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Company Equity: How It Works (Plus 14 Points of Negotiation)
Are you wondering how company equity works?
If so, you’re not alone. Navigating the ins and outs of company equity can be confusing let alone knowing what you can negotiate to maximize your company stock options. Fortunately, this article shares everything you need to know!
After reading this article you will understand company equity terminology, how typical company equity works, and what to consider when being offered equity in a company. You’ll also learn 14 points of negotiation that will help you to increase and protect your company equity.
If you’re ready to learn about company equity and what parts of your company equity you can negotiate then keep reading!
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Company Equity (Terminology)
When an employee receives company equity and the company performs well the equity has the potential to be worth life changing amounts of money. Unfortunately, many employees that expected a big pay day from their company equity have been left disappointed because they misunderstood how company equity worked and/or how much equity they owned.
In order to maximize your company equity it’s important to understand how company equity works. The first aspect of learning how company equity works is understanding the terminology.
Below are company equity terms that you should know in order to: 1.) understand your company equity, and 2.) to maximize your company equity in a negotiation.
It may feel odd to read a list of terms but familiarizing yourself with the terms and concepts below will give you the foundation you need to understand an offer of company equity, ask questions about your company equity, and appropriately negotiate your company equity.
Company Equity (Terms to Know)
What is equity?
Equity represents an ownership stake in the company. The total amount of equity is represented by a percentage such as .2% or 2%. The total percentage of equity is made up of a number of shares.
What are shares?
Shares are a unit of ownership in a company that collectively make up an individual’s ownership percentage in a company. An individual gains ownership of a share when they either invest in the company (and get preferred stock in return) or exercise their right to purchase their stock options (and get common stock in return).
What are company stock options?
Company stock options are “options” to gain ownership in a company if the stock options are purchased. Purchasing stock options is most commonly referred to as exercising stock options.
A stock option can be exercised by an employee when the terms and conditions of their stock option agreement are met. When an employee exercises stock options, they gain ownership of shares. Unlike investor shares, early startup employee company shares typically do not include voting rights.
The price at which an employee exercises their stock option is referred to as the strike price, the fair market value of the stock option at the time that the option to purchase was issued in the employee stock option agreement.
What is common stock
Common stock refers to the type of stock allocated to a startup’s employees. Common stock is typically granted with terms and conditions (e.g. purchasing the stock after it has vested) that must be met in order for the employees to gain the rights to the stock options and own the shares.
The most common types of common stock are incentive stock options (ISOs) and non qualified stock options (NSOs).
Common stock is stock that does not include dividends, does not benefit from liquidation preferences, and typically does not have voting rights. When a company experiences dilution common stock is hit the hardest. This is because common stock does not benefit from liquidation preferences or anti-dilution provisions.
What is preferred stock?
Preferred stock, also referred to as preferred equity, is stock allocated to investors that purchase an equity stake in the company. Preferred stock, unlike common stock, receives dividends. Additionally, when a startup has a liquidity event preferred stock has preference over common stock in regards to who is paid first. The percent of preferred stock ownership an investor has typically determines if the shareholder has voting rights and a seat on the company’s board of directors.
Preferred price is the fair market value of a company’s stock that investors pay for preferred stock options. The preferred price is established through the completion of a 409a valuation.
The preferred price is almost always higher than a current employee’s exercise price because the preferred stock that is being purchased is purchased when the company raises money.
Raising money increases the value of the company and its shares. The increase in a company’s value is reflected in its pre-money valuation and post-money valuation.
The exception to this is when a company is not performing well and raising a down round which means that the price per share is less than what it was during a previous round of financing.
In the case that a company has a buyback clause the price at which an employees’ shares are purchased is typically the current preferred price.
What is a pre-money valuation?
A pre-money valuation is the value of a company before it receives any type of investment or financing. A pre-money valuation is calculated by subtracting the amount of funding received from the post money valuation (e.g. Post-money valuation – Amount of funding = Pre-money valuation).
What is a post-money valuation?
A post-money valuation is the value of a company after it raises funding. For example, if a startup has a pre-money valuation of $10 million and raises $5 million in funding, the post-money valuation (i.e., the value of the company after raising funding) would be $15 Million.
What is preferred equity?
Preferred equity, also referred to as preferred stock is equity allocated to company investors. Preferred equity is subject to the receipt of dividends, liquidation preferences, and depending on the percent of ownership voting rights.
What is participating preferred stock?
Participating preferred stock is preferred stock issued only to investors with additional rights. When a company has a liquidity event holders of participating preferred stock get their money back and share in the proceeds of the liquidity events as a common stockholder as well based on their percentage of ownership.
Participating preferred stock holders get paid out twice. This is good for them and bad for employees as the amount employees are paid is reduced by participating preferred stock holders who “double dip.” If a company gives out a lot of participating preferred stock employees who have been with the company for years could see the value of their equity and payout severely diminished.
What is capped participation on participating preferred stock?
Capped participation on participating preferred stock is similar to participating preferred stock however the amount at which an investor is able to benefit from the proceeds of the common stock in addition to their preferred stock is capped at a certain amount. Capped participation allows an investor to double dip but only up to a certain amount.
What are employee stock options?
