs diminishes. (This is the number that is used for the $100k NSO limit I mentioned earlier, not the preferred share price)
2. Option Strike Price: This is how much it costs for you to exercise one of your ISOs to convert it into a common stock. Typically it is set to whatever the FMV at the time is. While the FMV will change every year due to a new 409A or a liquidity event like fundraising, your strike price will be fixed at the time of joining. The tax implications here will be covered in a future article so stay tuned and please subscribe to my Substack.

Evaluating a Startup Offer:

Back to my example offer of $120,000 + 10,000 ISOs over 4 years. Here is the information I was given:

These are fairly normal numbers for a company in the Series A/B rounds of funding. I would say the total number of shares is on the lower side but other than that nothing stands out.

From this, I can calculate the following bits of information:

• The 409A valuation for the company was calculated as:

• My total cost to exercise my grant is

• My total grant worth is

• My total percentage ownership is

• My illiquid total comp is, therefore:

This is a typical example of what a new grad software engineer would make at an early-stage Silicon Valley startup a few years ago. The equity depending on how far along the company is offered is pretty low. A good benchmark for generous startups hiring new grads would be for the equity grant to be around 150k worth of stock over 4 years, about double what you see here.

To get an idea of how much money the next four years will make you, along with the ability to forecast different growth rates of the business. I like to use the levels.fyi calculator. Here is a link to my offer as an example for you to start with as a baseline.

Conclusion

Understanding and evaluating startup equity is crucial before you sign on the dotted line. It’s about balancing optimism with realism, recognizing both the opportunities and the risks. Most people are not qualified to advise on how to evaluate these offers and you should always make sure to put yourself in a position to financially benefit from positive outcomes.

In follow-up articles in this series, I will walk through examples of how these equity grants can potentially play out and what some realistic exit outcomes are along with what reasonable equity packages for different roles/levels in Silicon Valley startups look like along with how equity in different countries around the world works.

Please comment down below if there is anything I missed or would like to see covered next time. Please subscribe to stay up to date, and join me on Substack to get access to these articles sooner.