Startup Employee Equity: A Guide to Understanding Stock Options

Author: Partha Chakraborty Published on: November 14, 2023 Published in: Uncategorized

So you’ve just joined a startup and been promised stock options or equity. Congratulations!

Equity is often one of the biggest perks of joining an early-stage company – it allows employees to think and act like owners. But equity can also be complex and confusing.

I’ve been on both sides of the table, as an early startup employee trying to figure out my equity and also as a founder trying to explain equity.

Here’s my beginner’s guide to everything employees need to know about equity, from the basics to advanced tips.

What Are Stock Options?

Equity usually comes in the form of stock options. Stock options give you the right, but not the obligation, to buy shares in the company at a specified price at some point in the future. They are called options because you have the option to exercise them.

For example, if you are granted 10,000 stock options at an exercise price of $1 per share, this gives you the right to buy 10,000 shares at $1 in the future. If the shares are worth $5 when your options vest, you can exercise your options to buy shares at $1 and immediately sell them at $5. You pocket the $4 per share difference.

Equity is often granted with a 4-year vesting schedule. This means you earn 25% of the options (2,500 shares in the example above) after one year, then monthly over the next 36 months. Vesting incentivizes you to stay with the company. If you leave before fully vesting, you only keep the vested portion.

Why Do Startups Offer Equity?

Startups offer equity because they can’t match the salaries at more established companies. Equity allows early employees to share in the growth and success they help create.

The tradeoff is risk vs. reward. Established companies provide smaller rewards but more predictable compensation and career growth. Startups present huge potential rewards through equity, but also huge risks that the options may never be worth anything.

As an early startup employee, you have to decide if the risk-reward tradeoff is right for you at this point in your career. Here are some key factors to consider:

Potential reward: Could the equity be worth a life-changing amount if the company is very successful? Look at market size, business model scalability, and team experience.
Risk tolerance: Are you financially secure enough to take a chance on options that may never pay off? Do you have a safety net from family or savings?
Career growth: Will you get invaluable experience at a rapid growth startup that prepares you for future leadership roles?
Stage of company: Later stage startups are less risky. Have they raised significant funding? Do they have strong traction and metrics?
Personal belief: Do you believe in the company’s mission and want to play an integral role in making it happen? Passion reduces perceived risk.

As you evaluate equity offers, think carefully about whether the risk-reward profile aligns with your personal financial situation, career goals, risk temperament, and beliefs.

Equity Basics: Common Terms and Acronyms

Navigating startup equity can feel like learning a foreign language. Here are some of the most common terms and acronyms you’ll encounter:

Options: An option gives you the right to buy shares at a specified price within a certain period of time. You have to exercise (or use) the options to turn them into shares.
RSUs: Restricted Stock Units are shares of stock that are promised to you but haven’t been issued yet. No need to exercise – RSUs convert to shares automatically.
ISOs vs. NSOs: Incentive Stock Options receive more favorable tax treatment than Non-Qualified Stock Options. But ISOs have lower exercise limits, so you may be granted some of each.
Grant date: The date when stock options or RSUs are officially granted to you in an options agreement. The terms are set at the grant date.
Vesting schedule: The vesting schedule, often 4 years with a 1 year cliff, sets the timeline for earning the right to exercise your options.
Exercise price: The price per share at which you can exercise your options to buy stock. Also called the strike price.
Expiration: The last date when you can exercise your vested options before they expire worthless. Usually around 10 years from grant.
Cap table: A capitalization table that shows the company’s ownership breakdown – who owns what types of stock and equity stakes.

These are some of the most common terms used around equity compensation. We’ll unpack how they fit together in more detail throughout the rest of this guide.

Four Ways to Get Equity in Startups

There are four main avenues for employees to get equity in startups:

1. Stock Options

As we covered, stock options give you the right to buy shares at a set price. Options must be exercised to turn into stock. They are issued with a vesting schedule (often 4 years) to incentivize you to stay with the company long-term.