Startup equity compensation is typically issued in the form of employee stock options (ESO). When you are granted employee stock options you do not own the stock options. They are granted through an employee stock option agreement, a contract that outlines the terms and conditions in which you receive the right or “option” to purchase your employee stock options at the strike price, also known as exercise price. The most common form of employee stock options are incentive stock options (ISOs) and non qualified stock options (NSOs).
What does strike price mean?
The strike price, or exercise price, is a fixed price in an employee stock option agreement that reflects the fair market value of the employee stock options at the time they are granted. It is the price that the employee pays to purchase their stock options when the terms and conditions of their employee stock option agreement have been met. When a company does well and grows its value an early employee with a low strike price has an opportunity to generate a lot of money.
What does fair market value (FMV) mean?
Fair market value, often referred to as FMV, refers to the price of a share of a company’s common stock that is determined by a third-party through the completion of a 409a valuation. The fair market value is the strike price of an employee’s stock options at the time they receive their employee stock option grant (i.e. employee stock option agreement).
What are incentive stock options?
Incentive stock options (ISOs) are a type of common stock granted to employees through an employee stock option agreement. ISOs can only be granted to employees and have been the preferred choice of startups to grant stock to employees.
Incentive stock options are the preferred type of common stock for employees due to the fact that when employees exercise ISOs they generally get to benefit from a lower tax rate when sold, only paying capital gains tax and not having to pay federal income tax. In addition, when ISOs are granted and vested the employee has a longer period of time to exercise their stock, up to 10 years from the grant date.
What is an iso stock?
ISO stock refers to incentive stock options, abbreviated as (ISO). ISO stock is a form of employee stock options used by startup companies to issue stock to employees. Benefits of ISO stock include a lower tax rate and a period of up to 10 years to exercise stock after the terms and conditions to gain the right to purchase the stock have been met. ISO stock can only be granted to employees.
What are non qualified stock options?
Non qualified stock options are a type of common stock options that can be granted to employees, board of directors, consultants, advisors, contractors, and vendors. Non qualified stock options are taxed twice. They are taxed at the time of exercise and taxed at the time of sale. Terms such as whether or not the stock options expired (i.e. how long you have to purchase the stock options) are determined by the terms and conditions of the stock option agreement.
What does number of options mean?
Number of options refers to the aggregate number of shares an employee has the right to purchase after terms and conditions of the employee stock option agreement are met. When terms and conditions are met an employee has the right to exercise a number of options at the predetermined strike price and gain ownership of the shares.
Equity percentage refers to the percentage of ownership that a shareholder has in a company.
Equity percentages can change over time as new shares are issued or existing shareholders sell their shares. Employees typically receive a lower equity percentage than investors because they do not provide monetary capital to the company. Instead, they contribute their time and labor.
The size of an employee’s equity percentage will depend on variables such as: the company’s stage, traction, level of funding, the position that they hold (and its level of importance to the company), how experienced the company’s leadership is at issuing employee stock options, and if the company has standardized equity percentage for each position or not.
Startup stock is a type of equity that is typically offered to employees of early-stage companies. Startups are often not yet profitable and may not have the cash to pay high salaries. Instead, they offer company stock options as a way to attract and retain talent.
Stock options give employees the potential to make a lot of money if the company is successful. However, there is also a risk that the company will fail and the employee will end up with nothing.
What does percentage of ownership mean?
Each share of equity represents an ownership stake in the company. The number of shares an employee owns determines the percentage of the company they own.
An employee’s true percent of ownership refers to the percentage of stock options they have exercised (i.e. purchased) and own. When negotiating startup equity the equity is typically negotiated in percentage of ownership that the employee could exercise and own when terms and conditions of the stock options are met.
Let’s walk through a very simple example…
Percentage of Ownership Example (Very Simplified Example)
This means that you own 0.1% of the company.
If the company were to be acquired for $10,000,000.00 and the company has no investors then you would receive $10,000.00 (subject to tax based on the type of stock option).
What are shares?
Shares equate to immediate ownership in the company. Unlike employee stock options there are no terms and conditions that must be met such as a cliff vesting schedule. Shares are generally reserved for investors. Depending on the amount of shares purchased and/or the company’s corporate structure the amount of shares purchased will determine additional certain rights such as dividends, a percentage of profits, and voting on corporate governance issues.
What is the difference between stock options and shares?
The difference between stock options and shares is that the purchase of shares immediately makes the person a shareholder whereas the granting of stock options gives the person the right to purchase shares when terms and conditions have been met. When the terms and conditions have been met the options can be exercised (i.e. purchased) and the person will become a shareholder but typically will not have voting rights on corporate governance issues.
Exercise stock options
When you meet cliff vesting requirements and have vested your stock options you gain the ability to exercise your options which means you can officially purchase your employee stock options at the strike price.
What is vesting?
Vesting is the process by which an employee or founder earns the right to purchase or own a certain number of shares over time. The period of time over which vesting occurs is called the vesting schedule.
What is a cliff?
A cliff is a period of time that an employee or founder must stay with the company before they begin to vest shares.
Cliff vesting is when an employee or founder earns the right to purchase or own their stock options after they hit a time period milestone at the company.
The most used cliff vesting schedule is four years with a one year cliff. This means that the employee or founder vests 1/4th of their total number of employee stock options after meeting the one year cliff time milestone and 1/48th of their total number of employee stock options vests each month thereafter until they are fully vested (over four years).
