Startup Equity For Employees

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The re-heating of the venture funded tech market has pushed a heat up of the hiring market, and I'm getting more calls from friends asking for help understanding startup stock (equity) offers. More than one friend has suggested writing the advice down, so here it is.

If you're a founder or near-founder, your equity terms are likely defined by the funding terms negotiated with the investors. For a very good summary of investor terms, see Brad Feld's writeups on term sheet terms and Brad's book "Venture Deals" (2nd edition, Dec 2012). I've read many books on startup funding, and "Venture Deals" is a must-read. Even if you're not the one raising money, it gives a great backdrop on what's going on.

Important disclaimer: I've got experience negotiating stock compensation packages from both sides of the table. However, I'm not a tax accountant or attorney; my notes here should not be a substitute for real tax or legal advice.

Stock

Let's start with the basics: a share of stock represents fractional ownership in a company. To know what the fraction is, you need to know the total shares outstanding (i.e. total number of shares issued). For example, if you have 100,000 shares of stock in a company with 10 million shares outstanding, then you own 1% of the company.

Here's the point: a share number is meaningless without knowing the total number of shares outstanding. Owning 1 share of a company with 10 shares outstanding is a much better percentage than owning 100,000 shares in a company with 10 million outstanding. If you've been presented a offer in terms of a number of shares, you need to ask about the number of shares outstanding. Unfortunately, some startups are hesitant to give that information, because it can give insight into confidential terms on how the company has been funded.

My advice: politely ask for the shares outstanding, or for what percentage your share offer represents (then confirm the approximate shares outstanding). If the company won't provide you with this necessary information, it's unlikely they're going to be straight with you on other issues; go work somewhere else.

Stock Classes: Common and Preferred

Most venture-funded startups have different classes of stock: common and various flavors of preferred. Your offer will almost surely be for common stock. Preferred stock classes typically go to investors, and in some cases founders (usually where the founders have already invested some of their own money to build the company). By convention, preferred stock classes are lettered, increasing for each round of funding: Series A, Series B, etc.

The preferred stock held by investors has (as the name implies) more rights and privileges than the common stock issued to employees. The most important right is the right to get paid before the common stock holders, a right commonly referred to as "the preference". If the company is acquired or liquidated, the preferred stock holders will get paid first. Then, if any money is left over, the common stock stockholders will get paid.

The preference amount is usually (but not always) the amount invested. For example, if Series A stock is sold to first-round investors for $1/share, the preference amount for that stock is usually $1. (In some cases, usually when the company is in a weak position to raise money, there may be "preference multiple" where the preference is larger than the share purchase price).

Common stockholders should care about the preference, because that preference is "ahead" of the commons in any acquisition outcome. For example, let's assume that the company raises $5m dollars by selling 5,000,000 shares of Series A stock for $1/share. That means that there's a total of $5m of Series A preference in the company. If the company is acquired for $5m (or less), the preferred stock holders get all of the proceeds and the common stock holders get nothing.

The total preference is less of an issue in early stage companies (e.g. Series A), because it's relatively small. However, it can be a significant issue in later stage companies that have raised a lot of money. I've seen companies with $75m of preference, and very frustrated common stockholders that realize the company needs to get acquired for $100m or more for them to start making any money.

(To keep things simple, I've omitted many details for preferred stock, such as "participating preferred" mechanisms. Common stock holders can use the "total preference" to estimate their returns. In addition, IPOs are a special scenario, where the preference usually goes away and all stock classes are in equal footing).

My advice: get the "total preference" number from the company, especially for companies that have raised a lot of money. If the company is reluctant, point out that you need this information to accurately value your common stock. If they won't tell you, go work somewhere else.

Additional advice: Also, don't ask for any preferred stock unless you really know exactly what you're doing and are prepared to write a check. Asking for preferred stock will usually peg you as a total novice.

Dilution

Companies raise money by selling new stock after the board of directors authorizes the sale to investors. Those new shares are created out of thin air by the company, and will dilute all of the current stockholders.

Let's say you have 100,000 shares of a company with 10m shares outstanding (e.g. 1% ownership). The company raises $6m by selling 2,000,000 Series B shares for $3/share, resulting in 12,000,000 total shares outstanding. Since you still have 100,000 shares, your ownership percentage is now dropped to 0.8333% -- you just got diluted.

In a startup, dilution happens, and you just need to factor it in. If you're considering a early stage offer (Series A), your percentage ownership will likely start out as high as it's ever going to be, then go down with each round (Series B, Series C, etc.) In some cases, the company may "re-up" you by granting some more stock. But this usually happens NOT to compensate for dilution, but to recognize a bigger contribution to the company than what you were originally hired for.

