Whether you consider it a perk or a consolation prize, one of the realities of working for an early-stage startup is that your compensation will likely include some amount of equity. For many first-time startup employees, what equity is, how it works, and what it’s worth aren’t necessarily obvious. Most people considering working for a startup understand the idea of equity—you get “shares” and eventually, maybe they make you a millionaire—but might not have a great handle on the specifics. We thought it would be helpful to clarify a few things.
What is Startup Equity?
Every company has owners. For simpler companies (i.e. a standalone hat store) there might just be one owner, typically the person who started the business or purchased it from a previous owner. Startups and larger corporations, however, usually have many part-owners, generally called “shareholders.” Owners can be people or companies, but each is in control of a set amount of the overall company, which provides them with profits or dividends in some cases or a piece of the payout if the company is sold, along with some rights specific to their type of ownership. That set amount of ownership is called “equity.”
What kind of owners, how they own the company, and how the company distributes ownership all depend largely on the type of company, of which there are many, depending on the state in which the company was incorporated. The most typical legal type of company that startups choose (for reasons related to taxes and convention) is the Delaware C-Corporation. While many startups initially choose to be LLCs, they generally eventually have to convert to C-Corporations, so for the purposes of this article, we’ll only be discussing equity in C-Corporations.
C-Corporations are divided into a large number (commonly 10,000,000 at first) of “authorized shares” of stock. When the company “issues” a portion of these shares, they become the property of the person to whom they were issued. If the company has issued 8,000,000 shares, each of these shares of stock represents 1/8,000,000 of the overall value of the company—the remaining 2,000,000 unissued shares don’t count towards the ownership, because nobody owns them. For startups, most of this stock (and therefore most of the company) is owned by the founders. These shares are called “common stock.”
Price Per Share and Fair Market Value
To issue shares, the company must specify what each share costs. Each share’s price is determined by dividing the “fair market value” of the company, i.e. what the company is worth, by the number of issued or outstanding shares. So, what’s the company worth?
Shares can’t be given away for free, but a new company is typically worth nothing (because it has no assets) at the time that the founders grant themselves common stock. As a result, founders generally buy their shares at a nominal “par value” (which is established for accounting and compliance purposes) of, say, $0.00001 per share (which, for 10 million authorized shares, makes the maximum total value of the company $100).
The first time the company is usually said to be worth more than that $100 is at the first fundraise, which typically triggers two related events: first, a new valuation, and second, the creation of an option pool.
An option pool is an amount of shares specifically set aside to grant as stock options to employees (or advisors). These are subtly different from common stock—rather than directly representing ownership themselves, stock options represent the right to buy a certain amount of common stock. So, if you were to be granted 15,000 stock options, you could (eventually) purchase 15,000 shares of common stock. The reason that these are more advantageous for employees than simply being granted common stock down the road is that options have a “strike price” set at the time of grant, which is derived from the fair market value.
At this point, the value of the company is agreed upon between the founders and the investors. The investors agree to buy a percentage of the company for a certain amount, from which a price-per-share and a total valuation can be derived: if it’s $200,000 for 25%, then the company’s “pre-money valuation” is $1,000,000, and the price-per-share is $1,000,000 divided by the number of all outstanding and issued shares, including the entire option pool. After the round is concluded, the company will be worth $1,200,000, the “post-money valuation.”
Options and Strike Prices
Let’s say that, after the first fundraise, the company is said to be worth $1,200,000. The two founders each have 2,500,000 shares, investors received an additional 2,000,000. The company allocated 1,050,000 more shares to the option pool (which is usually kept at around 10–15% of total ownership). What is the strike price of one of these options?
The price per share comes from a very simple formula:
fair market value / # of issued and outstanding shares and warrants = price per share
So in our case,
$1,200,000 / 8,050,000 = $0.149
Why is this important? The answer is that typically no one except investors receives their grant all at once. To make sure that employees (and founders) stick around to actually do the work they were expected to do to earn their shares, nearly all stock and option grants include a mechanism called “vesting.”
What is Vesting? How Does it Work?
