Learn about the basics of equity, stocks, ownership, options, and compensation
Compensation: in general.
Your compensation is everything you get for working for a company. When you negotiate compensation with a company, the elements to think about are cash (salary and bonus), benefits (health insurance, retirement, perks), and equity (what we discuss here). Equity compensation refers to owning stock or having the right to buy stock in a company.
In general, this Guide is focused on equity compensation in corporations, not limited liability companies. The reasons for this are: (i) Corporations are the most common form of startup company in the U.S. (LLCs are rarely used as the choice of entity for technology startups.) (ii) Equity compensation for limited liability companies is dramatically different from equity compensation in corporations.
Equity compensation is commonly used for founders, executives, employees, contractors, advisors, directors, and others.
The purpose of equity compensation is twofold:
(1) To attract the best talent and (2) To align individuals' incentives with the interests of the company. Equity compensation generally consists of stock, stock options, or restricted stock units (RSUs) in the company. We’ll define these concepts next.
Stock
Stock represents ownership of the company, and is measured in shares. Founders, investors, employees, board members, contractors, advisors, and others may all have stock.Stock in private companies frequently cannot be sold and may need to be held indefinitely, or at least until the company is sold. In public companies, people can buy and sell stock on exchanges, but in private companies like startups, usually you can’t buy and sell stock easily. Public and some private companies can pay dividends to shareholders, but this is not common among technology startups.The total number of outstanding shares reflects how many shares are currently held by all shareholders. This number starts at an essentially arbitrary value (such as 10 million) and thereafter will increase as new shares are issued. It may increase or decrease for other reasons, too, such as stock splits and share buy back.If you have stock, what ultimately determines its value is percentage ownership of the entire company, not the absolute number of shares. To determine the percentage of the company a certain number of shares represents, divide it by the number of outstanding shares.
☝️However, there are subtleties to be aware of regarding what this outstanding total refers to: Private companies always have what is referred to as “authorized but unissued” shares. For example, a corporation might have 100 million authorized shares, but will only have actually issued 10 million shares. In this example, the corporation would have 90 million authorized but unissued shares. When you are trying to determine what percentage a number of shares represents, you do not make reference to the authorized but unissued shares. You actually want to know the total issued, but even this number can be confusing, as it can be computed more than one way. Typically, people refer to the total number of shares “issued and outstanding” or “fully diluted.”
“Issued and outstanding” refers to the number of shares actually issued by the company to shareholders. Note this will not include shares that others may have an option to purchase.“Fully diluted” refers to all of the shares that have been issued, all of the shares that have been set aside in a stock incentive plan, and all of the shares that could be issued if all convertible securities (such as outstanding warrants) were exercised. A key difference is that this total will include all the shares in the employee option pool that are reserved but not yet issued to employees. (The option pool is discussed more below.) Generally, it’s best to know the fully diluted number to know the likely percentage a number of shares is worth in the future. The terminology mentioned here isn’t universally applied, either, so it’s worth discussing it to be sure there is no miscommunication.
What is your stock worth?
It is hard to value private company stock. A stock certificate is a piece of paper that entitles you to something of highly uncertain value, and could well be worthless in the future, or highly valuable, depending on the fate of the company.
🔸 Generally, selling stock in a private company may be difficult, as the company is not listed on exchanges, and in any case, there may be restrictions on the stock imposed by the company.
In startups, it is typical to hold the stock until the company is sold or becomes public in an IPO.
A sale or IPO is often called an exit.
Sales, dissolutions, and bankruptcy are sometimes called liquidations.
🔹 Private sales: In a few cases, you may be able to sell private company stock to another private party, such as an accredited investor who wants to become an investor in the company, but this is fairly rare.
This is often called the secondary market. Sales generally require the agreement and cooperation of the company.
For example, typically your shares would be subject to a right of first refusal in favor of the company (meaning you couldn’t sell your shares to a third party without offering to sell it to the company first).
Another possible roadblock is that private buyers may want the company’s internal financials to establish the value of the stock, and this typically requires the cooperation of the company. There have been some efforts such as SharesPost, Equidate, and EquityZen to establish a market around such sales, particularly for well-known pre-IPO companies, but it’s still not a routine practice.
Kinds of stock
Stock comes in two main types, common stock and preferred stock. You’ll also hear the term founders’ stock, which is (usually) common stock allocated at a company’s formation. It’s complicated, but in general preferred stock is stock that has rights, preferences, and privileges that common stock does not have. For example, preferred stock usually has a liquidation preference, which gives the preferred stock owner the right to be paid before the common stock owners upon liquidation. Liquidation overhang refers to how much liquidation preference is ahead of the common stock. For example, if the company has received hundreds of millions of dollars in investments from investors, the common stock will not be worth anything on a sale unless the sale price exceeds the liquidation overhang.Generally employees and service providers receive common stock or options to purchase common stock in return for their service, and investors receive preferred stock.
