Career Transition, Industry Explanation

Understanding an Equity Offer

By Marty Speight-
understanding-an-equity-offer

The prospect of joining a high-potential startup can be very exciting. Startups and private companies sometimes entice recruits with an offer of equity compensation to offset lower cash compensation (base and bonus). The equity represents ownership — having a stake in the company you’re helping to grow and succeed. However, understanding and negotiating the equity offer can be difficult and time consuming. The nuances of equity include different types of plans as well as other variables such as a subjective assessment of the future value of the company.

When evaluating an equity offer, you must first understand the lingo. You’ll want to ask educated questions and determine as much as you can about your equity offer up front in order to judge the value and weigh the risk versus potential reward. Here’s the basic terminology associated with equity:

Option — The most common form of equity offer, an option, gives you the right to buy the company’s stock — usually common stock — in the future at a predetermined price, aka the strike price. The company must set the strike price at what is deemed the fair market value of the enterprise at the time the options are created. The strike price will not change once an option is awarded. The spread refers to the difference between the market price (at some future date) and your strike price.

Grant or Restricted Stock Unit (RSU) — Shares of stock are granted outright usually with restrictions like a vesting schedule. You can sell the vested shares when the company has a “liquidity” event. Ask the company for a copy of its equity plan document and a sample grant document to make sure you understand how its plan works. Also, make sure to understand whether grants are milestone-based and whether other employees share these milestones.

Vesting — Shares vest on a schedule for earning the equity in increments over a specified period of time. The most common vesting schedule is four years, often with a one-year “cliff,” meaning you must be employed for a full year to earn the first 25 percent of your equity. Thereafter, you vest monthly into 1/48 of the total. Some companies are now moving to stricter vesting schedules if they want to affect employee retention, such as five-year vesting or “back-loaded” vesting where you earn smaller percentages of the shares in the first two to three years and a larger chunks in later years.

Exercise — The process of purchasing your vested options. You must eventually exercise the vested options in order to get any cash value, and this means coming up with the actual dollars to buy the shares (number of options times strike price). The timing of the exercise also has important implications, depending on the type of option.

Nonqualified Stock Option (NSO) versus Incentive Stock Option (ISO) — It is essential to know which type of option the company is offering as this legal designation determines the tax implications should you sell the stock. Consult your personal tax adviser to understand how the exercise or sale will affect your specific tax situation. NSOs are taxed as ordinary income at the time of exercise (based on a calculation of the difference between strike price and fair market value at the time of exercise). ISOs can qualify for long-term capital gains tax rates, if you meet certain provisions (exercising while employed and then holding the stock for one year after exercise or two years after grant date). ISOs can be particularly tricky to understand, as certain exits, like a cash acquisition, may violate holding requirements.

Exit or Liquidity Event — This is when a startup is either acquired by another firm or makes an initial public offering (IPO), which converts the company to a publicly traded company on the stock market. Generally speaking, your equity shares/options are not “liquid” (worth any cash value) unless or until there is an exit event. It’s important to gauge what the realistic exit scenarios might be for the startup. You’ll also want to know whether accelerated vesting would apply. When a company is sold, it is up to the acquirer to determine whether or not to continue the plan, plus there is no guaranteed payout for options that are unvested or unearned. If options carry accelerated vesting, then the vesting of those remaining options is accelerated and available for exercise and potential inclusion in the sale/payout.

Restrictions — These define a company’s rights versus your rights for vested shares. It’s especially important to consider what happens to your shares if you are terminated or quit. For example, it’s typical to have limited time (e.g., 90 days) to exercise your vested shares when you leave. There can also be restrictions based on various exit or liquidity scenarios. For example:

Percentage of Ownership — Unless you know the total shares outstanding, you won’t know what relative ownership stake your offered options represent. It’s OK to ask in the negotiation what percentage stake the number of options represents and how that compares relative to other hires at similar levels and positions. AngelList, a platform for startup jobs and investing, provides a benchmark tool to compare startup equity percentage and salaries by role, location or sector. Be sure to ask what the fully diluted number of shares is — that is, the total shares as if every share issued has already been converted or excised. Future dilution is also important to try to understand. How big are expected future rounds of investor funding, and how will that dilute my awards? Will there be antidilution protection for employees during up-rounds to help reward them for company success?

Valuation — An offer of equity will typically be in number of shares or options and will rarely be given as a percentage stake. If you know the current share price, you can compute the current value: Number of shares times (current price minus strike price). This is only a theoretical value until there is an exit, and even then, the actual value will depend on lots of other nuances, such as liquidity preference (giving some owners and investors payout first) or an IPO lock-up period (a set amount of time, usually 90–180 days, that insiders must wait before selling shares after the company goes public).

Capitalization — Capitalization calculates the total overall funding into the firm with total outstanding shares, at various prices, and relative percentage ownership stakes. A cap table represents all the investments made in the company over time, including the founders and each successive round of outside investor funding (e.g., angel or venture), as well as any options pool (options set aside for new hires, both issued and unissued). Unless you’re joining as a founder or C-level early employee, don’t expect the company to share the cap table with you. The important point is that maturing startups (those beyond Series A funding) have usually set aside an options pool, which must be approved by the board, and is a fixed number of shares, typically about a 10-20 percent stake of the company.

Evaluating any compensation package is ultimately a very subjective process with many future unknowns. Once an offer is extended, there will be pressure to respond and move forward, so start your research on a startup as early in the recruitment process as possible. Thinking through these points will help you negotiate:

  • What’s your assessment of the firm’s viability and growth potential? Will they share the business plan?
  • Who has funded the venture to date, and how much has been put in? What are the plans to raise more capital, and when?
  • What’s the current “burn rate” (cost of running the operation), and how long will current funding last?
  • What are the founder’s backgrounds and reputations? Do they have a track record with other startups? What is their plan for growth and an exit?
  • Who sits on the board and advises management?
  • How willing is the firm to share equity information with you?
  • Will you need the assistance of a tax adviser or attorney to help you evaluate the equity offer?
  • Be sure to get your offer in writing and ask for clarifications on items you discussed that are not clear in the offer letter.

Before joining a startup, you should first consider your career goals, professional and skills growth, and your personal tolerance for risk. Many startups fail, making the equity (and your personal investment in the company) worthless. Yet, startups can be fun places to work that offer lots of interesting challenges and intangible rewards. Getting an equity stake will hopefully give you an upside payout tied to the company’s success.

If you’re considering an offer or in a job transition, contact Alumni Career Services to help you assess the possibilities!