2. Restricted Stock Units (RSUs)

RSUs represent shares that are promised to you but not issued yet. No need to exercise – RSUs convert to shares automatically once they vest. RSUs are less common for early startup employees.

3. Stock Grants

Direct stock grants are shares issued and owned by you right away. 100% vests on grant. Rare for employees, more typical for founders.

4. Phantom Equity

Some equity alternatives use “phantom” equity that mimics real ownership. No actual shares are awarded. Payouts tied to company valuation or performance.

Stock options are by far the most common way startup employees get equity compensation. Let’s take a closer look at how stock options work.

How Do Stock Options Work? A Simple Guide

Here is a step-by-step overview of how stock options are granted, exercised, and converted into stock you can eventually sell for a profit.

1. Options Are Granted

You are granted an option agreement for a certain number of shares with an exercise price, vesting schedule, and expiration date. Nothing happens yet.

2. Options Vest

Your grant vests according to the vesting schedule as you work for the company. Usually 4 years with a 1 year cliff. Vesting gives you the right to exercise the options.

3. Options Are Exercised

Once vested, you choose whether to exercise your options by paying the exercise price per share to convert the options into owned stock shares.

4. Stock Can Be Sold

Once exercised into stock, you now own shares that can be sold. You can sell anytime, but taxes are usually lower on shares held for 1+ year.

Here are the key takeaways:

Options represent the right but not the obligation to buy shares later.
You must exercise vested options to convert them into stock.
Stock can be sold for profit if share price rises above the exercise price.
A vesting schedule incentivizes you to stay with the company long term.

This demonstrates how stock options reward you for staying with the startup as it grows and increases in value. Now let’s walk through some example scenarios to really cement how options convert into potential wealth.

How Much Are Stock Options Worth? 3 Example Scenarios

Since startup success is unpredictable, it helps to play out different valuation scenarios to understand the range of possible outcomes from your equity. Valuation is the company’s market value or stock share price. Pre-IPO private companies are valued based on periodic 409A valuations.

Here are 3 example valuation scenarios to illustrate how your equity value could play out:

Scenario 1: High Growth

You are granted 10,000 options with an exercise price of $1 per share
Company valuation grows quickly to $5B over 4 years
The stock price is now valued at $50 per share
Your options are worth $500,000 = (Current price – exercise price) * options

Scenario 2: Steady Growth

You are granted 10,000 options at an exercise price of $1
Company valuation grows steadily to $500M over 4 years
Stock price is $5 per share
Your options are worth $40,000 = (Current price – exercise price) * options

Scenario 3: Company Struggles

You are granted 10,000 options at an exercise price of $1
The company struggles to gain traction and is worth just $50M
Stock is valued at 50 cents per share
Your options aren’t worth exercising

As you can see, startup outcomes can vary enormously. Before joining the company, spend time understanding what success could look like in an exceptional case, base case, and worst case. Make sure the potential reward justifies the risk.

Beware the Myth of the Promised Land

Early employees are often sold on the dream: “If we IPO at this valuation, your stock could be worth millions!”

However most startups fail or experience more modest growth. One study showed over 90% of startups fall short of founder projections. Another reported the median successful exit value is just $55M.

Derisking your personal finances is wise:

Always vest into your equity – don’t pre-exercise and pay early taxes on a big portion of unvested shares.
Diversify your portfolio with safer public market investments. Don’t allocate more than 20-30% to any single private company.
Have a safety net in savings accounts. Don’t spend future paper wealth before it materializes.

Founders paint incredible visions of the future. But make sober assessments of risk when managing your finances. Your equity will likely be worth less than the dream – hopefully still life-changing, but plan conservatively.

Equity Ownership Percentage: How Much Equity Should You Get?

Early employees are sometimes disappointed by how little equity their startup options seem to represent. It’s common for first engineers or early leaders to receive ownership stakes of just 0.5% – 2%.

