The Ins and Outs of Equity Compensation for Startups

Casey Fenton

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November 18, 2023

Do you want to attract top talent to your team, but struggle to compete with the big guys on salary alone? Fear not, because startup equity compensation can give you an edge in the war for talent. By offering equity ownership in your company, you're not just offering a job—you're offering a stake in the future of your business. And when your employees have skin in the game, they're more likely to work harder and stay with you through thick and thin.

But before you start handing out equity packages left and right, it's important to understand the ins and outs of equity compensation. From types of equity compensation to vesting schedules and tax implications, there's a lot to consider when it comes to offering employee equity. In this article, we'll break it all down for you so you can make informed decisions about how to offer startup equity compensation to your team.

So, whether you're an early-stage startup trying to retain your first few or early stage employees or a more established company looking to keep your top talent engaged, read on to learn everything you need to know about equity compensation for startups.

Understanding Equity Ownership and Value

Equity ownership is the ownership percentage of the company that an employee “owns” through startup equity compensation. This equity value is the current value of the employee's equity stake in the company. It is determined by the company's stock value, which is usually the fair market value.

The value of an equity can change over time as the company's stock value increases or decreases. Equity ownership and value are important because they determine how much an employee will earn if the company is sold or goes public. As the company's value increases, the value of an employee's equity stake also increases.

Retention and Employee Turnover

Startup equity compensation can help to minimize employee turnover by incentivizing employees to stay with the company for a longer period of time. Retaining early stage employees is particularly important because they can be instrumental in the company's growth.

Profit Sharing and Liquidity Event

Equity-based compensation can also be used to offer profit sharing to employees. This can be structured in different ways, but it usually involves distributing a percentage of the company's profits to employees who have equity ownership.

A liquidity event, such as an initial public offering (IPO), can also provide a way for employees to cash in on their equity compensation. When a company goes public, employees with equity ownership can sell their equity grants on the open market.

Navigating Vesting

The vesting schedule is the period of time over which an employee's equity compensation will vest. This can be structured in different ways, but the most common vesting schedule is a four-year vesting with a one-year cliff.

A four-year vesting schedule means that the equity compensation will vest over four years. The one-year cliff means that the employee will not receive any equity compensation until they have worked for the company for one year. After the one-year cliff, the equity compensation will vest on a monthly or quarterly basis.

Types of Equity Compensation

There are several types of equity compensation that a startup can offer its employees. The most common types are:

1. Stock Options

These are contracts that give employees the right to purchase company stock at a specified price, known as the strike price. The strike price is usually the fair market value of the company's stock at the time the option is granted. Stock options are a form of startup employee equity that offers workers the potential to profit from the company's growth without having to invest their own money.

In addition to regular stock options, there are two subcategories of stock options that startups can offer to their employees: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).

Incentive Stock Options (ISOs)

ISOs are a type of stock option that is granted to employees with certain tax benefits. The employee does not have to pay ordinary income tax on the stock option grant or exercise and instead pays capital gains tax on the difference between the strike price and the fair market value of the stock at the time of exercise. To qualify for these tax benefits, the employee must hold onto the stock for at least two years from the grant date and one year from the exercise date. ISOs are typically offered to key employees or executives and can be a valuable tool for attracting and retaining top talent.

Non-Qualified Stock Options (NQSOs)

NQSOs are a type of stock option that does not have the same tax benefits as ISOs. The employee must pay ordinary income tax on the difference between the fair market value of the stock at the time of exercise and the exercise price. NQSOs are typically offered to a wider range of employees, including rank-and-file employees. One advantage of NQSOs is that they can be granted a lower exercise or strike price than ISOs, which can make them a more attractive form of employee equity.

2. Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are grants of company shares that vest over a period of time. Unlike stock options, Restricted Stock Units (RSUs) have a fair market value when they are granted. RSUs are a popular form of equity compensation because they offer employees a guaranteed company equity value that will vest over time.

3. Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) are grants of company shares that have restrictions on their transferability until they vest. Restricted Stock Awards (RSAs) are similar to RSUs, but they are more restrictive because they cannot be sold or transferred until they vest.

How Much Company Equity to Offer to Employees

Offering equity compensation can be a powerful incentive for employees, but it is important to offer the right amount of company equity. Offering too little equity can make it difficult to attract and retain talented employees while offering too much equity can dilute the company's ownership and decrease its value.

When deciding how much to offer equity compensation, it is important to consider the following factors:

1. The stage of the company

The stage of the company is a crucial factor in determining how much to offer equity compensation. Early stage startups may need to offer more equity to attract and retain talent, as they often have limited cash flow and a higher degree of risk. On the other hand, later stage startups that have already gained traction may not need to offer as much equity to attract talent.

