Meditations
EquityZen's Blog On Startups and Their Economics

Understanding Equity Compensation and What it Means for Startup Employees

Shriram Bhashyam | June 27, 2014


In our travels, we've talked with many folks who work at startups and two common threads have emerged:

  1. Startup employees don't have sufficient avenues for liquidity, and 
  2. Startup employees don't have a clear understanding of how they are paid.  

The former is a primary reason why we do what we do and the latter is the topic of this post.  We will break down the basics of incentive compensation at startups, survey tax considerations, and identify key points to raise with employers during compensation negotiations.


Background

Source: The New Yorker

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

How much of one's compensation is in salary and how much is in equity depends less on the role (e.g., business development, engineer) and more on company maturity.  A seed-stage company employee will likely have a greater proportion of her compensation in equity than will an employee who works at a company that has completed its Series C financing. AngelList has a neat tool that allows you to  explore salary and equity compensation; give it a whirl.  Two notes: the source data here is job listings on AngelList (and not compensation at actual jobs), and AngelList skews more towards early stage companies.

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 hers; the other main prong of restriction is that the stock, even upon vesting, is subject to restrictions on transfer, resale, and pledging.  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, she would walk away with no equity.

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").

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.

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.  In the opaque world of startup equity compensation, this sounds clearer in writing than it is in reality, but we're here to help with these issues.  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 key difference between ISOs and NSOs is that ISOs offer favorable tax treatment (discussed below).  ISOs are granted to employees of the company (or its parent or subsidiaries).  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.

Tax Considerations
(EquityZen does not provide individual tax advice.  You should consult your tax advisor for advice specific to your personal taxes and financial situation.)

83(b) Election.
Failing to make a timely "83(b) election" can have significant adverse tax consequences for a startup employee (or founder, for that matter).  If an employee chooses to make an 83(b) election, she would recognize income upon the purchase of the stock (she would otherwise recognize income, if any, until the stock as vested).  This election must be made within 30 days of the employee's purchase of the stock.  While the details of making an 83(b) election are beyond the scope of this post, we would be happy to discuss the mechanics, pluses, and minuses further with anyone who's interested.  Shoot us an email here.

Tax Treatment of Equity Compensation.
The tax treatment to employees varies based on the type of compensation and the stage.  At the time of grant, there is no tax impact, but that is the time when an 83(b) election can be made.  The chart below summarizes the basic tax implications of the most common types of equity compensation.

 

 

 

 

Compensation Type
Tax Impact at Time of Vesting
Tax Impact at Time of Exercise
Tax Impact at Time of Sale
Consequences of Termination
Key Takeaway
ISO
None.
None, unless subject to alternative minimum tax (but 83(b) election may be available).
If sold within 1 year of exercise date or within 2 years of grant date: taxed as ordinary income on the difference of share price on exercise date and the sale date.
 
If sold after 1 year following exercise date and 2 years after grant date: taxed as long term capital gain on the difference of share price on exercise date and the sale date.
For vested options, employee has a window in which to exercise or forfeit.
Favorable tax treatment, but employee does not own stock until she exercises her options.
NSO
None.
Taxed as ordinary income to the extent of any excess of FMV at time of exercise over exercise price.
If sold within 1 year of exercise date or within 2 years of grant date: taxed as ordinary income on the difference of share price on exercise date and the sale date.
 
If sold after 1 year following exercise date and 2 years after grant date: taxed as long term capital gain on the difference of share price on exercise date and the sale date.
For vested options, employee has a window in which to exercise or forfeit.
Less favorable tax treatment than with ISO, and employee does not own stock until she exercises her options.
Restricted Stock Grant
Taxed as ordinary income in the year of vesting (unless 83(b) election is made).
N/A.
If sold within 1 year of vesting date: taxed as ordinary income on the difference of share price on vesting date and the sale date.
 
If sold after 1 year following vesting date: taxed as long term capital gain on the difference of share price on vesting date and the sale date.
Vested shares are property of the employee.
Grant means employee does not pay for the stock.  83(b) election may make sense.

Remember These Points When Negotiating Your Compensation

We recommend asking the following questions when negotiating your compensation.

What percentage of the company's equity do the options represent?
While being offered 50,000 options may sound flattering, it doesn't mean much without knowing how much of the company those options represent.  The point here is that the denominator matters.  50,000 options out of 50,000,000 shares outstanding is not an 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.

What was the most recent "409A" valuation and when was that valuation done?
The "409A" valuation is an appraisal done for tax purposes and is commonly done every 6 months.  The exercise price of options is often set by reference to the 409A valuation.  If the company won't tell you 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 more cryptic may 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 holdings.  See our earlier post, which addresses the topic of dilution.

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 is nice to have in these situations.

*     *     *     *     *


We'd love to hear your thoughts on this topic and please feel free to contact us directly if you'd like to discuss any point in greater detail.

comments powered by Disqus

Back to blog homepage

Stay up to date

I've got equity

I'm an investor

Search the Blog

We've partnered with Wealthfront to provide our clients with sophisticated, low-cost investment management services.

Full terms: here

Tags

Recent Posts


Check out our Knowledge Center for more resources.