How to understand equity as an employee of a startup

If you’re thinking of accepting a job with a startup, you will likely be offered equity in addition to your salary and benefits. Because cash is usually tight at a startup, founders use equity to help offset below-market salaries.

Having equity means you own a portion of the business you’re helping to build. It is basically deferred compensation based on the hope that you will someday own a piece of a valuable startup. But equity packages vary tremendously. You need to know what you’re getting before you take equity as part of your compensation.

Before you consider an equity offer, be familiar with these 11 terms

1. Four-year monthly vest
You’ll receive a fraction of your equity every month, but you need to remain with the company for four years before you receive the full amount.

2. One-year cliff
You need to stay with the company for at least one year to receive any equity benefit.

3. Options
This is the option to buy shares of equity at a later date at a set price.

4. Strike price
This is the price you agree to pay for your options — the lower the better. If the strike price is higher than the value at liquidation time, the options are said to be “underwater.”

5. Nonqualified stock options
When you exercise your Nonqualified Stock Options (NSO), the difference between your strike price and the current market value will be taxed as ordinary income.

6. Incentive stock options
When you exercise your Incentive Stock Option (ISO), you don’t pay income tax. Instead, you pay capital gains tax when you sell shares. However, you may encounter an alternative minimum tax, so it’s best to consult with your tax advisor to understand your liability.

7. Liquidity event
This is when your company is acquired or goes through an Initial Public Offering (IPO). It is the moment when your company converts shares of ownership into cash and your equity has value.

8. Accelerated vesting
If your company is acquired before you finish your four-year vesting period, the rest of your equity is allowed to vest in the shorter time period.

9. 83b election
You can choose to pay taxes on the total fair market value of restricted stock when it’s granted instead of waiting until the stock is vested. Consult your tax advisor to see if this is a good option in your situation.

10. Preferred stock
This is the amount of money guaranteed to investors and preferred shareholders — you, as an equity holder without preferred shares, will only receive a percentage of what is left.

11. Founder preferred stock
This class of stock is becoming more popular, and it enables founders to convert into any series of preferred stock sold by the company to VCs in a future round of financing. You would only choose to do this if you intend to sell those shares to investors.

How to evaluate your equity offer

Your equity is a nice-to-have, but it’s not something you can rely on like salary. It’s possible that you are joining a company that will have a sizeable exit, and you’ll realize a significant bonus in years to come. But that may not happen. First, it’s important you have a livable salary. Second, you need a complete understanding of your equity offer.

To assess the potential value of your equity offer, you’ll need from your prospective employer:

• Last preferred price
• Post-money valuation
• Hypothetical exit value
• Number of options in your grant
• Strike price

All this information should be in your offer letter. However, if anything is missing, be certain to ask. You can then use an equity calculator to help you understand the potential value of your offer.

How taxes are affected by equity offers

Nonqualified Stock Options (NSO) and Incentive Stock Options (ISO) are taxed differently, and the difference could have serious tax implications. When you exercise NSOs, the spread between the strike price and your shares’ current market value is treated as ordinary income and you pay income tax. In other words, you’re paying taxes on money that you may only have theoretically.

Whereas with ISOs, they’re taxed at the typically lower capital gains tax rate, and only when you sell the shares. In this case, you’re paying taxes on money you actually have.

How vesting works

Your equity grant will usually be paid out according to a four-year vesting schedule. You’ll receive a fraction of your equity package each month, and four years later you’ll have your entire package.

Your vesting schedule typically comes with a one-year cliff. This means if you leave the company for any reason within the first year — even if you’re terminated — you’re not entitled to any equity benefits.

How a liquidity event impacts your startup equity offer

If your company is acquired or goes public before your vesting period is complete, one of three things can happen:

1. You immediately receive the remainder of your startup equity grant — this is called accelerated vesting.
2. You work for the purchaser or new public company and continue your vesting schedule.
3. You lose your equity startup grant and receive nothing.

Your employment contract should detail what happens after a liquidity event but accelerated vesting is clearly the best for turning your options into money.

How to evaluate your company’s exit strategy

It is important to understand your prospective employer’s plans — and timetable — before you accept your position. Whether the founders keep the company private, choose to be acquired or go public through an IPO, it may impact your future with the company and the value of your equity options.

At a liquidity event — or exit — investors and other preferred stockholders are the first to be paid. This is called the “preference stock” and it can impact employees’ startup equity grants. To understand the impact the preference stock may have on your offer, there are three questions to ask:

• What is company’s most recent valuation?
• What is the rate of annual growth?
• How much will the company need to sell for before my equity has value?

If the most recent valuation is close to or exceeds the needed sale price, your equity offer has value. However, if the needed sale price is much higher than the company’s most recent valuation, you need to make a decision. Based on its current growth rate, how many years will it take for the company to reach the needed sale price? Are you comfortable investing that much time — or are you okay having equity options with little or no value?

The job may be a good opportunity for other reasons, but a clear understanding of your equity opportunity can help you make a more informed decision. To help evaluate the value of your offer, use this calculator.

When to sell your equity

If you’ve enjoyed a great experience and you now own equity that has significant value, when to sell is a personal decision. First, talk with your tax advisor to determine your tax liability, then assess your personal situation. If you don’t have any immediate need for the money and you’re confident that your equity will continue to grow, there’s no reason to sell. However, it may be wise to speak with a financial advisor to see if diversification is appropriate.

On the other hand, you’ve worked hard to make your company a success. Perhaps it’s time to use some of the money to treat yourself and your family.

Equity can be a terrific employee benefit, but:

• Do your research
• Ask the questions
• Project the value to create a complete picture of your offer
• Enjoy your new job knowing you have a fair deal