Graded vesting is a type of vesting schedule where employees vest a certain number of stock options over time in equal increments. For example, an employee with a four-year graded vesting schedule will vest 1/48th of their total number of stock options each month until they are fully vested.
Graded vesting is different from cliff vesting in that with cliff vesting the employee or founder does not earn the right to purchase any stock options until a certain period of time has passed, while with graded vesting the employee or founder begins to vest their stock options immediately.
Accelerated vesting is a type of vesting schedule where employees and/or founders vest their stock options at a faster rate than a typical cliff vesting schedule. Accelerated vesting may be triggered by the sale of the company, an initial public offering (IPO), or other events, if the founders include accelerated vesting conditions in corporate governance.
What does vested mean?
Vested means that an employee or founder has met the requirements to purchase or own some of their stock options.
What does fully vested mean?
Fully vested means that an employee or founder has met the requirements to purchase or own all of their stock options.
What is an exercise price?
The exercise price is the price per share that an employee or founder must pay to purchase their stock options. The exercise price is determined by an annual 409a valuation. The exercise price is set at the time of grant. In some cases founders may set the exercise price without a formal 409a valuation. This isn’t a good practice and something that potential new hires can negotiate against.
What is an exercise period?
The exercise period is the time during which an employee can purchase (vested) shares of the company’s stock at the strike price. The exercise period varies by the type of stock. For example incentive stock options have to be purchased within 10 years of the grant date whereas non qualifying stock options have to be purchased based on the terms and conditions of the individual’s stock option agreement.
What does exercisable stock options mean?
Exercisable stock options refers to the employee stock options an employee has gained the right to purchase. Exercisable stock options can be a partial amount of a stock option grant or the full amount of a stock option grant and are subject to annual purchase amount limitations. For example, the purchase of incentive employee stock options (ISOs) is capped at $100,000.00 per year whereas the purchase of non qualifying employee stock options (NSOs) has no annual exercise limit.
Post termination option exercise window
A post termination option exercise window, commonly referred to as a PTE Window, is a period of time in which an employee has the right to purchase stock options they have gained the right to purchase by meeting the terms and conditions of their employee stock option agreement.
Once the post termination option exercise window closes an employee loses their right to purchase the stock options they have gained the right to purchase. When an employee loses the right to purchase their stock options it is usually due to: 1.) Choice as they do not believe the purchase of the stock options will result in a future payout for them, or 2.) They do not have the money to purchase the stock options, more specifically they do not have the money to pay the taxes on the stock options.
Companies such as EquityBee have emerged to help employees exercise stock options and taxes that may otherwise prohibit them from exercising their stock. To prevent paying for stock option taxes out of pocket, employees can negotiate the inclusion of a cash bonus that covers the cost of stock option tax as a part of their total rewards package.
What is a down round?
A down round is a financing round in which the valuation of the company is lower than the valuation from the previous round. This can happen when a company is not performing as well as expected or when the market conditions are not favorable for startups. A down round impacts shares that have been previously issued because the price per share is lower (i.e. they lose value).
What is an up round?
An up round is a financing round in which the valuation of the company is higher than the valuation from the previous round of financing. Up rounds take place when a company is performing well and investors are willing to pay more for preferred shares.
What is a 409a valuation?
A 409A valuation is a process used to determine the fair market value of a share of common stock in order to set the strike price. To ensure a fair strike price is set an annual 409a valuation is required by companies that offer stock options to employees.
What is sweat equity
Sweat equity is equity issued to an employee based on their contributions to the company. Sweat equity is the compensation of stock options in lieu of base pay or other monetary compensation.
This equity is typically offered to founders, founding team members, first hires, and early employees who are working for a lower base pay or no base pay in order to own a larger stake in the company and/or because the company does not have the financial means to pay market rate employee salaries.
Sweat equity is often used as an incentive to hire early employees when a startup company wants to minimize the amount of base pay an employee receives in order preserve cash flow also commonly referred to as runrate (i.e. the amount of time a company has to operate and hit it’s next milestone before it runs out of money).
Often founding CEOs will opt for a $1.00 salary and prefer to work for sweat equity in order to maximize ownership of stock. This choice can result in big payouts and has created billionaires such as Elon Musk, founder of Tesla and SpaceX, Jack Dorsey, founder of Twitter, amongst many others.
What is a liquidity event?
A liquidity event is a situation where shareholders are able to sell their shares. This can happen through an initial public offering (i.e. IPO), company acquisition, company merger, or secondary market sale. A liquidity event allows shareholders to cash out some or all of their equity.
What are shares outstanding?
Shares outstanding refers to the number of shares the company has issued to employees and investors. The number of shares outstanding is a number that is used to calculate a company’s market capitalization, often referred to as market cap.
What is market capitalization?
Market capitalization, more commonly referred to as market cap, is how much a company is worth. The formula to determine this is to multiple the share price by the total number of shares outstanding.
What is a restricted stock award?
Some early stage startups will issue very early hires and/or hard to hire positions restricted stock awards (RSAs) instead of employee stock options (ESOs). Like ESOs the stock has terms and conditions (e.g. cliff vesting) that must be met in order to receive them. These terms and conditions are outlined in the restricted stock award agreement. In addition, like ESOs when you leave a company unvested restricted stock awards are subject to a buyback clause.
Unlike ESOs restricted stock awards do not have to be purchased. Restricted stock awards are considered “restricted” due to the fact that they cannot be freely traded or transferred to another person.
