What Equity Compensation Means for Startup Employees

Shareholders Education

You’ve received an offer to work at a startup -- congratulations! Now, how do you go about evaluating your equity compensation package? Here we’ll break down the basics of incentive compensation at startups and identify key considerations to keep in mind during compensation negotiations.

Startups rely heavily on equity compensation for their employees for two reasons: (1) startups typically are not cash rich, and (2) incentive alignment: equity compensation ties the fortunes of the employee to the fortunes of the company, aligning interests towards company success.

The breakdown of compensation between salary and equity depends less on the role (e.g., sales, engineer) and more on a given company’s maturity. A seed-stage company employee will likely have a greater proportion of their compensation in equity than an employee who works at a company that has completed its Series C financing. 

Equity compensation, no matter the form, is typically subject to restrictions. Most importantly, equity compensation is usually subject to vesting, which means that an employee must hit certain performance or time-based (more common) milestones in order for all of the stock to truly become theirs. The market standard for an employee vesting schedule is a four year vesting period with a one year "cliff."  That is, 25% of an employee's total equity compensation will vest after one year, with the balance vesting monthly over the following 36 months. If the employee were to leave or be terminated prior to completing one year at the company, they would walk away with no equity. Furthermore, even once stock vests it is often subject to restrictions on transfer, resale, and pledging. 

Types of Incentive Compensation

There are three basic flavors of incentive compensation at startups: restricted stock, incentive stock options ("ISOs"), and non-statutory or non-qualified stock options ("NSOs").

Stock Options
Stock options are the most common form of equity-based compensation at startups.  A stock option gives the employee the right to purchase company stock during a specified period of time for a predetermined price (referred to as the “strike price” or “exercise price,” which is usually the fair market value of the stock on the date the option is granted). The value proposition for employees is that the employee can exercise the option at the strike price at a time when the stock may be worth more than the strike price. Stock options are also typically subject to vesting.

Let's use an example to highlight how options work.  Startup Inc. grants its employee, Emma, an option to purchase 400 shares of company stock, subject to a four year vesting schedule with a one year cliff. The strike price on the option is $1 per share. The option remains open for 5 years. One year following the grant of the option, 25% of Emma's grant has vested – she can exercise her option to purchase 100 shares at $1 per share. Let's say that Emma believes in Startup Inc.'s upward trajectory and has decided to wait to exercise her option. After four years, her option has fully vested and she can purchase 400 shares at $1 per share. The company assesses a fair value of $10 per share. If Emma were to 
exercise her options in full, she would have "paper" gains of $3600 (the $10 each share is worth minus the $1 she must pay to exercise her option, multiplied by 400 shares).

The key difference between ISOs and NSOs is that ISOs offer favorable tax treatment.  ISOs are granted to employees of the company.  NSOs are typically granted to non-employees, such as consultants, who are not eligible to receive ISOs and to certain employees to whom the company wishes to confer benefits not permitted under the relevant tax code provisions.

Restricted Stock
Restricted stock plans provide for the grant or sale of company stock to employees.  Grants (unlike purchase plans and options plans) are nice because the employee does not pay anything for the stock, however these plans are less common amongst private companies.

Key Questions When Negotiating Your Compensation

What percentage of the company's equity do the options represent?
While being offered 50,000 options may sound enticing, it doesn't mean much without knowing how much of the company those options represent. Denominator matters - 50,000 options out of 50,000,000 shares outstanding is not as attractive an offer as 5,000 options out of 500,000 shares outstanding.

What was the most recent valuation of the company?
This will also help determine the value of your compensation, but not all companies will be willing to share this information with a prospective hire. Look for information about the company’s most recent funding round and the valuation tied to that funding round, if publicly available.

What was the most recent "409A" valuation and when was that valuation done?
The "409A" valuation is a third-party appraisal done for tax purposes, typically every 6 months. The exercise price of options is often set by reference to the 409A valuation. If the company won't disclose what this valuation is, you should nonetheless ask when the last 409A valuation was done. If it's been a while, the company may have to do another 409A valuation, which means your exercise price may go up.

Does the company expect to issue stock or fundraise in the foreseeable future?
This will give you some insight into whether there are any dilutive events on the horizon. A less direct way to back into this information is to ask "how long do you expect your current funding to last?" Fundraising typically has a dilutive effect on your equity holdings. 

Does my vesting accelerate if the company is acquired?
It is not uncommon for companies to offer accelerated vesting upon the company's acquisition. Layoffs are unfortunately not unheard of after a startup is acquired and the acquiring company might not be the right fit for you. Accelerated vesting could be a benefit in these situations.

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