Is that fair? Here are some factors startup founders consider when allocating equity:

Stage of company – Earlier stage startups have to give more equity to attract initial team members. Later stage startups can offer less.
Role and experience – More experienced executives and founders get higher equity stakes. Early individual contributors receive less.
Compensation tradeoffs – Low cash pay means employees need more equity upside. Higher salaries support less equity.
Risk tolerance – Joining an unproven idea warrants more equity vs. joining later with traction.
Market norms – Certain roles have market compensation expectations around equity that founders benchmark against.

While it may seem small, even 0.5% – 1% equity at a successful startup can result in very meaningful wealth creation. Focus less on percentage and more on potential value creation vs. the risks.

How you vest into your equity also matters just as much as the headline percentage. Let’s look at optimal vesting next.

Maximizing the Value of Your Equity with Optimal Vesting

Vesting is the schedule by which you earn rights to your equity compensation over time. The standard schedule is 4 years with a 1 year cliff. This means:

No equity vests in the first 12 months – you face a “cliff”
You vest 25% of your grant at month 12
Then remaining equity vests monthly over next 36 months

This backweights equity – you get most in years 3-4 as the company matures. It incentivizes employees to stay for an extended period.

However, the standard schedule isn’t necessarily optimal for employees. Here are better alternatives to request:

5 year vesting – Extends the runway for you to earn equity. 20% vests each year.

1 year cliff, monthly vesting after – Removes the large 1 year cliff so you vest gradually.

Early exercisable with 83(b) election – Pay low taxes early when the exercise price is lowest. Big tax savings.

Accelerated vesting – Faster vesting if the company is acquired. “Single trigger” is better than “double trigger.”

Extended exercise window – The option to buy shares lasts longer after you leave a company.

Vesting has a big impact on how much you realize from equity. Negotiate terms that help maximize your upside based on your personal risk preferences.

Equity Compensation vs. Salary: Navigating the Tradeoffs

Startups with limited funding often ask employees to trade some salary for more equity. This can be an opportunity if you believe strongly in future upside, but also dangerous if you underestimate the risks. Consider the key tradeoffs:

Less cash compensation

Forces financial hardship if equity doesn’t pan out
Signifies belief in vision to sacrifice near-term cash
Allows a company to extend the runway and hire more people

More equity upside

Allows outsized financial gains if the company succeeds
Aligns incentives between employees and the company
Rewards risks taken early by compensating in future value

How you balance these factors depends on personal circumstances like cost of living, financial security, belief in the company, and career stage.

Some best practices as you evaluate salary vs. equity offers:

Make sure you understand the equity terms and can model out possible scenarios from best to worst case.
Discuss vesting schedule – optimize so more equity vests upfront when risks are higher.
Consider asking for non-standard vesting like 5 year schedule or monthly vesting to derisk.
Benchmark market salary norms – is equity makeup abnormally high for this role?
Get advice from mentors who have navigated startup equity tradeoffs successfully.

With these steps, you can make an informed decision on salary vs. equity that matches your personal financial situation and belief in the company.

Reading and Interpreting Your Stock Options Agreement

Once you’ve verbally negotiated an offer with equity compensation, you’ll receive a stock option agreement formally outlining all the grant terms.

This complex legal document governs your equity relationship with the company. Here are key sections to understand:

Number of shares – How many stock options are you being granted?
Grant/start date – When do these options officially begin vesting?
Exercise price – The set price per share you can buy stock by exercising options.
Expiration date – The last date when your vested options expire if they remain unexercised.
Vesting commencement – When does your vesting schedule start ticking? Often your start date.
Vesting schedule – Outlines how many options vest over what time period. Example: 4 year vesting schedule with a 1 year cliff.
Acceleration provisions – What happens to your unvested equity if the company is acquired or you are terminated? Always negotiate acceleration.
Exercise procedures – How do you actually exercise your vested shares when ready? Are there certain windows?

Equity lawyers have designed these documents to protect the company. But employees need protection too. Don’t hesitate to negotiate more founder-friendly terms for yourself or consult a lawyer.