2. The role of the employee

The role of the employee is also an important consideration when planning equity-based compensation. The senior engineer and the board member, for instance, may require more equity than junior employees to reflect their higher levels of responsibility given to the senior engineer and a board member, as well as their contribution to the company's success.

3. The company's valuation

The company's valuation is another critical factor to consider. A higher company valuation generally means that the company's stock is worth more, which can reduce the amount of equity needed to be competitive with other offers. Conversely, if the valuation is low, it may need to offer higher equity compensation to be competitive.

4. The employee's cash compensation

When deciding how much equity to offer, it is important to take into account the employee's cash incentives. Early employees who receive a lower cash salary and equity compensation may require more stock-based compensation to balance out their total compensation package.

5. The vesting period

The vesting period, or the amount of time an employee must work at the company before becoming fully vested in their equity grant, is another important factor to consider. A longer vesting period may require greater equity compensation to retain employees, as the longer time horizon may be perceived as a greater risk.

In addition to those listed above regarding how much equity to offer early employees, startups should also consider the strike price or the price at which employees can purchase company stock through their equity grant. A lower strike or exercise value can make the equity grant more attractive to employees, but it can also lead to higher dilution for existing equity holders if the company's value increases over time.

Overall, planning equity compensation for employees requires careful consideration of a variety of factors, including the stage of the company, the role of the employee, the company's value, the employee's cash compensation, the vesting period, and the strike price. By offering the right amount of equity, startups can attract and retain employees while minimizing dilution and maximizing the value of the company's equity.

Equity Compensation Structuring

Equity compensation is an important part of employee compensation for startups. It offers employees partial ownership in the company and can be a powerful incentive to work harder and stay with the company for a longer period of time. However, it is important for both the company and the employee to understand the tax ramifications of equity compensation and to offer the right amount of equity to attract and retain talented employees.

To ensure that it is structured properly, startups should have an equity compensation plan in place. The equity compensation plan outlines the types of equity compensation that the company can offer, the vesting schedule, and other important details. An equity compensation plan can also help to ensure that equity is distributed fairly and that employees are incentivized to work towards the company's goals.

Here are the concepts you need to study about for your startup equity compensation planning:

1. Fair Market Value (FMV)

FMV is the price at which a willing buyer and seller would agree to transact in an arm's length transaction. FMV is important because it determines the value of the company's stock for tax purposes and also affects the exercise price of options.

2. Stock Price

The stock price of a company is the price at which its shares are trading on the open market. When planning equity compensation, the stock price is important because it determines the value of the equity being offered to employees.

3. Exercise Price

The exercise price is the price at which an employee can purchase stock options. This is usually set at or above the FMV of the company's stock at the time the options are granted. This is to ensure that the options are granted at a fair price and to avoid any potential tax consequences for the employee.

4. Company Valuation

Company valuation is the process of determining the value of a company. This is important for the equity compensation plan because it affects the FMV of the company's stock and can also impact the company's ability to attract startup investors like venture capital.

5. Capital Gains

Capital gains tax is a tax on the profit earned from the sale of an asset, such as company stock. When planning equity compensation, it's important to consider the potential tax liability for employees who exercise their options or sell their stock.

Tax Implications of Equity Compensation for Startups

Startup equity compensation has different tax implications for both the company and the employee. It is important for both parties to understand the tax obligations before accepting equity compensation.different tax implications

For employees, the tax implications depend on the type of equity compensation they receive. Stock options are taxed as ordinary income when they are exercised. RSUs and RSAs are taxed as ordinary income upon vested equity. Employees who accept equity compensation should be prepared to pay taxes on the value of the equity at the time it is taxed.

For the company, the tax consequences depend on the FMV of the company's stock. If the company's stock value increases, the value of the startup equity compensation will also increase. This means that the company will owe more in taxes as the value of the startup equity compensation increases.

Equity-Based Compensation Solutions For Every Business Stage

Equity compensation is an important part of employee stock compensation for startups. It offers employees partial ownership in the company and can be a powerful incentive to work harder and stay with the company for a longer period of time. However, it is important for both the company and the employee to understand the tax liability of startup equity compensation and to offer the right amount of equity to attract and retain talented employees. 

Regardless, by having an equity compensation plan in place, startups can ensure that equity is distributed fairly and that employees are incentivized to work towards the company's goals.

Here at Upstock, we understand how you want your employees to feel valued. That’s why we have created a no-fuss, cost-efficient equity management platform that centralizes all your employee equity needs. Leave us a message here and one of our representatives will get back to you for more info!

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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