What Designers Should Know About Startup Equity
Over the years, I’ve been hit up by several product/UX designer friends joining startups with questions about their equity arrangement. Designers are generally not familiar with equity or general business minutiae because it isn’t part of design curriculums. As a result, I feel like designers are often disadvantaged in compensation negotiations and can potentially screw themselves over without fully understanding what all this means.
I want to help demystify the subject to the best of my ability, or at minimum, highlight that this subject can be really complicated and encourage people to do more research. This isn’t intended to be a deep dive but rather an overview of potential “unknown unknowns” that designers may have.
What is equity?
Put simply, equity is an ownership stake in a company — think stocks. In a startup, founders will be issued stock and will own the majority of the company in its early days. Additionally, stock is often awarded to early employees to offset not being able to afford market rate salaries and to incentivize long term commitment.
Preferred vs. Common Stock
There are two main types of stock. Preferred shares are usually reserved for large investors. These shares come with extra rights relating to liquidation preferences, pro rata participation, and other potential provisions that aren’t all that important for this discussion. Common stock is what’s awarded to founders and employees. Common stock does not carry these special rights. Preferred shareholders get paid first when the company sells. Whatever is left then goes to common shareholders.
RSAs vs RSUs vs ISOs
There are several different ways equity may be given, but I’ll discuss the most popular ones below.
Restricted Stock Award (RSA)
RSAs are shares of stock issued to you but they cannot be sold until they vest. It is common to be granted stock with strings attached, such as how long you have to be with the company or achieve a specific milestone to fully earn your stock.
Restricted Stock Units (RSU)
RSUs are a promise to receive shares of stock at a future vesting date. These are often tied to performance goals as well. You’re probably unlikely to encounter RSUs in a startup equity arrangement because it can cause liquidity issues for the startup and an unwelcome tax bill for the employee. These are more common in huge public companies.
Incentive Stock Options (ISO)
The most common method for startups to award equity is through stock options. ISOs are a right to purchase a set amount of company stock at a predetermined price. This price is referred to as the “strike price”. For example, say you’re awarded 100,000 options at a strike price of $0.10 per share. To exercise all your options, you’re going to have to pony up $10k to take possession of that stock. I think this often gets glossed over — especially for many kids right out of college that wouldn’t be able to do that without the ability to call in a favor from parents since banks do not traditionally lend for these kinds of transactions. It’s even more important to understand that many options agreements have expiration dates.
Graduated vs Cliff Vesting
Good equity arrangements have vesting schedules, which ensure that you don’t get all of your options or grants right away and instead they gradually mature. It would be bad for a startup to give an employee a bunch of stock only to have that employee quit the next day and have a significant ownership chunk. With a graduated vesting schedule, an employee will accrue equity incrementally over time. With a cliff, equity can be awarded all at once after a specific date or milestone.
Other Cliffs
It’s common for graduated vesting schedules to include a “cliff” of 1 year baked into the agreement. This means you aren’t entitled to any of your equity until you complete a year of service. Again, these are employed to protect the company from an employee that doesn’t stick around very long.
Valuation
To understand what your stake is worth, it’s critical to know what the company is worth — this is the company’s valuation. If you’ve been granted options, your company likely has done a 409A valuation and will have to divulge that to you if you exercise your options. I don’t think companies are obligated to provide a valuation to you otherwise, but you should push your company to be transparent about it. These valuations are typically conducted yearly or at each significant capital raise.
Dilution
It’s important you understand how dilution affects your stock. At each stage of fundraising, your stock will be diluted — meaning your percentage of the company will decrease. This is generally a good thing provided the valuation of the company increases. For example, let’s say you own 1% of a company valued at $5 million with 10 million shares outstanding. If the company raises a $2 million Series A round and issues another 4 million shares, you now own 0.71% of the company. But because the valuation of the company increased at the fundraising, your stake is actually worth more than before.
Taxes
Taxes aren’t fun, but unfortunately, there are many tax implications that come with company ownership. Get a good tax person so you don’t get big, unexpected tax bills or piss off the IRS.
Contracts
Another topic that’s not fun is legal contracts. Startups are often high stakes endeavors that have the potential to go sideways if you’re not careful. It’s important to get what’s promised to you in writing. Some states honor verbal contracts but you shouldn’t rely on those. Furthermore, employment / equity agreements can be written in esoteric legalese and difficult to understand. With so much on the line, it’s worth it to run your contract by an attorney friend or spend a few hundred bucks on a contract expert to look for red flags before signing.
Liquidity Event
Hopefully your equity will be worth a meaningful chunk of change one day. For that to materialize, your company will need to have an exit, such as being sold or going public (unless you’re able to sell your stake on a secondary market like Sharespost or Forge). Tech companies on average take nearly a decade to achieve this so understand that you’re signing up for a long term commitment.
Game out a few scenarios on how you think the startup might play out and see how you’ll fare. What are similar companies selling for? What percentage will I own fully diluted? What would my stake be worth? What’s the annualized return?
Here are some good calculators to conduct this exercise. Fiddle around with the numbers. Your range of outcomes might surprise you.
triplebyte.com/startup-equity-value-calculator
shan.io/startup-equity-calculator
tldroptions.io
Which leads me to…
Earn vs Learn
Please read this article by well known VC Mark Suster:
bothsidesofthetable.com/is-it-time-for-you-to-earn-or-to-learn
For anyone looking to join a startup, I always recommend it. Mark does a great job of explaining tradeoffs and having realistic expectations about joining a startup. There’s no other environment where you’ll learn as much or as quickly as you will in a startup. I highly recommend you take the leap at some point, but do it knowing what you’re getting into.
Other Resources
Here’s a random smattering of other stuff I think would be helpful.
Venture Deals
This is a really great book for anyone interested in the details of startup funding and will help provide more context to equity arrangements.
amazon.com/Venture-Deals-Smarter-Lawyer-Capitalist
Carta
The Carta blog has many good articles if you want to read more on these topics.
carta.com/blog/category/employee-resource-center
YC Startup Library
This has several good articles in it pertaining to equity to learn more. This particular one provides some insight from the founder’s perspective.
ycombinator.com/library/4S-how-to-offer-stock-equity-to-your-employees
These are some of the unsexy parts of joining a startup especially if you just want to build cool stuff. Even so, it’s important knowledge to have to protect yourself and your financial wellbeing. Hopefully this has been helpful and a good jumping off point for learning more.
