October 25th, 2018

What do startup employees fail to understand about equity?

Spenser Skates

CEO and Co-Founder of Amplitude.

I have never met a prospective employee who understood 100% of the ins and outs of equity before talking to us. That's really unfortunate because equity compensation is a big upside of joining a startup.

The first thing to understand about equity is what it could be worth. I would start with asking your employer "if the company sells for its most recent fundraising valuation, what is my equity grant worth?"

At its core, the value of equity comes from the fact that it gives you economic ownership in a company. There are some caveats, but in basic terms, the value of equity is determined by two things: 1) the percentage of the company that equity represents, and 2) the valuation of the company. You multiply the percentage of the company the equity represents with the valuation of the company to get the value of the equity.

Both numbers will change over time. The percentage of a company equity represents will go down as the company issues more shares to sell to investors and grant to future employees. The valuation of the company will almost certainly change even more. Valuation is anything but guaranteed: most startups end up shutting down, going bankrupt, or selling for an amount that makes the equity worthless. Most of the expected value in the equity comes from the company growing a lot in an upside case. This is almost impossible to predict upfront, but it's important to understand.

I'm hopeful that employees at startups will get a deeper understanding of equity compensation in the future. That will lead to better evaluations of the offers they receive and better terms for them overall. You can read more about what employees should understand about their equity in a post I wrote in 2015.

Christine Spang

CTO and Co-Founder of Nylas.

For small startups, you should ask whether they plan to raise more capital, how much, and what their plans for growth are—how important is profitability, and what metrics are they using to measure success in the absence of it? Do they plan to have an "exit" (sale or IPO) or stay private forever? Most startups anticipate an exit eventually, but smaller businesses aiming for sustainability might not, in which case equity ownership isn't that useful because you can't really turn it into cash in the future.

Rand Fishkin

CEO and Co-Founder of SparkToro.

  1. At most startups, you make less than bigco wages, but have the hope/promise of stock options. But, in ~94% of cases, this is a terrible financial tradeoff.
  2. The valuations set by 409a standards determine whether the stock you get is going to be worth much in an eventual transaction, but you (and even the founders/leadership/board) have very little influence on this. Most of it is determined by the public market's valuations of your competition, a poor proxy at best.
  3. If you leave your company before the company sells/IPOs (which, 90%+ of early employees will), you'll need to execute those options, which means paying thousands or tens of thousands in the hopes that the company someday has a transaction for a higher value than your stock did (and that the length of that time is small enough that sticking that money in an index fund wouldn't have been a better bet). Yikes.

Fred Stevens-Smith

CEO and Co-Founder of Rainforest QA.

Equity is both a bet on the company's success, and an interesting signal to understand how the founders think.

Plenty has been said about the former. Just know that, basically, the equity won't be worth anything meaningful unless there's a big outcome. Therefore it's simplest to think of your equity as being worth nothing in dollar terms, and then any upside will be a nice surprise. When comparing two companies, if all else is equal then choose the one where you think there's a greater chance of the equity being worth something meaningful. In reality, your decision will tend to come down to other things, like culture or the role.

The other aspect to equity is that it makes you, in literal terms, an owner. It's easy to be cynical about startup equity, and it's a huge mistake - the founders have chosen to give you some of their company. Think about that - to build something with blood and sweat and tears, and to value your contributions so much that they want you to own some of it. While we're used to it in startups, it's actually a huge deal.

Finally, how a company decides your equity says a huge amount about the founders. If they approach it based on dollar value they are big-company trained and likely "don't get it." Early employees should get a huge amount of equity relative to later employees. And vesting schedules mean that equity is actually pretty low risk compensation for the company. So if they have a complex formula that spits out 0.01% and you're the 10th hire, walk away.

Alyssa Ravasio

CEO and Co-Founder of Hipcamp.

The biggest thing is that in most cases, you're not actually being granted any stock—you're being granted the option to purchase stock at a certain price. This means that if you leave your company, you will mostly likely have to "exercise" this option to purchase the stock within 90 days or so—which means paying the company. This is less of a problem at seed or Series A stage startups, but if you're joining a later stage company, the cost of exercising can become expensive quickly, and if you don't have the funds set aside to do so, you will forfeit your rights to purchase the stock. You should plan ahead and ask what the "strike price" is of the options you're being granted. Multiply this by how many options you get, and you'll know how much a future exercise could cost you.

Bilal Mahmood

CEO and Co-Founder of ClearBrain.

Employee equity is tricky as there are a lot of variables in assessing value. In the end, equity value is really a differential between the price you buy your stock options and the price at which you sell.

If you are one of the first 25 employees, the valuation of the company is likely low, and your options cheaper to exercise. If you can, I would recommend early exercising your options to minimize your tax liability.

Whenever you exercise options, you will incur an AMT tax based on the difference between the price when you received the option and the fair market value at the time of purchase. If you exercise at the time of receiving the options though, the strike price and FMV are usually equivalent, your resultant AMT negligible, and the upside potential only higher.

A nice bonus to being an early employee at a startup!

Alexey Malafeev

Co-Founder of Sensor Tower.

Startup equity is confusing, even for startup founders. Until you are listed on the public market or acquired by another public company, or acquired for cash, startup equity is just that: equity.

My advice is to educate yourself as much as possible on the various situations, terms, and definitions. Doing so will be great for you in the long term. With that in mind, here are some questions to help you evaluate things from a more analytical perspective:

Note: This by-the-numbers approach is not the only way to consider the upside of equity or whether to join a startup. However, I do think an honest conversation about these topics will shed light on the health and structure of a startup. No one can give a definite answer, but they're important to consider.

  1. How many outstanding shares are there, and how many are you getting? What does that entail as percentage ownership?
  2. How many preferred shares are there, and what is their liquidation preference? (In case of a hypergrowth outcome, this does not matter much, but in an outcome where a company exits for less than the valuation it raised at, this can be an important point to consider.)
  3. What is the latest valuation (either from a fundraising event or a 409(a) valuation), and what is the current strike price?
  4. What are the plans for further fundraising?
  5. Is the vesting schedule reasonable?
  6. What are compatible potential revenue multipliers of similar companies that have had an exit, and what could reasonable growth do to grow the value of your equity?

There are a couple of other considerations:

  • Are you getting a stock grant or stock options, ISO/NSO or RSU?
  • Is the company small enough and are you committed enough that it makes sense to early exercise your equity and do an 83(b)?

If these terms seem unfamiliar, take the time to learn about their meaning. A lot of these questions can open up further discussions about the health of the company, revenues, revenue growth, customer metrics, churn, team composition, and many more. An honest conversation on these topics can be good, just don't get too stuck in the details.

Ultimately, you should join a startup because you believe in the product, the team, and have a great learning and growth opportunity. Do not neglect having a roof over your head, but do keep in mind that startups are a risky proposition.

Share image by David Travis on Unsplash.