Getting Start-up Equity? Everything You Need to Know

There are plenty of perks when it comes to working at a start-up (hello, never having to put on a suit again!). But, while ping pong tables and video game breaks in the office may help you get through the day, owning a piece of a potentially multi-million (or billion) dollar start-up is undoubtedly one of the best.

In short, having equity in a company means that you have a stake in the business you’re helping to build and grow. You’re also incentivized to grow the company’s value in the same way founders and investors are. To quote Fred Wilson, founder of Union Square Ventures and blogger on AVC.com, employee equity “reinforces that everyone is on the team, everyone is sharing in the gains, and everyone is a shareholder.”

But receiving equity is no simple matter—equity packages come in all shapes and sizes, and it’s important to understand the ins and outs of what you’re getting before you join any start-up. To get you started, here are some key questions you should ask yourself and your potential employers to help you evaluate your offer.

Is This the Right Company?

Investors buy equity in a company with money, but you’ll be earning it through your investment of time and effort. So it’s important to think rationally, as an investor would, about the growth prospects of your start-up.

Attorney Mary Russell, Founder of Stock Option Counsel based in San Francisco, advises that anyone receiving equity compensation should evaluate the company and offer based on his or her own independent analysis. This means thoughtfully looking at the company’s capitalization and valuation. (Bear in mind that only very few at the top are privy to the company’s capitalization table—so unless you are a C-level executive, you probably won’t get to see it. If you work at a venture-backed start-up, the most recent round of funding would have determined the company’s valuation. Ask the company founders or executives about valuation.)

Next, consider that VCs often make 10 or more investments in different companies and hope for a big exit from one or two. In other words, they calculate the risk that most start-ups fail. And, unfortunately, so should you.

While this doesn’t sound like good news, it really just means that you need to think big picture and consider the whole package when accepting a job. Getting a potentially lucrative equity stake shouldn’t be your only reason to take a job—you should also make sure you’re getting meaningful career experiences and receiving benefits such as cash compensation and health insurance from the job.

Is There an Exit Strategy?  

To put it simply, an exit event is when the company is either sold or taken public. And as part of your evaluation, you should ask the founders what their overarching exit strategy is. Do they plan to sell? Do they want to take the company public in five years?

Should your start-up exit at a great valuation, your equity could turn into cash. But should your start-up not make it—or should it stay afloat, but never sell or go public—your equity may not turn into anything.

What is the Percentage of My Ownership?

This is arguably the most important question you can ask about your equity compensation, as the percent you own will determine how much you’ll be paid out in an exit event.

So, when you’re told the number of shares or options you’re being offered, also ask about the total shares outstanding. The number of shares or options you own divided by the total shares outstanding is the percent of the company you own.

At a typical venture-backed startup, the employee equity pool tends to fall somewhere between 10-20% of the total shares outstanding. That means you and all your current and future colleagues will receive equity out of this pool.

To help you gauge “market rate” for your equity compensation, there are some free benchmarking resources. Both AngelList and Wealthfront offer an interactive tool where you can sort salary and equity compensation by position, skill level, and location. Ackwire, an online database of anonymous start-up salaries and equity, allows you to sort a similar set of data also by company valuation and head count.

Am I Receiving Stock Options or Restricted Stock?

Next, you’ll need to find out what type of equity you’re receiving.

If you receive stock options—the most common form of employee equity compensation—you get the right to buy stocks at a predetermined price, or strike price. You “exercise your options” when you purchase the underlying stocks at strike price. The company is legally bound to set your strike price at what is deemed fair market value of the company stock when the options are granted to you. When the strike price is equal to fair market value, the options are considered “in the money.”

So, if you were granted “in the money” stock options with strike price of $1, and you were to exercise your options on the same day, you would pay $1 for each stock, and own that stock valued at exactly $1. You would have a net gain of $0. As company grows over time, the value of stock would rise.

Now, exercising your options on the same day of the grant is not common because you generally first have to vest. In other words, you’ll mostly likely be granted stock options with a vesting schedule that requires you to work at the start-up for a period of time before you can exercise any of your options.

Restricted stock, on the other hand, is stock granted to you with restrictions (vesting being one of the most common). In other words, you don’t have to buy this stock; it’s granted to you. Also it’s typically given to founders and early employees when the stock value is very low, or close to $0.

How Long is My Vesting Schedule?

Make sure to ask about the specifics of your company’s vesting schedule to know exactly how much you’ll own and when. Again, vesting means that you’ll earn your equity grant in partial amounts over time. For example, if you’re told on your first day that you’re granted 10,000 shares with a vesting schedule, you don’t yet own any equity on that day. You will be earning the full amount over a specific period of continued employment.

The most common vesting schedule for employees is four-year vesting with a one-year cliff. A one-year cliff means that you don’t vest during the first year of employment—if you leave the company before the first anniversary of your hire date, you will leave with nothing. The idea is to avoid a hit-and-run situation, where an employee who turned out to be a bad fit gets to walk away with a piece of the company. (For the same reason, founders and co-founders are also usually subject to a vesting restriction.)

Once you’ve been with the company for a full year, a quarter of your total equity grant will become yours. After this point, the balance of your equity vests to you on either a monthly or quarterly basis.

What About Taxes?

If you’ve ever received a paycheck, then you’re familiar with ordinary income tax, which as of 2013, ranges from 10% to 39.6% of your total income. The IRS considers both cash and equity compensation taxable income. There are special rules governing when and how equity compensation is taxed. Ask (both the company and potentially a tax professional) about the potential tax liability of your equity compensation to avoid tax-related pitfalls and any surprises.

The most common form of stock options given to employees is incentive stock options, or ISOs. If certain limitations and specific holding requirements are met, ISOs can provide tax advantages when you exercise options and later when you sell the stock for profit. So if you are granted ISOs, make sure to ask for an explanation of these tax advantages in detail.

When Can I Sell My Shares?

Once you have fully vested stock or have exercised your fully vested options, you have two options: You can hold your stock until there is an exit event or sell the stock in a private transaction to either outside investors or back to the company. This may require company approval and may be subject to restrictions under federal law.

Private sales in secondary markets are actually growing in popularity through services such as SecondMarket and SharesPost. Some companies use these services to give employees an early chance to cash out before an exit event. For example, Sharepost serviced Facebook employees selling their equity to private investors before the company went public on May 2012.

If you hold vested options and if you leave the company, you may be required to exercise all vested options within a specific period of time or forfeit them. If you leave in good terms with the company, you may be able to negotiate a special privilege where the company lends you the strike price or immediately buys back a number of shares upon exercise to help you cover the cost of exercising. Maintaining a good network with current and former colleagues could help you stay in the know about what you can realistically expect when you leave the company.

If this sounds like a lot—well, that’s because it is. But knowing as much as you can about your equity offer up front will help you determine its value and decide whether the risk of joining a start-up is worth the potential reward.

Most importantly, as attorney Zeke Vermillion, partner at Brooklyn-based Adler Vermillion & Skocilich, advises: It’s critical to get “something on paper early on, even if it’s a non-binding term sheet written on a napkin.” He says this is because, “you are in the best position to negotiate your compensation terms early in the relationship. Insisting on full legal docs at that point can be a distraction, but having some written memorial of your deal is helpful to avoid misunderstandings later on.”

Photo of woman reviewing document courtesy of Shutterstock.