Restricted stock awards are intended to be an employee incentive. Most startups, however, do not issue restricted stock grants because the amount of tax on the stock can become obscene. Restricted stock awards issued to early hires and/or hard to hire positions should be issued when the company is also willing to issue a cash bonus to cover the cost of the taxes.
If you are awarded restricted stock it’s important to file an 83b election with the IRS within 30 days of receiving the stock grant. The 83b election provides the option to pay taxes on the fair market value of the restricted stock at the time the stock is awarded, not once the stock has vested. Filing an 83b election will save you a lot of money if the company is not providing a cash bonus to cover the cost of the taxes.
What is an 83(b) election?
An 83b election is a filing with the IRS that gives recipients of restricted stock awards the option to pay taxes on the fair market value of the restricted stock at the time the stock is granted, not once the stock has been vested. Filing an 83b election can save a lot of money. An 83b election must be filed within 30 days of receiving the award.
What are restricted stock units?
Restricted stock units (RSUs) are a form of equity compensation used by later stage mature startups. When a company matures the strike price of employee stock options tends to become too great creating a financial burden for the employee to exercise their options. When a company reaches this stage the company will offer employees restricted stock units instead.
Like employee stock options, restricted stock units are subject to terms and conditions such as cliff vesting. These terms and conditions are outlined in the restricted stock unit agreement. Once the terms and conditions are met an employee gains the right to acquire the stock.
Unlike other employee stock options the employee doesn’t have to pay money to the company to own their restricted stock units. When an employee is allocated their restricted stock units they are issued at the fair market value. When this occurs the restricted stock units are seen as taxable income. A good analogy for acquiring restricted stock units is thinking of them as a non cash bonus that continues to increase in value so long as the company performs well.
Double trigger acceleration
Double trigger acceleration is a type of accelerated vesting in which part or all of unvested shares are vested when two events occur at the same time such as a change in control of the company (e.g. the sale of the company to a new owner) and the new company owners terminate employees or founder(s) without cause or employees or founder(s) resign with “good cause.” A double trigger acceleration clause is a clause founders put into their investor term sheets in order to protect and reward employees.
Single trigger acceleration
Single trigger acceleration is a type of accelerated vesting in which part or all of the unvested shares are vested when a single event occurs such as a change in control of the company because the company was purchased. A single trigger acceleration clause is a clause founders put into their investor term sheets in order to protect and reward employees.
What are golden handcuffs?
Golden handcuffs are a type of retention bonus that is paid to an employee in order to keep them from leaving the company. Golden handcuffs can be employee stock options and other forms of monetary reward such as cash bonuses. When a golden handcuff takes the form of employee stock options the stock options are typically vested overtime with the majority of options vesting towards the end of the vesting period.
Golden handcuffs are used to retain key employees who may be tempted to leave for higher-paying opportunities. Golden handcuffs are also often used by high-growth startups to retain hard-to-recruit positions and positions that are hard to replace such as software engineers and product managers.
What does dilution mean?
Dilution refers to a decrease in the value of ownership percentage. Employees experience dilution when the company issues shares of stock to employees, investors, or in preparation for an initial public offering (IPO). The percent value of a stock decreases (i.e. dilutes) because new shares are created.
Dilution is not always a bad thing. Dilution can signal that a company’s value is increasing. This is the case when a company has raised capital that is not a down round and thus increases the company’s post-money valuation.
Dilution is a bad thing and negatively impacts the value of an employee’s stock options when the company:
Didn’t perform as well as resulting in a decrease in company value
When investor liquidation preferences are not favorable to employees
When a company restructures stock in advance of an IPO to maximize the payout to consultants and leadership charged with taking the company public (this is an egregious yet common practice that dilutes employees that stayed with a company to benefit from the expected payout of their golden handcuffs)
What is a liquidation preference?
When a company has a liquidity event and there is a liquidity preference it means that there is an order in which stockholders will be paid out. This order goes from preferred stock with multiple preferences, to preferred stock, to participating preferred stock alongside common stock.
When there are liquidation preferences stockholders do not receive “a slice of the pie” based on their percentage of ownership of the entire pie but the amount of the pie that is left when it is their turn to be paid.
Every time someone is paid out the remaining amount of the pie is what the remaining stockholders waiting to be paid are paid out of. This reduces the value of their equity and can be severely unfavorable to employees that hold common stock and are the ones who contributed to the success of the company.
What is a multiple liquidation preference?
A multiple liquidation preference is a preference given to some preferred stock holders that entitles them to receive a guaranteed “multiple” on the amount that they invested before anyone else is paid, including founders. It also entitles them to be paid out first if they have a “senior multiple liquidation preference.”
Multiple liquidation preferences can be anywhere from 1X – 3X. Meaning the investor gets one to three times the value of their original investment before anyone else gets paid.
What is a non-participating liquidation preference?
If preferred stock includes a non-participating liquidation preference, also referred to as straight preferences, the investors gains the opportunity to maximize their payout by activating their liquidation preference or convert their preferred stock to common stock and be paid equal to their percentage of ownership. This preference gives the investor a “this or that” option to maximize their return.
What is a ratchet clause?
