Understanding Equity Compensation In Tech

*This is not financial advice, please don't sue me 🙂

What is equity?

Equity is “having ownership in something”. Many startups aspire to be publicly traded on the stock market, and the road to get there is long and tedious. Along the way startups reward their early employees with generous options or grants to make up for a lack of cash to hand out in salary form. Companies that are already public also use equity as an incentive to reward employees in a way that ensures they have incentive to work towards long term goals, and not just collect a paycheck.

Why do shares/stocks exist?

Some quick semantics to clear up: The terms “stocks” and “shares” are generally used interchangeably. For example, you could say you own “100 shares of Apple” or just “Apple stock.”

Stocks are used to split ownership of a company. The shares of a new company are usually split between the founder(s) and a company treasury, which is the general term for stock that can be used for other purposes. Other purposes include selling stock to early venture capital investors in exchange for cash, incentivizing new employees, and selling shares from the treasury onto the open market to raise capital once public.

How are share prices determined?

If your company is publicly traded on the stock market, the price of a share is a reflection of what the market thinks your company is worth. This used to be based on your company's assets and revenue projections, divided by the number of shares. There are also many instances where share value is based on hype instead of fundamentals. I’m writing this in 2024, and the stock market is currently a circus. There’s really no rhyme or reason to stock prices right now. Many large companies currently have inflated stock prices because giant retirement funds need somewhere to park money, and many innovative startups that should have a hype premium have seen their stock prices battered into the ground.

If your company is private, your share value is determined by a regular 409A valuation by a third party.

Vesting Schedules

Most equity, regardless of type, is subject to a vesting schedule. This means that you gradually earn your shares over time. The vast majority of vesting schedules are four years long with a one year cliff. This means that you do not receive any of your shares until one year of employment, at which point 25% of your shares will “vest” and belong to you. The remaining 75% will be vested over the remaining three years, usually on a monthly or quarterly basis.

Not all equity is subject to a vesting schedule. Some companies will hand out fully-vested equity as a cash bonus alternative, as part of promotions, or it can be given out company-wide to celebrate a collective milestone. Equity you earn after your initial grant when hired is called a “refresher”.

Once your equity vests, it’s yours regardless of if you leave the company. 

Liquidity Events

When you join an early stage startup that’s still private, you’re banking on them having a “liquidity event” some day so that your equity can be worth something. A liquidity event is something that  turns your illiquid (unsellable) shares into a cash equivalent. Most startups aim for an Initial Public Offering (IPO) or an acquisition. Until one of these events happens, your equity is just a number recorded on Carta. You cannot buy a Lambo with a Carta screenshot, you must yearn for a liquidity event to change your life.

Initial Public Offerings:

When a company gains enough momentum, they can “go public”, offering their shares for sale on the public stock market. There aren’t strict rules regarding which companies can go public and when, but timing it wrong can be catastrophic. In a normal market, companies usually want to reach a certain size and achieve certain revenue goals for an IPO to make sense. However, during hot markets companies often IPO with no profit, while operating at a loss, with their value entirely being derived from expected future performance. Uber was a great example of this, and has since turned a profit.

An IPO allows employees and early investors to sell their shares on the stock market whenever they want to, making them liquid. If you own shares of a startup that’s not publicly listed, they have a value determined by regular (often annual) valuations, but there usually isn’t anywhere to sell your shares. An IPO fixes this problem.

It’s worth mentioning there are some situations where you can sell shares pre-IPO, and some startups have tried to create a marketplace for this, but the concept hasn’t really taken off.

Acquisitions:

If you’re helping build a disruptive startup in a space with larger competitors, an acquisition is your more likely liquidity event. Another company will offer to buy your startup for a certain amount of money per share. This is great because you’ll know exactly how much money you’ll walk away with once the acquisition happens, whereas with an IPO it’s often still a mystery due to market fluctuations. That said, an acquisition squashes the dreams of a stock market runup where your shares could continue to gain value post-IPO if your company had gone down that route. Another downside is that there are often mass layoffs after an acquisition, your job is much safer with an IPO.

Two Major Types of Equity

Every equity agreement is different. You’re usually dealing with RSUs or options. Most setups follow what I’m describing below, but make sure to read the fine print in any agreement you sign. If you’re at a later stage in your career, please do yourself a favor and have a lawyer review your agreement.