Stock Options
Stock options (called “employee stock options” when given to employees) are contracts that allow you to buy shares. When you buy shares, it’s called exercising the options. Options are not the same as stock; they are only the right to buy stock upon and subject to the conditions specified in the option agreement.Stock options allow you to buy shares at a fixed price per share, the strike price. The strike price is generally set lower (often much lower) than what people expect will be the future value of the stock, which means you can make money when you sell the stock.Options expire. You need to know how long the exercise window will be open.Options are only exercisable for a fixed period of time, typically seven to ten years as long as you are working for the company.
❗ Importantly, options can expire after you quit working for the company. Often the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point.
Recently (since around 2015) a few companies are finding ways to keep the exercise window open for years after leaving a company, and promote this as fairer to employees. See this list, which includes Amplitude, Clef,Coinbase, Pinterest, and Quora.
🔸 Vesting: Stock and stock options may be granted to you, but they come with a variety of conditions and limitations. One of the most significant conditions is that you usually “earn” rights to the shares or options over time or under certain events. This is called vesting.Vesting usually occurs according to a vesting schedule. You vest only while you work for the company.
For example, it is very common to have stock or options vest over a period of four years, a bit at a time, where none of it is vested at first, and all of it is vested after four years.
Vesting schedules can also have a cliff, where until you work for a given amount of time, you are 0% vested. For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you have not vested in any part of your award.
Similarly, if the company is sold within a year, depending on what your paperwork says, you may also receive nothing on the sale of the company. A very common vesting schedule is vesting over 4 years, with a 1 year cliff.
This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and 1/48th (2.08%) more vesting each month until the 48th month. For example, if you leave just before a year is up, you get nothing, but if you leave after 3 years, you get 75%.Vesting might also occur in certain situations. You may have acceleration, where vesting is triggered if a company is sold (single trigger) or if it’s sold and you’re fired (double trigger). This is common for founders and not so common for employees. Grants for advisors typically vest over a shorter period than employee grants, often two years.
📥Advisor grants also typically have a longer exercise window post termination of service. Typical terms for advisors, including equity levels, are available from the
Founder Institute’s Founder/Advisor Standard Template (FAST).
RSUs
Restricted stock units (RSUs) refer to an agreement by the company to issue you shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that you will receive in the future. The date on which you receive the shares or cash payment is the settlement date.🔸
RSUs may vest according to a vesting schedule. The settlement date may be the time-based vesting date or a later date based on, for instance, the date of a company’s IPO.Both options and RSUs are common forms of equity compensation, with RSUs more common for larger companies and options more common for startups. RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares. This is not a bad result when the company has sufficient capital to help the employee make the tax payments, or the company is a public company that has put in place a program for selling shares to pay the taxes. But for cash-strapped private startups, neither of these are possibilities. This is the reason most startups use stock options rather than RSUs, stock bonuses, or stock awards.RSUs are often considered less preferable to grantees since they remove control over when you owe tax. Options, if granted with an exercise price equal to the fair market value of the stock, are not taxed until exercise, an event under the control of the optionee. If a company awards you an RSU or restricted stock award which vests over time, you will be taxed on the vesting schedule. You have been put on “autopilot” with respect to the timing of the tax event. This can be a really bad thing if, on the date of vesting, the shares are worth a lot and consequently you owe a lot of tax.
You don’t want to confuse “restricted stock units” with “restricted stock,” an entirely different thing (described next).
Other Equity Concepts
These are a few different types of equity awards and topics that are less common, but we mention for completeness.
“Phantom equity” is a type of compensation award that references equity, but does not entitle the recipient to actual equity in the business. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a company’s stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something. Two examples of phantom equity are phantom stock and stock appreciation rights: A phantom stock award entitles you to a payment equal to the value of a share of the company’s stock, upon the occurrence of certain events.
Stock appreciation rights (SAR) give the recipient the right to receive a payment calculated by reference to the appreciation in the equity of the company.Warrants are another kind of option to purchase stock, generally used in investment transactions (for example, in a convertible note offering, investors may also get a warrant; or a law firm may ask for one in exchange for vendor financing). As an employee or advisor, you may not encounter warrants, but it’s worth knowing they exist. They differ from stock options in that they are more abbreviated and stand-alone legal documents, not granted pursuant to a “plan.” Also, because they are usually used in the investment context, they do not typically include service-based vesting provisions or termination at end of service, and are valid for a set number of years (often, 10 years).
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