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Navigating the complex world of startup equity

By Laura E. Mize

[NOTE: This article is not tax advice, and none of the speakers in this piece are tax experts. Make sure to speak to a tax expert before making any decisions relating to equity compensation or taxes.]

Working at a startup is an adventure with its own highs and lows. There’s the anticipation of what the company might become, the zeal to fulfill a common mission, the struggle of forging a new path, and dreams of a big payout when the company (hopefully) becomes a success.

Most early employees at tech startups receive equity — a share of ownership — as a form of compensation. That’s what helps nascent companies attract and keep top-tier talent despite the inherent risk in new, young companies. It’s also part of the appeal to employees.

Will your whole financial picture change someday because these shares you received for a bargain-basement price — or even better, for free — have gone through the roof?

Potentially. But there’s a lot to know about equity before you get there.

“Equity at startups: It’s this black box,” says Ben Grynol, head of growth at Levels. “If you haven’t been exposed to equity before, it can be pretty overwhelming. There are a bunch of questions.”

Grynol, Zac Henderson, Michael Mizrahi, and Sam Corcos unpacked the basics of startup equity through two episodes of Levels’ podcast A Whole New Level, as a primer for the company’s early employees and member investors. They also brought Henry Ward, co-founder, and CEO of Carta (which helps companies manage equity), into the conversation. Below, we run through some of the main takeaways from those discussions and define several key terms related to startup equity.

GLOSSARY

Buyback: When a company buys its own stock back from a shareholder.

Cliff: A set point in time when employer-granted stock or stock options begin to vest; often, one year in startups.

Equity: Ownership in a company. Early employees of a startup, for example, often receive equity as part of a compensation package, in addition to traditional benefits and salary.

Exercise: Using one’s option to buy stock in a given company.

Incentive stock option (ISO): An employer-granted stock option that often comes with tax benefits for the holder.

Initial Public Offering (IPO): One way a company transitions from a private company to a public company, making shares first available on stock exchanges.

Liquidity: When the owner of equity is able to sell it or borrow against it and receive cash.

Option: The right to buy a stock at a fixed price.

Regulation crowdfunding: A way for the general public to invest in private companies, with income-based limits on how much each individual can purchase. May also be called equity crowdfunding.

Restricted Stock Award (RSA): Shares usually given to a company’s founder and a few early employees, with a restriction against selling the shares to anyone outside the company.

Restricted Stock Unit (RSU): An employer’s pledge to give an employee a certain amount of stock once the employee meets specific criteria. The employer also might give the cash equivalent of the predetermined amount of stock.

Secondary sale: Allows an employee stockholder of a private company to sell shares to investors before the company’s initial public offering. It’s one way to convert equity into cash.

Strike price: The price at which one can use, or exercise, the option to buy a particular stock.

Tender offer: Occurs when an investor in a company offers to buy stock from an employee, and the company helps to facilitate the sale.

Vesting: The process by which your predetermined amount of equity becomes formally yours such that you can sell or exercise it over a period of time.

83(b) election: A tax strategy allowing an employee to prepay taxes on a stock grant before it is vested. This often allows the employee to pay taxes at a lower valuation than the stock may reach by the time it fully vests. The risk is that if the stock value goes down before vesting, the employee does not receive back any of the money paid in taxes.

FAQ

Q: Why do startups give equity to employees?

Zac Henderson: In the non-startup context, you’re getting paid, usually cash for work. If you do especially well, there might be a bonus at the end of the year. But you pretty much know the value of your compensation package on day one, and it’s unlikely to change down the road.

That model isn’t a great fit for a startup company that may not have a lot of cash to spend but is looking to grow. Equity is a great way to compensate startup employees because by giving them a piece of ownership in exchange for work, the employee has the opportunity to benefit from the upside of the company’s future growth.

Q: How do startup employees receive equity?

ZH: Most equity packages at startups are given over a four-year period with what’s called a one-year cliff. The “cliff” is basically a delay on vesting: a year’s worth of your equity will vest all at once, at the one-year mark. This “cliff” serves two main purposes: first, it helps to motivate new hires to stay for at least one year. Second, it gives the company time to feel certain the employee is a good fit, and someone the company feels comfortable having as an equity holder.

After that one-year cliff, the remaining equity grant typically vests on a monthly basis. Altogether, this means that for a standard four-year equity package, your first 12 months’ equity vests at the one-year mark, then 1/36th of your remaining equity vests each month after that.

Q: Can employees buy more equity?

Often, employees are given what is known as an option to buy more equity in the company. An option may have an expiration date.

ZH: An option is basically a right for you to buy stock at a fixed price, even if the value of that underlying stock increases in the future. Let’s say you are issued 1,000 incentive stock options (ISOs) and the strike price (which is the fair market value at the time those ISOs are granted) is 10 cents. Really reasonable. The strike price may be extremely low in a very early startup.

Let’s say three years down the road, you are ready to actually exercise your stock options and buy the underlying stock. Maybe the price of the stock has gone up to $10. The cool thing about the stock option is that you get to buy those shares at the 10-cents-per-share strike price and sell them at $10 per share, netting the difference as profit (less taxes, of course).

Q: Are there tax consequences tied to employee equity?

Michael Mizrahi: There are a few different points at which you pay taxes, depending on what kind of equity you receive — options or shares — and how you receive it. Typically no taxes are owed at the time of grant — but depending on what form of equity you hold, there may be taxes at vesting, at exercise, and at sale. Some forms of equity have special tax benefits. For example, holders of incentive stock options don’t owe ordinary income tax when they exercise. But just like with physical items, you would owe taxes when you sell the shares if you make money doing so. This is capital gains tax, a form of income tax.