Restricted Stock Units, AKA RSUs

RSUs are stock grants. A “grant” means that it is given to you at no charge. The “restricted” part of RSU means there are some hoops to jump through to get them, with a vesting period being the most common restriction.

At a pre-IPO startup, RSUs work like this:

A certain amount of RSUs are included in your job offer, with a four year vesting period + one year cliff. A year goes by without a liquidity event, and your shares start vesting. The amount of shares you’ve vested are recorded by your company, which probably uses Carta to keep track of this. You don’t typically have an option to sell them at this point. 

If your startup IPOs a year later, the shares you have vested will then become liquid shares on the stock market that the company sends to the brokerage account of your choice. If you stay employed through the rest of your vesting schedule, the rest of the shares will be sent to your brokerage instead of simply being a number on your Carta account every time you vest.

If your vesting schedule ends without your startup having a liquidity event, they remain yours, but only as a number in a Carta ledger. If your startup sells a few years later, you will be sent the public shares whether you are employed at the startup or not. 

RSUs at a public company:

RSUs at public companies are much simpler to understand: They just send you the shares when you vest. This is common at FAANG companies and large enterprises. Trying to determine what your shares will be worth years in the future is a bit of a crapshoot, but if you’re at a company with a steady stock price, or with consistent long term growth, you can get an idea of how much those shares will be worth when considering your job offer. Some employees sell their shares immediately after vesting and treat them like cash, while others hold onto them if they think their company will remain on an upwards trajectory. If you stay at the company for a while and your RSUs become a significant part of your net worth, it’s often wise to sell some and diversify your investments.

Options

Stock options give you the right, but not the obligation, to purchase shares at your company at a predetermined price.

At a pre-IPO startup, options work like this:

As part of your job offer, your employer gives you 10,000 options on a typical four year vesting period. On the day that you were hired, a recent 409A valuation values your shares at $1 each. This means that no matter what the stock price fluctuates to in the future, you have the option to buy these shares for $1 once they’re vested.

Buying your shares once vested is called “exercising” an option. Most people do not exercise their options at private companies until after there is a liquidity event, or when they leave the company. Companies usually require you to exercise your options within 30-60 days of your departure. If you think the company has potential, it could be worth buying them on the way out. If it’s clearly a dumpster fire, best to cut your losses and not spend money on a failing investment.

Lets say your startup IPOs at $20/share three years into your employment. At this point you’d have 7,500 shares vested. You can purchase those 7,500 shares for $7,500, but they’ll be worth $150,000 when they hit your brokerage. Congrats - you just spent $7,500 to make $142,500! Make sure you talk to an accountant before doing so, because the government will be eager for their cut. Our endless global wars aren’t going to pay for themselves!

Options at a public company:

Options at public companies aren’t really common. When they do happen, you’re usually granted options at a discount to the stock price on the day you’re hired. So lets say the company you join is currently trading for $80/share, they may give you the option to buy shares at $60/share once you’re vested. This could be great if the stock price is $100 a few years into your employment, or could be useless if the price drops below $60. Instead of offering options, companies will often let you take part in an employee purchase program where you can buy shares at a set discounted price on a regular basis instead of being locked into a long term option situation.

Dilution

Dilution is when your percentage of company ownership drops due to more shares being created by your company. This doesn’t necessarily mean your equity is worth less, but that can be the case if your company creates too many new shares. If you’re at a pre-IPO startup, your shares get diluted every time your company raises a new round of funding. Your shares get diluted due to new shares being issued to investors who give the company cash in return. 

If you initially accepted a job offer at a series-A startup where you got .1% of the company’s shares, you could be diluted down to half or even a tenth of that percentage by the time the company IPOs. If dilution causes the value of shares to drop, companies will often grant extra equity to existing employees as “refreshers”.

Taxes

If you are signing an agreement with a significant amount of startup equity, you need to consult with an accountant knowledgeable on this topic. Many aren’t, so you’ll want to shop around for someone in a tech-heavy major city. Many of the actions I described above are considered taxable events. Laws on capital gains are constantly changing (and a hot topic during this election season), so don’t rely on a Google search or an LMM for tax advice.

Fin.

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