Understanding your options agreement gives you clarity on the structure of your compensation. Next, let’s talk about stock option taxes.

How Stock Options Are Taxed: The Tax Basics

Exercising options to buy stock and later selling shares for a profit trigger important tax events:

Exercise

When you exercise options, the bargain element is considered taxable compensation income.

If exercise price is $1 and shares are worth $5:
- $4 income per share taxed as W-2 income
- Taxed at ordinary income rates
- Company withholds shares to cover withholding taxes

Sell

When you sell the stock, you pay capital gains taxes on the increase in value since exercise.

If you exercise at $1 and sell at $7:
- $6 capital gain per share
- Taxed at short or long-term capital gains rate
- Pay when you file annual tax return

Planning around taxes is crucial:

Exercise incrementally each year to smooth out tax liability
Hold shares 1+ years before selling to qualify for lower long-term capital gains rates
If granted ISOs, exercise ASAP to benefit from special ISO tax treatment

Work closely with your tax advisor to minimize tax liability when exercising options and selling shares. With the right planning, you can reduce your tax bill significantly.

13 Advanced Tips to Maximize Your Equity Compensation

Here are some more advanced strategies to help you get the most out of your startup equity:

1. Negotiate more equity – Get multiple offers and negotiate firmly but fairly. Know market rates.

2. Request faster vesting – Push for shorter cliffs or monthly vesting to reduce risks from leaving early.

3. Allocate equity across years – Negotiate grants annually so you get upside from growth each year.

4. Seek upside in acquisition – Push for acceleration clauses so all equity vests in a change of control.

5. Diversify holdings – Limit overconcentration in any one private company’s stock.

6. Index some gains early – Exercise and sell small amounts each year to lock in and diversify some gains.

7. 83(b) election to prepay taxes – If granted restricted stock, make 83(b) election within 30 days to maximize tax savings.

8. ISO exercise timing – Carefully manage exercise timing on incentive stock options to maximize tax treatment.

9. Monitor expiration dates – Be aware of expiration deadlines for vested options and exercise in time.

10. Line up buyers for private shares – If the company stays private, find a broker or buyer for your shares like EquityZen.

11. Secondary sales – Take advantage of opportunities to sell private company shares in secondary offerings.

12. Review company docs – Read latest business plans, financials, cap table to evaluate company progress and your potential equity value.

13. Talk to a financial advisor – Get professional advice on exercise strategy, tax optimization, and managing liquidity.

Equity compensation is complicated but can be financially life-changing. Learn these tips and strategies to optimize your equity for maximum impact while managing the risks wisely.

Frequently Asked Questions About Startup Equity

Here are some common questions I hear from startup employees about equity:

How much equity should I get?

There are market norms for equity ranges based on role, stage, and other factors. First engineers at early startups often get around 1% equity. Angels aim for 5-20% for their investment. Execs and founders can receive 10% or more. Focus on potential value creation vs. headline percentage.

When can I sell my shares?

You need to exercise your options to convert them to shares, then hold the stock until the company has an exit via acquisition, IPO, or possible secondary sale. This often takes 5-10+ years. Manage your finances conservatively despite the potential paper wealth.

What happens if I leave the company before vesting?

Your unvested equity is forfeited back to the company. Make sure you fully vest into as much equity as possible before leaving. Negotiate extended exercise periods so you don’t lose vested options on your way out.

How do taxes work on startup equity?

Exercising options triggers ordinary income taxes on the bargain element. Selling shares incurs capital gains taxes on the growth since exercise. Careful tax planning through tools like 83(b) elections and ISOs can save huge amounts.

How can I get liquidity without the company exiting?

Some alternatives like secondary markets, debt facilities, and revenue/profit sharing plans allow employees to access some liquidity before a company has a major exit. Discuss alternatives with the founder if interested.

Does my equity get diluted over time?

Yes, as the company sells more equity to investors and hires more people, your ownership will get diluted over time. Make sure your contributions help the company increase in value faster than your dilution.