Q: Are there ways to minimize the tax consequences?

There are several avenues for reducing tax consequences surrounding employee equity. Here we discuss early exercise and 83(b) election. Incentive stock options, defined in the glossary, are another common route.

MM: A company may allow an employee to early exercise their options, generally around the six-month mark. It depends on the company specifics.

Early exercise is the process of exercising one’s options even though the equity has not yet vested. This process can have several benefits for an employee, including starting their capital gains clock — a holding period before an employee would be eligible for favorable long-term capital gains treatment at sale. It can also enable the employee to file an 83(b) election with the IRS.

ZH: An 83(b) election is a kind of deal the IRS makes with people who own unvested shares. The idea is that once you’ve early-exercised your option, now you own some unvested shares, and you will owe taxes on those shares the moment they vest. An 83(b) election gives the equity holder the right to elect to pay taxes today, on their current value — instead of when the shares vest at whatever value the shares have on that date. This is a bit of a gamble, but usually a good idea. If the value of the shares has increased at the time of vesting, then your 83(b) election saved you money. On the other hand, if the value of the shares has gone down at the time of vesting, then you paid more taxes than you would have had to — but the IRS won’t give it back. That’s what you agree to when you file an 83(b).

[Editor’s note: If you take an 83(b) election, you will still have to pay taxes when you sell the stock. You are allowed to prepay ordinary income tax on the lower cost of the stock, $10/share. If you make $100 per share when you sell the stock, you will be allowed to pay capital gains tax on the amount you made per share over $10. Capital gains tax can be significantly lower than ordinary income tax, so paying capital gains tax instead on your $90 profit per share is advantageous.]

Q: How can employees sell equity?

Employees who hold equity in a private company, which most startups are, usually have limits on their ability to sell stock and reach liquidity.

The main routes for employees to do so are tender offers, buybacks, and secondary sales (see definitions in the glossary). Traditionally, private companies have provided these opportunities infrequently.

If a private company goes public, employees can freely sell their shares to anyone who wants to buy, after a set waiting period.

Sam Corcos: For most early-stage employees, it’s common for an employee to end up having no liquidity for upwards of five to ten years.

Q (SC): Why aren’t secondary sales more common?

Henry Ward: There’s a bit of a legal challenge. In the public world, because all these stocks and securities are publicly registered, the government basically said that anybody can buy and sell these things and the company can’t put restrictions on that. In the private world, because they’re unregistered, not just anybody can buy and sell these things. The company can put in restrictions preventing the stock from trading. [Editor’s note: These can be done through restricted stock awards.]

Also, if you talk to a venture investor who’s over 35 or 40, they will tell you nobody gets liquidity until the investors get liquidity. It’s just a mindset that the old generation has. Those under 40 are much more progressive thinking, but there’s a little bit of the cultural mindset to get over.

Another factor is that venture-backed companies rely on capital markets. We rely on investors. I don’t want to have to compete with my own employees or my shareholders for access to capital. So that’s why the company always gets the money first [by working with the investors and sometimes not holding secondary sales]. Then if there’s excess demand, it leads into the secondary market.

Q: What are some of the other differences between public and private companies?

ZH: The Securities & Exchange Commission expects big public companies to be very public about their financial situation because investment is open to basically everyone. So, there are rules forcing a lot of disclosure. While important, this disclosure process is both expensive and time-consuming.

One reason that public companies are permitted by the SEC to put their shares out on the public market is that the SEC feels comfortable that there are enough consumer protections in place — through strict transparency and financial requirements — to ensure that even non-sophisticated investors have enough information to invest. But the SEC doesn’t force private companies to make all these filings and disclosures. And this makes sense: most small companies simply don’t have the resources and employee power to publish quarterly or more frequent reports detailing their internal financials.

Q: Are there opportunities for the general public to buy into a private company?

ZH: The SEC tries to limit how much everyday people can invest in private companies that, after all, are not disclosing all of their financial details.

Pretty recently, the SEC has allowed something called regulation crowdfunding — which has been around for a while — to expand.

Ben Grynol: This is when you offer people in the general public the opportunity to invest in a company at an early stage.

ZH: Now private companies can raise up to $5 million from everyday people, so long as there are income tiers in place. So depending on your income, you can invest up to a certain amount of money.

Levels recently worked with a company called Wefunder, and we raised $5 million from our members in something like five-and-a-half hours.

MM: The Wefunder activity was definitely interesting to watch and really encouraging. Worth noting: The average check size there was relatively small. We’re talking a few hundred dollars, not massive investments.

Q: How else might Levels differentiate itself from some of the companies with traditional equity strategies?

SC: I have found, talking to a lot of people about how they understand the value of startup equity, they often think of it as a lottery ticket. It really doesn’t mean anything to them until, at some random point in the future, it can be worth a lot of money. A lot of companies I’ve talked to also use the lack of liquidity as a retention mechanism, which I think is kind of gross. That I want to make sure we avoid.

We’re thinking about doing regular secondary sales, maybe twice a year.

HW: I think what’s starting to happen is the best companies are doing this and employees are noticing and migrating to companies that offer liquidity. I think you’re going to start to see that the best companies are starting to do it. It’ll attract the best talent because now the offer is cash, stock options, and liquidity. That’s more attractive than just cash and stock options. They’ll start winning the talent wars, and everybody else will have to follow suit.

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