If you’re new to the tech industry or, like me, not the kind of person who is generally attuned to the intricacies of personal finance, you may not have a great idea of how equity compensation works beyond “ooh equity, that sounds fancy.”
Other parts of your compensation are fairly straightforward: salary (how much is in your paycheck), benefits (e.g. health insurance, retirement account), and bonus (big check once a year). Equity compensation is a different beast altogether.
Equity compensation means that in addition to other things, the company is offering you some kind of stake in the company, usually in the form of shares of stock. However, all equity compensation is not created equal. Various aspects can drastically change how you should think about equity compensation.
Why should you care? Because equity scales faster and further than salary and bonus! For senior-level employees at large tech companies, equity compensation ends up eventually exceeding salary and bonus. This goes all the way to the top — a CEO might earn 5x the salary of a senior employee, but earn 100x or more in equity compensation.
Note: I am not a financial expert, quite the opposite! However, I have gradually become familiar with lots of things related to equity compensation from being in tech for a long time. This post tries to summarize everything I wish I’d known about equity compensation but didn’t.
Options v. Grants
Stock options are what you find most often in startups, and essentially offer you the ability to buy shares (called “exercising” your options) in the company at a certain price (called the “strike price”) at some time in the future.
Example: Ada has stock options for 10,000 shares with a strike price of $1.00 per share. Later, the company’s stock has risen 10x to be worth $10.00 per share. Alice exercises her 10,000 options by paying $10,000 to purchase them at the strike price. She is now holding stock worth $100,000 at current value (a $90,000 profit).
Stock grants are generally more straightforward — the company is paying you shares of stock as part of your compensation. These are typically structured as Restricted Stock Units (RSUs) and, often on a periodic basis, you will simply receive shares in the company as part of your income. Grants are much more common in larger, later-stage companies and are most common (but not exclusively) found in public companies.
Liquidity refers to how easily a given asset can be converted to cash, and is extremely important when it comes to evaluating equity compensation.
Publicly traded companies have liquid equity: at any point in time (barring time-based restrictions around insider trading) you can sell shares you hold for cash money. When evaluating an offer from a publicly-traded company, you can consider equity compensation to be nearly (but not quite) equivalent to cash compensation.
Private companies (startups et al) have illiquid equity: you own shares but there is no easy way to simply sell them for cash. You may not be able to sell any of your shares until there is a liquidity event (the company goes public or is bought by another company). This means you need to think about equity differently. It’s not nearly equivalent to cash, and depending on the stage of the company it’s very very very not equivalent to cash. You should discount the value of equity substantially in private companies, and drastically more so in early-stage companies.
For very early stage companies the share price and number of shares are fairly meaningless — instead, find out the total share of the company you are being offered. Remember also that this share will likely decrease over time due to dilution from new investment (where new shares are added to the total, thus reducing all existing shares total ownership percent). Unless you’re a founder or a key employee being offered, say, 2% or greater stake, you can think of this kind of equity as a lottery ticket (fun to have, but assume it will be worth nothing).
Vesting and Cliffs
Regardless of the type of equity compensation (stock/grant), you will likely be subject to a vesting schedule for your stock. This means that you will receive the options / granted stock gradually over time and only while you still work for the company. Equity compensation is generally used as a retention tool — you benefit from staying at the company because you still have equity that’s yet to be paid out to you.
How your stock vests can be very important, especially at large publicly traded companies. There may be a vesting cliff (most commonly one year) where you need to work at a company for a period of time before you receive anything.
Example: Grace receives a sign-on equity grant of 4,800 shares vesting monthly over four years with a one-year cliff. For the first 12 months, she receives nothing. After one year she has reached the vesting cliff and receives 1,200 shares all at once (a full year’s worth). Going forward, she receives 100 shares each month as they vest until the grant runs out after four years.
If you’re well-established and have a significant savings reserve already, vesting details might not be super-important. If you don’t, however, you should educate yourself on exactly when you’ll start receiving equity and when you’ll be able to sell it.
Vesting schedules are one way companies compete in offers — recently some companies have done away with cliffs altogether such that you begin vesting on a monthly basis immediately. At the other extreme, some companies have multi-year cliffs or only vest stock annually.
Thinking Through Job Offers
When I received job offers, salary was the number. I wanted to make sure other stuff was there (e.g. health insurance), but salary was the only thing I was really looking at or trying to negotiate. This is a mistake!
Salary can and should be negotiated, but companies often have fairly tight constraints on salary. At large tech companies, there are salary bands for each level that can’t be circumvented without significant escalation. At small companies that are concerned about burn rate (how fast money goes out of the bank), salary is the hardest thing to compromise on.