Ratchet clauses give investors the right to increase their ownership stake in the company if it raises future rounds of funding at a higher valuation. Ratchet clauses protect an investors’ level of investment in the case the company raises a future round of funding at a lower valuation. In this case investors protected by a ratchet clause would be granted additional stock at no extra cost to them to account for the dilution they experience (i.e. the clause protects their investment from diminishing in value).
What is a warrant?
Warrants give investors the right to purchase additional shares of the company at a set strike price. Warrants incentive investors because it gives them the option to buy shares in the future at a discounted price (when the company performs well) but they are not obligated to purchase the shares.
Warrants can be dilutive to employees as they allow investors to buy more shares for less than the fair market value (as they would in a funding round).
What are preemptive rights?
Preemptive rights give investors the right to maintain their current ownership stake in the company. When a company issues new stock investors with preemptive rights have the right to purchase the stock before it is offered to others. For example, if an investor with preemptive rights owns 25% of a company’s shares and the company issues new shares in another round of funding they have the right to purchase up to 25% of the new shares before anyone else.
What is an anti-dilution provision?
An anti-dilution provision is a clause in a contract that protects investors from dilution of their ownership stake in a company. This clause typically gives investors the right to purchase additional shares of the company at a lower price if the company issues new shares of stock at a lower price than the price paid by the original investors.
Senior-level and/or highly valued and skilled employees can negotiate for anti-dilution provisions (this is something I have successfully done). Employees negotiating for an anti-dilution clause is an underutilized practice to protect an employee’s percent of ownership stake and financial outcome during liquidity events.
What is a tag along right?
A tag along right is a contractual right that allows minority shareholders to sell their shares when the majority shareholder sells their shares. This ensures that minority shareholders are not forced to sell their shares at an unfavorable price. Tag along rights typically only apply to shares that have been issued after the tag along right has been put in place.
What is an exit strategy?
An exit strategy is a plan the company has to create a liquidity event that allows shareholders to sell their shares of the company. The most common exit strategies for a startup are the sale of the company to another company, referred to as an acquisition, or an initial public offering (IPO), where the company allows its private stock to be purchased on a stock exchange.
What is a buy back clause?
A buy back clause is a clause a startup may include in their employee stock option agreement that facilitates the sale of stock options an employee has gained the right to purchase back to the company if certain terms and conditions are met. These terms and conditions are typically that the employee has been laid off, fired, or resigned. A buy back clause is typically put into place to help the company control the number of people who own shares of the company who do not work for the company.
🎉Congrats on learning company equity terms! You should be proud!
Reading a bunch of company equity terms is not typical but your understanding of them will completely change how you view and negotiate your company equity.
Now that you have an understanding of company equity terminology you can have an informed and meaningful conversation when you are being offered equity in a company.
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Company Equity (Overview)
Companies issue employees equity to:
- Attract top talent that is interested in company stock options as a form of compensation
- Align interests between the startup founders, investors, and employees
- Reward employees for generating value in the company
- Motivate employees to perform their best
- Incentivize and retain employees to stay with the company overtime
Company equity pros:
- Ownership for employees
- Potential for high returns and the creation of wealth if the company does well
- Alignment of interests between employees, founders, and investors (everyone is working together towards a common goal)
Company equity cons:
- Equity does not mean that there will be a guaranteed monetary payout
- Equity can create golden handcuffs where the employee is tied to the company for a period of time in order to vest equity in the hopes that they will see a beneficial payout
- Equity can create tension if there is disagreement about the best way to grow the company
- Equity can create tension when fundraising decisions maximize shareholder (i.e. investor) value/payouts over employees
- Equity has tax implications
- Startup equity may not be liquid, meaning that it may be difficult to cash out
- There may be clauses and/or situations that result in the value of an employee’s equity to reduce in value while not impacting (and often benefiting) investors, founders, or leadership team members)
- While equity means that an employee “becomes an owner” employee equity does not have voting rights or other privileges related to corporate governance
When being offered equity in a company it’s important to consider:
- How likely the company will perform well resulting in your equity to increase in value, and
- If there is a real chance that the company will have some form of liquidity event.
To assess the likelihood of a startup succeeding and having a liquidity event that results in monetary compensation you can examine:
- The market, the problem the company is solving, and the company’s unique approach to solving the problem
- The company’s leadership team and experience
- The company’s investors
- The company’s level of talent throughout its employees
- If the founders have a track record of success
- How experienced the founders are at raising capital
- If the company completed a tech accelerator and/or built an advisory board with significantly experienced people to help facilitate success (something especially important for first time founders)
- How the company operates (i.e. is there a clear plan, product road map, metrics to define success, processes to measure success, do the leaders communicate well with employees, do employees work as a team aligned in a greater goal, is there a pattern of setting a goal and accomplishing that goal)
- The company’s diversity as the S&P 500 consistently demonstrates that companies with diverse teams outperform competitors in innovation, creativity, problem-solving, and profit by an average of 21%
When you examine the variables above you will develop a sense of your personal belief in the company’s ability to be successful and have a liquidity event. This information will contribute to how you choose to negotiate for startup equity.
