Craig Donofrio — Break It Down
In this new series, we break down the most complicated financial topics we can find in terms anyone can understand.
That salary offer at your new startup might be less impressive than you had hoped for, but they’re throwing in 100,000 shares of their hot new company as part of your compensation. One hundred thousand shares! Dreams of cruises and vacation homes bubble up in your mind for a moment before they pop. What does all this equity mean, anyway, and how much is it worth?
Why are they giving this to me?
Startups don’t have a lot of cash and you’re likely getting hired at a lower salary. To make up for it, they need to sweeten the pot. In this case, it’s a tiny slice of the whole pie. This compensation strategy also carries an additional benefit for the company.
“The theory is, if you’re deeply connected with the company and its ideals, employees have an incentive to keep what they do in the company in line with the company’s best interests,” says Stever Robbins, CEO of Ideas Unleashed who has both founded startups and been an initial team member of 10 startups.
The thinking goes, if the company takes off and you stick with them, you can make decent money with those stocks—and since you’re working there, you’re doubly motivated to make every workday count.
Will I get rich?
Most likely not. How much that equity is worth depends on several different factors. First, the amount of equity offered to you depends entirely on the startup and your contract. But for an idea, check out AngelList’s estimates for startup salaries and equity based on position and location. The majority of startups around the country offer equity of less than 1 percent for most positions. “Remember, there’s only 100 percent to go around, and the entrepreneur is going to want 51 percent, and then the investors [angel investors or venture capitalists, etc] want more,” Robbins explains. “A lot of people think equity will make them rich. That’s happened 10 or 11 times in history,” he says, cautioning that expecting huge successes like Google isn’t realistic.
But not all equity is created equal. If the startup never takes off, that equity might be worth diddly squat. Roughly half of all startups don’t even make it beyond four years (Fun fact—the most cited reason for failure is incompetence).
And in many cases, it’ll take four years for you to officially own all those shares. This leads us to the issue of vesting.
Vesting, or how businesses entice you to stick around
In a nutshell, vesting is the amount of equity available to you depending on certain factors. Let’s say a startup grants you 10,000 stock equity. It would be a dumb move on the employer’s part to give those to you right away—no owner wants an employee who worked for three months to walk away with a slice of the company’s worth.
Instead, think of vesting as a payout schedule, only for stocks. A typical vesting schedule for a stock option plan looks like this: On a four-year vesting plan of 10,000 shares, you get only 25 percent, or 2,500 shares, for each year you stick with the company beginning after the first full year (meaning if you quit before one year, you get nothing). Quit after two years, and you’ll walk away with 5,000 shares. Stay with them for four years, and you’ll get all 10,000.
However, certain factors—namely, the company getting bought out—can mean getting that equity immediately.
What kind of stock do I have?
The startup will probably offer you either an employee stock option plan, restricted stocks units, or even a combination of the two.
With employee stock options (or ESOs), you purchase the shares for how much they were worth when you first signed on. Ideally, they would be dirt cheap compared to what they’re worth after the buyout. So, if the stocks were 10 cents a share when you signed on, that’s the price you get them at, regardless of the current worth. That’s known as the “strike price.” ESOs are available after they are vested.
Another thing to recognize with ESOs is whether they are incentive stock options (ISOs) or non-qualified (NSOs), which have different tax implications. When you exercise your NSO, the difference in value between strike price and exercise price is considered taxable income. As long as they’re exercised in a timely manner, ISOs are not considered taxable income. If you need to get into the weeds on this, consider consulting a certified public accountant.
Restricted stock units (or RSUs) are stocks granted to you—meaning they’re free. Kind of. While you don’t have to buy the stocks yourself, they are treated as taxable income and those taxes will cut into your bottom line. RSUs also won’t become available until they are vested.
In the event a bigger company buys out your start up, accelerated vesting could occur. This means a portion or all of your unvested stocks become immediately exercisable—in other words, you can buy or sell them.
Notice we said accelerated vesting could occur. That’s because accelerated vesting isn’t a guarantee. Robbins says it depends on buyout agreements as well as your initial contract with the startup.
“Never assume they have your best interest at heart about this,” Robbins says. “Explicitly ask what happens if the company is acquired. Do I have the option to stay? Does it vest immediately?” Understand your contract because after a buyout, “If you can’t vest immediately and have no guarantee you’ll stay employed, you’re screwed.”
I quit! (or they expire)
If you have vested stock but you quit the company, you may have to exercise those stocks within a time frame—typically two or three months—or forfeit them. Often this means just buying the stocks outright (or if you think the startup is doomed, forfeiting them).
Even if you love your company and can’t imagine leaving, you need to know the expiration on your options. If that date passes you by and you’ve never exercised your options, you end up with nothing. Ouch.
Comparing the competition
If you compare a startup to another more established business, you’re probably getting more equity but less salary for your position. What about all those other benefits, like healthcare and retirement plans? Unless you have a specific company in mind, it’s like comparing apples to imaginary oranges. Even if the company is huge there’s no guarantee you’ll get solid benefits, as even Fortune 500 companies are shifting more benefit costs onto employees. Make sure you’re armed with accurate information about salaries for your position and geographic location, as well as exactly what benefits you’ll get and when you qualify for them.
If you’re trying to parse offers from two startups, it becomes even more important to (gently) grill your prospective employers about the terms of your equity agreement—a smaller percentage that you understand completely may serve you better in the long term over a larger offer that is confusing or unclear, those details could come back to haunt you one day.
Not always simple
We’re keeping it simple here, but remember when it comes to stock options, contracts, buyouts, and the like, “There are a hundred moving parts,” Robbins says. For example, you might have 1 percent of stock now, but in several years, you could own a smaller percentage if the stock is diluted. Tricky contract language can also end up giving you less than you thought you had.
“It’s very hard to protect yourself,” Robbins says. “If you’re giving up salary to get that stock, think really long and hard about how much that stock is worth and if it’s going to be worth it.”
But you likely already know that startups can be risky, at least you can wear jeans whenever and don’t have to conform to a buttoned-up corporate culture. That flexibility alone could lower your healthcare costs.
Remember: this is just a primer to a subject that can get real complicated, real fast. If the stakes are high, you feel uncomfortable, or don’t understand the agreement’s language (and believe us, we don’t blame you), talk to a tax lawyer. Their advice might be the best investment you can make.