If you have wanted to work in a startup before, especially a tech startup, then chances are you have heard of the word equity compensation thrown about. It is the strategy that many businesses use to compensate employees and have them participate in the growth and upside of the business.
If you have been approached by a business that is offering equity compensation as part of their pay, you might be confused about the whole thing. Here is what you need to know about it and whether it will work for you.
In simple terms, equity compensation is when a company offers to compensate you in non-cash form. Most companies offer you a chance to buy shares of their business and the rules for this will vary based on the business you are working for. Many companies used this mode of compensation, but it is commonly used to compensate, retain, and align incentives with employees.
Companies may offer you stock as part of your compensation package. Depending on the type of stock option you receive, there are differences around when or how you have to pay taxes and whether you have to purchase the shares.
A stock option is the right to buy a set number of shares at a fixed price, also known as the strike price. This price is typically the market value of the shares when you receive your option grant and is determined by what is called a 409A valuation. If the value of the shares increase over time you can make money on the difference between your strike price and the eventual sale price. Note that you’re not required to exercise your options, hence the name options.
A company’s board of directors or board committee will typically approve and grant equity to employees subject to the terms and conditions of the company’s stock option agreement or equity incentive plan.
When you are granted equity, you’ll often expect to receive details on:
The most common types of options that are granted to employees are ISOs (Incentive Stock Options) and NSOs (Non Qualified Stock Options).
ISO stands for Incentive Stock Options (ISOs). ISOs give an employee the right to buy company shares with the added allure of a tax break on the profit. The profit on incentive stock options is taxed at the capital gains rate, not the higher rate for ordinary income. Unlike other types of stock options, you usually don’t have to pay taxes when you buy ISOs.
NSO stands for Non Qualified Stock Options (NSOs). NSOs give employees the right, within a designated time frame, to buy a set number of shares of their company’s shares at a preset price. With NSOs, you pay taxes both when you exercise the option (purchase the shares) and sell the shares, and are taxed as ordinary income.
Yes, sometimes companies offer restricted stock (or shares) instead of stock options, often in the form of Restricted Stock Units (RSUs) or Restricted Stock Awards (RSAs).
RSU stands for Restricted Stock Units (RSUs). An RSU is a promise from your employer to give you shares of the company’s stock (or the cash equivalent) on a future date if certain restrictions are met. RSUs have no tangible value until the vesting is complete, and are assigned a fair market value when they vest. Unlike with stock options, with RSUs you don’t have to pay anything to get the stock. Upon vesting, they are considered income, and a portion of the shares are withheld to pay taxes. You then receive the remaining shares and can sell them at your own discretion.
RSU stands for Restricted Stock Units (RSUs). An RSA is a grant that permits you the right to purchase shares at the fair market value, a discount, or at no cost. RSAs are given to the employee on the day they are granted. They do not have to be earned via a vesting schedule like RSUs do. However, they may still have to purchase them, depending on the nature of the offer. RSAs are more common with early employees at a startup before the first round of equity financing.
When you vest, you earn the right to buy your shares over a specified period of time, which is often tied to your continued service at the company. You typically have to reach what is called a cliff date before you can exercise your options, which is typically 1 year from the date the option is granted.
Generally, you can only exercise your vested options. If you leave your company, your unvested options will go back into the company’s option pool. Depending on the term of your company’s option plan, you may have the ability to exercise your options early. Early exercise can have certain tax implications depending on your individual situation. Note that in addition to time based vesting, RSUs may also be subject to additional vesting conditions based on your individual performance, company performance, or a market condition (such as a sale or IPO).
A cliff is the date at which the first portion of your option grant vests. After the cliff, you typically vest the remaining options each month or quarter, though that can vary depending on the company or structure of the option grant or shares.
A vesting schedule shows you when you’ll earn your options or shares. It defines the length of your cliff and how your shares continue to vest once the cliff has been reached. Cliffs are typically 1 year and stock options will typically vest over 4 year periods, often monthly or quarterly.
Note that for RSUs, vesting may be tied to length of service or a milestone that the company must hit. However, you don’t need to purchase the RSUs–you just need to wait for them to vest.
The date your equity is granted by the board, which may be before or after the vesting start date, and is often the same as your start date at a company.
Your vesting start date is the date at which the vesting period begins for an option grant, and is typically the same as the grant date.
The total number of shares that have vested and that can be exercised at a given point in time based on your vesting progress to date.
The total number of shares that remain unvested if you have either not hit your cliff, or that are still vesting subject to your vesting schedule after your cliff date.
A strike price is the price at which you can purchase your shares, and is typically based on the fair market value of the stock at the time of your grant.
A strike price is determined by what is called a 409A valuation, which is an independent appraisal of the fair market value of a company’s stock.
The cost to exercise represents what it would cost you to exercise your option and purchase the shares. It is calculated by taking the number of shares and multiplying that by the strike price that is set for the option grant.
The price per share is what investors paid for one company share during the latest investment round, and is calculated by taking the current estimated valuation and dividing it by the total number of shares outstanding.
The estimated net value of your equity includes your vested and unvested shares, and is based on the net value per share, which is the difference between the estimated price per share and strike price of your options. Note that for RSUs and RSAs, the estimated net value of your equity includes your vested and unvested shares, and is based on the estimated price per share (since RSUs and RSAs do not have a strike price).
Dilution occurs when a company issues new shares that result in a decrease in existing stockholders' ownership percentage of that company, which typically happens when a company raises additional rounds of funding or when stock options are exercised. However, if a company uses the funding for growth, you may have a smaller percentage in a more valuable company resulting in a potential increase in the value of your equity.
This post and information is not to be construed as legal, financial, or tax advice, and is not representative of the specific terms of any offer, employment, compensation, option grant, or any equity incentive plan. This is for informational purposes only and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Welcome or does not assume any liability for reliance on the information provided herein. We strongly encourage you to consult a tax advisor or lawyer before making any employment, equity, or compensation decisions. Nothing herein is intended to create an offer or binding agreement of any nature. Option grants are subject to all required approvals. There is always a possibility that the tax laws affecting equity and stock option tax treatment will change, and the information explained in this guide is subject to change at our discretion.
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