Variables that Impact Your Company Equity
If you decide that you believe the company has an opportunity to be highly successful it’s important to understand variables that can positively and negatively impact how much equity you can negotiate for. These variables include:
- The company’s stage (i.e. Pre-seed, Seed, Series A, Series B, Series C, Series D and beyond) and how much equity is typically allocated to employees at each stage
- If the company has standardized compensation practices that include equity allocation or if compensation practices are subjective
- How competitive your base pay is for companies at the same stage, in the same industries, in the same market
- How competitive the total rewards package (e.g. benefits, sign-on bonus, job perks, etc.) is for companies at the same stage, in the same industry, and in the same market, and what, if anything, you would be giving up to work with the company over a similar company
- What the typical equity allocation for your job function is by companies at the same stage, in the same industries, in the same market
- The company’s traction
- How early of a hire you are/will be
- The seniority of your position
- The importance of your position and how much the job function is valued by the company
- Unique skills and proven experience you bring to the table
- What the company’s exit strategy is
- Type of stock options you are being offered
- Percentage of ownership
- The vesting schedule and cliff
- Investor liquidation preferences
- If the company put into place favorable clauses and protections for employe equity such as single or double trigger acceleration vesting upon the sale of the company
- If the company put into place tag along rights and if they apply to common stock
- If the company has a buy back clause that would result in you having to sell back vested shares if you leave the company, are fired, or laid off
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The Impact of Funding on Company Equity for Employees
There are four main types of investors in startups: friends and family investors, angel investors, venture capitalists, and private equity investors.
Friends and Family Investors (Pre-Seed Funding Round)
Friends and family investors are typically non-professional investors who invest small amounts of money ($5,000.00 – $50,000.00) in return for equity in a business. They are generally not professional investors and consequently don’t expect as high of a return on their investment or ask for investment preferences angel investors, venture capitalists, and private equity investors ask for (or demand in order to consider participating in a funding round). Family and friend investors invest in a company because their friend or family member is a founder and they believe in them.
Angel Investors (Seed Funding Round)
Angel investors are typically wealthy individuals who invest their own personal money ($25,000.00 -$1 million) in startups in return for equity in the business. They usually invest smaller amounts than venture capitalists but often provide valuable mentorship to founders as well.
Many angel investors are founders themselves or former founders and startup operators. This often results in them being “founder friendly” meaning they don’t request as many preferences (that can be harmful employee stock options) as venture capitalists and private equity investors.
However, they are familiar with the ups and downs of startups and will look to protect their investment. Typical preferences angel investors ask for are tag along rights, participating preferred rights, preemptive rights, and warrants.
Venture Capital (Series A and Beyond Funding Rounds)
Venture capitalists (VCs) are professional investors who work for Venture Capital firms that invest other people’s money into startups in return for equity in a business.
VCs usually invest large sums of money ($1 million+) and expect a higher return on their investment than other types of investors. VCs will typically ask for a number of different preferences that optimize their return on investment.
Preferences VCs will request include, but are not limited to:
- Participating preferred rights
- Liquidation preferences (e.g. multiple liquidation preference and Non-participating liquidation preferences)
- Ratchet clauses
- Anti-dilution provisions
- These preferences dilute the value of employee stock and negatively impact the value of an employee’s payout during a liquidity event.
Private Equity (Series B and Beyond Funding Rounds)
Private equity investors are professional investors who work for private equity firms that invest other people’s money into companies that are not publicly traded in return for equity in the business.
Private equity investors usually invest large sums of money ($10 million+) and often have a more hands-on approach than venture capitalists, as they typically look to make operational changes to improve the company’s profitability.
Private equity investors will often look to invest in companies that are underperforming in order to maximize their return on investment. They will request the same types of investor preferences as VCs. However, given that they often invest larger sums of money then VCs they will also request larger multiple liquidation preferences (2X+).
Seed and early-stage investors typically don’t have much say in how a company is run, but later-stage investors (i.e., venture capitalists) often do. This is because they invest large sums of money. They often will take a hands-on approach by requiring a seat on a company’s Board of Directors or the ability to be a Board Observer. As a result, employees should be aware that their equity might be diluted more if the company takes money from later-stage investors.
How Funding Rounds Impact Employee Company Stock Options
Employee stock options give employees the right to buy shares of company stock at the strike price within a certain time period when terms and conditions like a vesting period are met.
Each time a startup raises funding, it will impact the employee stock options pool. The size of the pool is determined by the amount of money raised in the round and the valuation of the company. For example, if a startup raises $1 million at a $5 million valuation, then the employee stock options pool would be 20% ($1 million/$5 million). A 20% employee stock option pool is typical for companies to maintain.
The reason the employee stock option pool is important is that it determines how much equity each employee will own in the company. So, if the company raises another round of funding at a higher valuation, then the employees’ equity will be worth more. However, if the company raises funding at a lower valuation (known as a down round), then the employees’ equity will be worth less.
One thing to keep in mind is that whenever a company raises money from outside investors (i.e., anything beyond friends & family), employees will generally see a dilution in their ownership stake in the company—meaning their percentage of ownership will go down while the percentage owned by outside investors will go up.
However, this dilution can be offset by receiving more stock options at a lower strike price (the price at which you can buy shares). In general, employee stock options become more valuable as a company raises money at higher valuations. When this happens it means there’s more potential upside for employees if/when they exercise their options and sell their shares. Dilution isn’t always a bad thing.
One of the times dilution is harmful to employee stock options is during down rounds. When a company raises a down round it means that the options are worth less than they used to be. In addition, down rounds often result in employees losing their jobs, so an employee may not even have the opportunity to exercise their options when there are buy back clauses (due to being laid off). As a result, it’s generally not advisable for employees to stay at a company that is consistently raising money at lower and lower valuations.