Vesting is the practice of distributing an equity grant over a period of time, rather than all at once. By far the most typical vesting schedule is four years with a one-year “cliff.” What this means is:
No equity accrues to the grantee for a year
At the one-year mark, ¼ of the grant “vests,” i.e. accrues to the grantee
Over the next three years, the remaining ¾ of the grant vests at a regular rate
So, for an employee who received a 15,000-share option grant at the first fundraise’s strike price of $0.149 in our last example, they won’t actually be able to “exercise” all their options (i.e. buy their shares) until four years later, at which point the value of the company (hopefully) will be significantly higher.
Let’s say that four years have passed, and the company has just completed its third round. Its valuation is now $10 million. For the sake of simplicity, we’ll skip all the cap table math and just say that there are now 15,000,000 outstanding and issued shares. What’s our current price per share?
$10,000,000 / 15,000,000 = $0.667
Our grantee’s strike price was set at $0.149 at the time of grant, so to purchase their shares, they only need to pay $2235—but the shares of stock are now “worth” $10,005. Now, let’s talk about why we just put “worth” in quote marks.
When is Equity Worth Something?
The entire point of equity is to incentivize employee and founder performance to maximize the value of the company as a whole (and to compensate for generally lower salaries than are available at a more established company). That’s one reason why vesting is so important—you earn your equity at the same time you’re working to make sure its value goes up. But when does it turn into actual money?
The answer, unfortunately, is “not often.” Most startups fail. For this reason, it’s generally good advice to consider equity to be more like free lottery tickets than a form of compensation you can count on to pay your bills eventually. Even once your options have vested and you choose to buy them outright (which usually only happens when an employee leaves the company; otherwise there’s no pressure to actually buy the shares), you can’t sell them because the company is privately owned. Those shares will only turn into actual money when there is a liquidity event of some sort—either the company is sold to another company, or it goes public, converting all privately-held equity into publicly-tradable shares that can be sold on the stock market. In the former case, usually all remaining options will vest instantly and you will be given the value of your shares less the cost to buy them (and you’ll also have to pay taxes on the gains). In the latter, you can choose to hold or sell as you would with any other public-company stock.
On the other hand, when the startup does have a successful exit, the results for you as an employee can sometimes be pretty dramatic. There are many, many complicated layers of considerations in an exit scenario: debt must be repaid, some convertible debt may convert to ownership and dilute your shares’ percentage, value is paid out according to a preference order of different classes of equity, etc. But if the sale price is significant and the company is pursuing the exit because it’s a good deal for the investors and owners (including you), there’s a serious chance that your stake in the company will be worth a lot more than it was when you were employee five and the strike price was just a few pennies.
There are many, many more startup equity situations you may come across in your career. Some startups choose to issue restricted stock units (RSUs) instead of options, especially after they’ve grown to a certain size. You may also find it helpful to understand the concept of dilution, which is especially relevant when it comes to understanding the specifics of how option pools are sized—the canonical explanation for this process is “The Option Pool Shuffle,” which is written for a startup founder audience. There are also more thorough explanations of equity terms and concepts from Carta and Gust. In addition, it’s worth noting that the fundraising example here is for a traditional priced round—today, many startups choose to first raise money using either a convertible note or a Safe note, which both have slightly different consequences for employee equity.
As always, this information is intended to help you understand how startups work, and should not be taken as advice of any sort. For advice related to your specific situation, consult a lawyer or tax advisor.
Fair market value is actually slightly different from the valuations agreed upon by investors and founders in a fundraising negotiation. To issue options, companies usually seek an independent valuation from a third party to comply with IRC § 409A. This 409A report establishes fair market value of the company for tax purposes and provides option grantees “Safe Harbor Protection,” which shields them from personal fines in the event that they or the company are audited. Safe Harbor Protection also puts the onus on auditors to prove that the price-per-share isn’t justified, rather than on grantees to prove that it is.
There is also sometimes a scenario where employees are given the option to sell a percentage of their equity (say, 15%) at later-stage companies directly before another fundraise. The equity is typically sold to the investors. This often happens at an oversubscribed round, so that the investors can buy more of the equity they want and employees can take a little money off the table.