Unfortunately, some companies play games with offers timed around funding rounds. Make sure you understand your offer in post-funding (e.g. diluted) terms. I've seen cases where a 1% offer was really "pre-Series-A" and quickly became a 0.6% ownership after Series A was done.

My advice: negotiate for the largest equity portion you can, because that initial grant is going to be the bulk of your ownership and will get diluted down from there. If there is a round of funding, make sure you understand your post-funding (post dilution) ownership.

Vesting

You usually don't get all of your stock up front; it vests over a period of time, starting from your first day at work. Vesting parameters vary widely, but a classic model is 4 year vesting, a 1 year "cliff", and then monthly or quarterly vesting after that.

Four years means that you will have 100% of your stock after 4 years. Vesting is usually linear: 25% vested after 1 year, 50% after two, 75% after three, etc.

A "1 year cliff" means that you don't vest anything the first year, but you get 25% on your one-year anniversary. The idea behind this is preventing a "hit and run"; the employee who's there for 3 months, doesn't work out at all, and then leaves. If you're still there after one year, it's pretty safe to assume you're contributing and should get your stock.

Monthly or quarterly means that you start vesting at that interval until you are 100% vested. Personally, I prefer the shortest vesting interval possible; long intervals (e.g. one year) can cause employees to do unnatural career acts to make it to the next big vesting event. The last thing a company needs is someone hanging around who doesn't really want to be there, just because they have a big vesting event coming up.

The vesting terms are usually set by an "Incentive Stock Option (ISO) plan" approved by the company's Board of Directors, and are used for all employees. Unless you are considering an executive or other senior position, it may be difficult to negotiate changes to vesting terms; deviations from the standard plan require board approval. Also, most companies try to keep all employees on the same terms, and there are good management reasons to do that.

Some vesting plans may accelerate vesting for certain events, such as an acquisition. For example, the company may vest 50% of your unvested stock if the company is acquired, or may accelerate an additional year. The vesting may also by conditioned by a so-called "double trigger": you may only vest if you are acquired AND you lose your job. The idea here is that the company is partially compensating you for the stock you could have earned by staying for your full vesting period. These terms are frequently given to executives, especially ones who stand a good chance of losing their jobs in an acquisition.

My advice: make sure you clearly understand the vesting terms. If you are considering an executive position, make sure you understand the acceleration terms and consider negotiating something more favorable if your position is at risk of not surviving an acquisition.

Stock vs Options

So far, we've talked about the stock as "stock", but in most cases the company is not going to give you actual stock, but will grant you an option to purchase stock for some fixed price (the "strike price"). To actually own the stock, you have to exercise your option (as you vest), and write a check to the company for the total strike price.

For example, your 100,000 shares may be in the form of an option, with a $0.10/share strike price and a 4 year vest. At one year, you could write a check for $2,500 to purchase your vested 25,000 shares. At that point, you would be an official stock holder with 25,000 shares and 75,000 unvested options.

Owning the stock has a potentially significant tax advantage: it starts the timer for long-term capital gains. Any capital asset held for more than a year is taxed a low, long-term capital gains rate (currently 15% percent, maximum). Continuing the above example, let's say your company is acquired after another year for $10/share. Your 25,000 shares are now worth $250,000 and you only have to pay long-term capital gains tax when you sell. To liquidate your remaining vested options (e.g. exercise and sell) will likely incur steep regular income or short-term cap gain tax rates.

(My general advice to common option holders is to exercise as soon as you vest to get the long-term timer going, AS LONG AS you are (a) bullish on the company and (b) have the money. However, doing this has it's own tax issues (AMT); consult a tax professional for real advice).

Where does the strike price come from? It's driven by the Fair Market Value (FMV) of the common stock, set by the Board of Directors, usually based on an external "409A" evaluation of the company. The common stock price is usually a fraction of the preferred price, at least in the early stages.

The strike price typically goes up as the company raises additional funding (at higher valuations). If you are joining a later-stage startup, the strike price could be quite significant, requiring you to write large checks to exercise.

My advice: understand the terms of your option grant, especially the strike price.

Founder's / Restricted Stock

If you are joining the company early enough (typically before or during Series A funding), you may be able to get so-called "founder's stock" or "restricted stock". This stock is just common stock, but you purchase it all up front instead of getting an option. The company implements vesting with a buy-back agreement; if you leave before you are fully vested, the company can buy back the unvested portion at the price you paid (i.e. unappreciated). For example, if you left after 2 years on a 4-year vest, the company would buy back 50% of your stock.