Dilution is also harmful to employee stock options when a company goes public via an initial public offering (IPO) at a valuation that is lower than the last funding round. This can happen when a company takes too long to go public or when the stock market crashes (as happened in 2000 and 2008). In these cases, employees may find that their options are “underwater.” This means the stock options are worth less than the strike price.
When a company performs well and has an exit, such as the acquisition of the company by another company or an IPO, employee stock options can become extremely valuable. This is because employees usually have the ability to cash out their shares at a much higher price than the strike price. Many company exit events have created new millionaires.
When a company performs well employee stock options can be an amazing way to create wealth. The most extreme example of this is the graffiti mural artist who created a mural for Facebook when the company was just starting and opted to receive payment in stock options. The decision paid off for him as his stock options resulted in a payout of $200 Million.
This type of financial outcome is possible when working at a startup however it is the exception as 90% of startups fail. Findings from The National Center for Employee Ownership state that typical stock option payouts are between 12% – 20% of an employee’s base pay.
Of course, there’s always the risk that a company will never exit and the employees will never see any return on their options. This is why it’s important for employees to carefully consider the risks and rewards before taking a job at a startup.
Large employee payouts depend on how well a company performs and:
- The equity percentage an employee holds
- The structure of funding deals
- Terms included or excluded in funding deals that protect the value of employee equity
- The types of preferences given to investors
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Being Offered Equity in a Company (How it works)
Company equity is issued in the form of employee stock options (ESOs) through an employee stock option agreement, a contract that outlines the terms of your employee stock options.
Unless you are offered a restricted stock award or restricted stock units when you are granted employee stock options (eithers ISOs or NSOs) you do not own the stock options, rather the contract gives you the ability to purchase the stock options at a fixed price, more commonly referred to as the strike price or exercise price. The fixed price/strike price is a purchase price lower than the expected future value and price of the stock.
This means when certain conditions are met you gain the right to purchase “cheap” shares and then sell them in the future after the company has grown and become successful. It is this process that makes employees thousands to millions of dollars. Early startup employees that gain the right to purchase larger amounts of stock options at a low strike price have an opportunity, when the company does well, to have a big pay day.
If you are offered a restricted stock award or restricted stock units like ISOs and NSOs you have a stock option plan that outlines terms and conditions to receive the stock such as vesting. Unlike ISOs and NSOs you don’t have to purchase the stock. Once you meet terms and conditions of receiving the stock (like vesting) you own the stock.
Conditions to Purchase Employee Stock Options
The conditions to purchase your employee stock options (either ISOs or NSOs) are generally:
- A one year cliff,
- A cliff vesting schedule of four years, this is a typical vesting schedule of four years with a one year cliff that results in the employee vesting 1/4th of their total number employee stock options after one year of employment and 1/48th of their total number employee stock options each month they are employed at the company thereafter until they are fully vested.
Let’s walk through a vesting example…
Cliff Vesting (Example)
After you complete one year of employment you will vest 75,000 options. This means you have met conditions to purchase the options at the strike price set in your employee stock option agreement.
Given that you have met the one year cliff you will now vest 6,250 options every month you are employed at the company. Giving you the right to purchase the additional options that you vest.
The cliff vesting schedule is something that can be negotiated. How much you can negotiate will depend on things like your seniority, the importance of your job function to the company, your proven track record, and what you will contribute.
Cliff vesting negotiation options:
- No cliff (something that is rare but possible to negotiate, I have negotiated this), this means you would start vesting options immediately
- A cliff shorter than one year, for example three month cliff, six month cliff, or nine month cliff
- Vesting a larger amount of options upfront once the cliff has been hit, for example instead of vesting 25% of your options each year over four years you could negotiate vesting 35% of options once the cliff is hit, 30% options vesting monthly in year two, 20% options vesting monthly in year three, and 15% of options vesting monthly in year four
In order to consider an offer of startup employee equity an employer should provide you the following details:
- Percentage of ownership
- Number of options
- Strike price
- Terms and conditions to exercise options such as a cliff vesting schedule
- Type of equity (e.g. incentive stock options, non qualified stock options, restricted stock award, restricted stock units)
- Restrictions such as the ability to transfer ownership or sell shares at certain times
- Buy back clauses
- Post termination option exercise window
- Value of the equity at the time of the grant
Being Offered Equity in a Company (Determining the value)
Companies typically do not proactively share the value of equity being offered at the time of the offer.
It’s important to know the value of the equity you’re being offered, especially when a company is offering more equity in lieu of base pay, signing bonus, job perks, etc. Knowing the value lets you negotiate for more equity based on the value of anything the company can’t offer you.
For example, if the company can’t offer market pay and the market is paying $20,000.00 more than the company is offering you. You can negotiate for $20,000.00 more in company stock to make up the difference. This negotiation could result in a major payout if the company does well.
To determine the value of the startup equity you are being offered you can use the following formula:
(Preferred price – Strike price) * Number of options = Value of your equity at the time of the grant before paying taxes
If you’re considering accepting a job offer from a startup chances are your job offer includes company equity. The stock options being offered can become extremely valuable or end up worth nothing.