Equity is where the company usually has more discretionary wiggle room, and therefore you have more space to negotiate. When making a counter-offer, you can likely get away with a much larger equity increase than salary. This is also only fair to you: equity vests over time and has risk of losing value, so $10k in extra salary is more valuable than $10k in extra equity.
This all plays into counter responses, too. If you’re applying to an early stage startup and ask for a $10k salary bump, they might come back and say “we can only do $5k salary but we’ll also do $5k equity.” Remember our massive discounting! That $5k should probably be $50k+ to offset the relative dollar-to-dollar value and risk associated.
Evaluate offers holistically and try to get a handle on your total annual compensation. Use resources like levels.fyi to get an idea of where your compensation ought to be, and use that as a reference point. Just make sure to consider equity when considering the offer overall!
After you’ve joined a company, you may receive additional stock options/grants over time as part of performance/compensation cycles. These refreshes will usually be smaller than your sign-on offer. It works this way because refreshes stack on top of your still-vesting equity.
Example: Grace received a sign-on equity grant of 4,800 shares vesting over four years and is now one year into her new job. She receives a refresh grant of 960 shares that also vest over four years (but unlike her sign-on grant, there is no one-year cliff). She now vests 120 shares per month. Without additional grants, she will vest at 120 shares per month in years 2, 3, and 4, and then in year 5 she will drop to 20 shares a month.
An important side effect of the stacking of refresh grants is that there can be a significant impact on compensation when the sign-on grant is fully vested. This is often called the four-year cliff (since most equity grants vest over four years). In large tech companies, it’s not unusual for your total compensation to go down after four years even if you’ve been performing well.
Why does this happen? For a few reasons:
- Sign-on grants are usually significantly larger than individual refresh grants to serve as an incentive to join and an incentive to stay for a decent amount of time.
- If your company is doing well, the stock price may be going up significantly. Equity refresh grants are often allocated in dollars as opposed to shares, so it can be possible that the dollar value of a grant is larger but the number of shares is smaller.
- Because reasons? 🤷
Honestly, it’s a bit surprising to me that companies allow four-year cliffs to happen as much as they do. You’d think that retaining seasoned employees would be a top priority, but the system doesn’t seem to be set up to make that happen well. This can be why you’ll often see employee departures either after one year (first cliff) or four years (sign-on grant fully vests).
Companies have all kinds of ways to attract and retain employees: the work, the mission, the team, the free food. Equity compensation is just one piece of that puzzle, but it’s one that will continue to grow in importance throughout your career and may eventually become the single biggest factor in your overall compensation.
No one sat me down and told me any of this. I learned most of it after the fact, sometimes realizing I had been lucky and other times realizing I screwed up (oops! giant tax bill!). My hope is to demystify it all a little bit to put others on a more level playing field that I found myself.
Good luck out there. May your vesting schedule be rapid and your refreshes ever compounding!
Postscript: The following applies to stock grants in publicly-traded companies. If you’re looking at a private company or stock options, parts may not apply and feel free to skip.
To Hold or to Sell?
Once your stock has vested, you need to decide what to do with it — do you hold onto it or sell it? There are some who ascribe to immediately selling equity as it vests, even enrolling in “autosale” programs that will do this automatically. The theory goes that because you have a significant investment in the company already (they pay your salary, you have unvested stock), it is wise to immediately sell to diversify your holdings.
You may also decide not to sell any (if you don’t need the money) and hold it as an investment that will hopefully go up over time. You may also choose to hold some and sell some. Here there isn’t (in my opinion) a single right answer but you should be intentional about whether you’re holding or selling (don’t just ignore the accumulating stock in your account!).
When your stock vests, the company may sell a portion of the vested shares immediately to use for tax withholding. Stock grants count as regular income for tax purposes, so you need to report it just like you do your salary and bonus. This has implications come tax time!
Since your stock compensation is added to your salary and bonus, taken all together you might be in a higher tax bracket than you expect. You should make sure to adjust your voluntary withholding so you don’t end up with a massive surprise bill come tax season (been there, done that!). You may also be able to increase the withholding of the stock vesting.
Another important tax consideration for equity is capital gains tax. This is the tax you pay on the increased value of your stock when you sell it vs. when it vested. This will be either short-term or long-term capital gains tax, depending on whether you’ve held the stock for more than a year before selling it. This means that when you sell shares, the specific shares that you sell matter! An approach to picking shares to sell that I use is:
- Sell any shares that you’ve held for more than a year and will therefore be subject to long-term capital gains tax.
- Sell shares that vested at a higher price than the current stock price, if any (you won’t have to pay any capital gains tax on this).
- Sell either the shares that vested at the highest value or the most recently vested shares, depending somewhat on the specifics.