As described previously, holding stock has a HUGE long-term gains tax advantage over having an option. Companies can usually only do founder's stock at the early stage because a fair market value is established after the company is funded, and that amount can be significant. Let's say you're being offered 2% of a company with a valuation of $10m after funding. Buying your stock would cost $200,000!

Why can't the company just grant you the stock? The company can, but it creates a tax problem. If the company is funded, then the stock has value, and the grant of anything valuable is taxable income. In the above 2% case, the IRS would be looking for taxes on $200,000 worth of "income".

In the old days, companies would sometimes set up a loan to the employee to cover the amount of the stock they were purchasing. That loan could be repaid later (when the company was successful) or forgiven by the company. Those structures are rare today; even though they can be perfectly legal, they attract the attention of regulators and auditors.

In recent years, companies may provide an early exercise clause to provide option recipients some tax advantages. This clause allows you to exercise all of your stock (unvested) up front, as long as you agree to let the company buy back the unvested portion if you should leave. Assuming you can afford the exercise price, the net effect is nearly identical to founder's stock.

My advice: if you are joining before or shortly after Series A funding, you should ask for a founder's stock agreement. Some companies will push back, arguing it is "special", but it's not really; it's just more paperwork. The tax advantages can be huge.

If you can't get founder's stock, ask for an early exercise clause. See this sample agreement: [1]

Tax Advice: You probably should make a Section 83b Election if you are getting restricted stock. The IRS lets you choose: pay tax on the stock up front, or pay taxes as you vest (and the stock value appreciates). The former option is almost always the best in a startup scenario. However, the IRS requires you make that choice formally (i.e. declare it to the IRS in writing) and you have to do it in 30 days. Consult a tax attorney for details. Also see: [2]

Salary vs Equity

Most startups look at your compensation as a total package: stock plus salary. Since cash is precious at most startups, many will try to negotiate your salary down, arguing that equity is making up for any salary hit you might be taking.

It's hard to give general advice here, because the situation is totally dependent on the company and your personal circumstances. If your current salary is low relative to the market, you may be able to match or even increase your salary. If you are working at a large company paying above market salaries without equity compensation, you may take a salary hit. If you're coming from another startup, you may be able to argue a salary match because your existing salary already reflects an equity compensation component.

At a minimum, do your own personal finance homework so you know how much salary you need to live and not spend your savings.

My advice: share your current salary, but avoid telling the company "what you really need to pay the mortgage". Let the company make you an offer first, then negotiate from there. Make sure you get the full offer (salary + stock + terms) before you begin negotiating.

Negotiating a Fair Deal

I get asked all the time: how much equity should I expect? Unfortunately, there's no good answer. It's totally dependent on you, your circumstances, the company, the company's development stage, and how badly they want you (or not).

Keep in mind: when a company is figuring out how much stock to offer you, they're usually doing it relative to ownership for other employees, and they're doing it within some budget (the cap table).

For example, if you're the 5th engineer hired after the company has been around for 6 months, the company will compare your offer to other engineers. You'll probably get a little bit less than similarly skilled engineer #2, because you're coming into the company later. As the company progresses, expect stock offers be lower; late joiners are coming on board after more of the risk has been worked out.

The other factor is the "cap table" (capitalization table, or summary of who owns what stock). Companies allocate a pool of stock (usually called the Incentive Stock Option pool, or ISO pool) to grant to employees. The pool size is set during the funding negotiations with the founders and investors, and is typically sized to cover the first batch of hires up to the next round of funding. What's really going on when a company is figuring out your stock offer is not so much figuring out a percentage of the company, but a percentage of the ISO pool. The company not only has to balance your ownership with other employees, but it needs to budget enough stock in the pool for additional hires.

Depending on the company circumstances, the ISO pool may be large or small. For example, if the investors own a large portion (>50%) and the founders have large shares, then the pool may be very small. In other cases, if the company was highly valued at the funding rounds, the investor ownership may be relatively small (<25%) with a large ISO pool. Also, if there are a large number of "founders" the pool may be small.

You should care about the size of the ISO pool (in addition to your grant), because the size of that pool represents the ability of the company to attract top talent with competitive offers. Investors and founders that leave small ISO pools are usually being penny-wise and pound-foolish.

My advice: gently inquire about the size of the ISO pool and other ownership blocks. The company many not tell you, but if done correctly it doesn't hurt to ask.

My final negotiating advice: do your best at lining up multiple options (e.g. competing offers). That will give you the quickest and best sense of your market value, and the relative value of each of your offers.

References

Additional resources:

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