When negotiating your total rewards package it’s important to understand why companies raise funding, how stock options work, and how investor funding can positively and negatively impact the value of your company equity. Understanding this information helps you to negotiate company equity variables that can lead to a large payout in the future.
Company Equity (14 Points of Negotiation)
Now let’s dive into things you can negotiate to maximize your company equity. When you’re negotiating your equity the most important things to consider are how what you negotiate for:
- Maximize your percentage of ownership short-term and long-term
- Protect your ownership of the equity
- Protect the value of the equity during a liquidity event
- Create alignment between you and the company
- Reflect a fair exchange of value, the value you provide to the company to help become a success and the value of the equity to you monetarily
14 Company equity variables you can negotiate:
- ⭐ Percentage of ownership
- The number of stock options granted
- Type of company stock options you’re offered (ISOs, NSOs, Restricted Stock Award, Restricted Stock Units)
- No cliff (not typical but something I have been able to negotiate)
- Cliff time (less than one year)
- Vesting schedule (percent of equity vested each month/year)
- Exercise price
- Cash bonus when there is a liquidity event to cover the cost of taxes associated with your company stock options
- Cash bonus that is equal to the value of the dilution you experience due to investor preferences (you have no control over)
- Whether the stock options are transferable or not
- What happens to unvested options in the event of a change in control of the company (e.g.. single trigger or double trigger accelerated vesting)
- Post termination option exercise window
- Buy back clause that gives you the option not to have to sell back vested options if you leave the company or are laid off
- Anti-dilution provisions (not typical but something I have been able to negotiate)
Company Equity (FAQs)
What is 10% equity of a company?
Common stock is equity that is allocated to employees. When this equity takes the form of incentive stock options (ISO) or non qualified stock options (NSOs) it has to be vested and purchased. When this equity takes the form of restricted stock awards or restricted stock units an employee has to vest it but not purchase it to own it.
Preferred stock is equity that is purchased by investors. Unlike Common Stock it does not need to be vested.
10% equity in a company may mean that it is held by an investor and therefore the investor owns 10% of the company or 10% equity in a company may mean an employee has the right to vest and/or purchase the equity in order to own it.
Is company equity a good benefit?
Before taking a job at a startup, be sure to understand the company’s financial situation and business model. It’s also important to negotiate for the best possible terms on your employee stock options. By doing so, you can maximize your chances of making a profit on your company equity.
What are the 4 types of equity?
The 4 types of employee equity are:
- Incentive stock options (ISO)
Incentive stock options (ISOs) are a type of common stock that can only be granted to employees through an employee stock option agreement. ISOs must be vested and purchased in order for an employee to own the shares. ISOs are commonly used by companies such as tech startups because they have better tax benefits to employees.
- Non qualified stock options (NSOs)
Non qualified stock options (NSOs) are a type of common stock granted to employees through an employee stock option agreement. NSOs can be granted to anyone, regardless of citizenship or residency status.NSOs must be vested and purchased in order for an employee to own the shares. NSOs are taxed as ordinary income when they are exercised, and may also be subject to payroll taxes. They do not receive favorable tax treatment.
- Restricted stock awards
Restricted stock awards (RSAs) are a type of common stock granted to employees through an employee stock option agreement. They are unlike ISOs and NSOs in that they do not have to be purchased, they just have to be vested. While they do not have to be purchased, RSAs are not commonly used because they have heavy tax implications.
- Restricted stock units (RSUs)
Restricted stock units (RSUs) are a type of equity compensation that is generally granted to executives and key employees. RSUs are similar to RSAs in that they must be vested and are owned once vested. RSUs are generally used by late stage startups and public companies.
How do equity owners get paid?
There are several ways that equity owners can get paid, such as through dividends, capital gains, or a company sale.
Dividends are payments companies make to shareholders. They are typically paid out of the company’s profits and can take the form of either cash or stock.
Capital gains are profits that investors gain when they sell their shares for more than they paid for them. For example, if you buy shares of a company for $10 per share and sell them later for $20 per share, you have made a $10 capital gain.
A company sale occurs when the company is sold to another business or taken public through an initial public offering (IPO). Company sales often result in a large payout to the company’s shareholders.
Employees typically do not receive dividends or capital gains from their stock options until they exercise their options and buy shares of the company. However, employees can get paid for their equity when the company sells to another company.
How does getting equity in a company work?
Employees can get equity in a company through stock options. Stock options give an employee the ability to buy shares of a company at a set price if they choose to. The price is typically set at the time the option is granted and is usually below the market value of the company’s shares.
If the company’s stock price increases, the employee can exercise their option, buy shares at a lower price, and then sell the shares for a profit. If the company’s stock price decreases, the employee may choose not to exercise their option and will not incur any losses.
Employees typically have a vesting period for their stock options. This means that they cannot immediately exercise their options and must wait for a certain amount of time before doing so. Vesting periods typically last four years, but they can vary depending on the company.
Questions? Leave a comment.
Now, I’ll turn it over to you!
Did you know you can negotiate a cash bonus to cover the cost of the taxes associated with your company equity? Or, that you can negotiate variables such as the cliff?
Was there something else that surprised you?
I’d love your thoughts. Leave a comment.
When a company performs well the smallest fraction of a percent can result in a payout of tens of thousands to millions of dollars. If you found value in this article please share it with your friends and family or on social media so others can learn how company equity works and what they can negotiate to maximize their company stock options! Thank you.
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