In this article on evaluating startup offers, we discuss:
What’s typically shared about equity:
- Type of Equity – Incentive stock options (ISOs), Non-qualified stock options (NSOs), Restricted stock units (RSUs)
- Number of stock options or RSUs
- The vesting period of the equity
- Share price (typically the preferred share price paid by investors in the last round)
How does company equity work?
When a company is formed, shares are assigned among the founding members to reflect ownership in the business. In some cases, shares are reserved for future team members. For tax purposes, those initial shares have a very low value (typically a fraction of a cent).
When the company raises money, they’ll set a valuation with the investors and sell them new shares at this new price per share.
New valuation = (Existing shares + New shares being sold) x New price per share
The investors may also require that the company create an additional pool of equity that can be granted to future employees. That’s included in this valuation. This process of issuing new shares and setting a new value typically happens each time the company raises equity capital.
The investor shares are generally “preferred shares” versus the “common shares” of employees. In some scenarios both share types may be worth the same value. Other times the value may be widely divergent. More on that later.
How much equity are you actually being offered?
The future value of your equity is largely determined by an unknowable future share price. However, there are plenty of variables known when your offer is made that can help you understand its potential.
- How many fully diluted shares are outstanding in the company? This allows you to determine the percent of the company that your equity package represents.
- What is the cost to exercise each share? This is based on the company’s 409a valuation. It’s a discounted value from the preferred price. Typically the amount of that discount gets smaller as the company gets closer to an exit.
- What are the advantages of preferred vs. common shares? If the share price at exit is significantly higher than the last round, this may not matter. However, if the exit price is lower or even only modestly higher, preferred shares may end up with a disproportionate amount of the company value. For instance, there are scenarios where the preferred shares will get 2x their investment before the common shares are paid out.
What has to happen for me to own it?
Employee equity is typically structured in a way that employees do not have to pay any taxes to receive it. However, that means that employees typically do not “own” their equity outright. There is a vesting component, usually over four years, though there are other considerations.
For stock options, you’ll have to pay the exercise cost before you own the shares. This is important because even if you are vested in the equity, you likely will have to exercise within 90 days if you leave the company for any reason (including being fired). For RSUs, they may not vest until the company has a liquidity event.
What will it be worth?
While the future value of your equity is impossible to precisely predict, there are factors you can consider when it is issued.
- Will I be at the company long enough for all of my equity to vest?
- What are a few potential scenarios of the overall value of the business at an exit (or when you can sell shares)?
- How much capital will the company need to raise to get to that future valuation? Each round of new capital will dilute the overall % of the company your initial equity represents.
- How many employees or other stakeholders will receive equity beyond the pool that has been allocated to date?
How much will I be able to net after taxes?
Different equity types and actions you take along the way will impact the amount of cash value you ultimately receive from your shares.
- Can you early exercise? If you cannot, you will only be able to exercise as the equity vests. Also, you could subject to taxes in addition to the exercise cost.
- If early exercised, might the shares be eligible for Qualified Small Business tax treatment? This could make your gains tax free.
Give our 1:1 Equity Tax Planning sessions a try
The more of these factors you understand, the closer you can get to predicting the value of your equity. Our Equity Tax Planning Sessions can help you with exercise strategies and tax projections as you’re navigating your offer. Learn more about those sessions here.