A Guide to Startup Equity Compensation

Introduction

For new companies, money can be tight and founders can be stretched thin trying to handle all of the jobs a company needs to serve its customers. This often leaves entrepreneurs with a dilemma: do we hire more people and risk running out of money for operations, or do the founders continue trying to juggle it all and risk burning out or making major mistakes? This is where startup equity compensation may help.

Startups can offer equity compensation as a supplement to employee salaries without paying more money from a limited budget as the business is getting started. 

So what is equity compensation, and how can it benefit startups and their employees? Let’s dive into how equity compensation works for startups.

What is Startup Equity Compensation?

Startup equity compensation is when a new company offers its employees a portion of ownership in the company as part of the payment for each employee’s work. By offering equity compensation, startups have a way to still attract top talent, even if they have to pay a lower salary upfront. 

Depending on the type of startup equity compensation, the employees will later be paid out for their portion of ownership, such as if the company merges with another company, gets acquired, or goes public with an Initial Public Offering (IPO), after which employees could sell their shares.

But equity compensation has strict rules and regulations, especially regarding taxes, for employers and employees to follow. Startup companies and potential employees should understand how startup equity works and the benefits and risks before making any agreements.

How Does Startup Equity Compensation Work?

Individual stock agreements for startup equity compensation will vary on a case-by-case basis, but in general, equity compensation works by offering stocks, shares, or other forms of partial company ownership to employees as one form of payment for their work.

Equity compensation is typically offered to employees alongside a lower than market average salary. The idea is that if the company succeeds, the employees stand to make money from their shares while taking a lower salary upfront.

This type of agreement allows startups to offer more attractive compensation packages to new hires without overextending their budgets. It can also reduce turnover, as employees become part owners in the company and become more invested, literally, in the business’s success.

Types of Equity Compensation

Startups may offer equity compensation in a number of different ways. Usually, new hires receive stock options, but there are other forms of equity compensation to consider. 

No matter what type of equity compensation is on offer, the company will have a contract with terms and timelines. This offers more protection to the startup to avoid losing ownership to employees who leave after a short-term employment with the business. 

The types of startup equity compensation potential employees might find include:

Stocks

A startup company may offer stock options to its employees. Stock options grant employees the right to purchase a number of stocks at an agreed-upon price, called the strike price. Employees can then decide whether to exercise the stock options — usually in the case of a buyout or IPO (initial public offering) where the stock price of the buyout or IPO is more than the strike price is (typically, considerably more).

From there, stocks typically follow a vesting schedule, which vests certain amounts of the stocks after a certain time period has passed or once an employee or the business reaches pre-determined milestones. The specifics of the vesting schedule will be laid out in the legal stock agreement between the employer and employee — a common vesting schedule is 4 years, where each year 25% of the options vest. If the employee leaves before those years are up, they forfeit any options that have not vested.

For employees who agree to stock options as equity compensation, it’s important to understand that stock options are just that: options. Employees need to agree to exercise the options to actually receive any equity. 

According to a study by Carta, 13% of respondents didn’t exercise “because they were afraid of making a mistake or thought they already owned them.” Respondents in the survey also expressed interest in more education on equity compensation. Startups considering this method of compensation may want to look into providing educational resources for employees.

Performance Shares

Performance shares are a type of stock, typically offered to executives, managers, and other leaders in a startup, that are typically issued or vested once the company meets predetermined targets

Restricted Stock Awards

Restricted stock awards are grants of stock, rather than stock options, that come with restrictions or stipulations that need to be met before the stocks are issued. The difference? Stock options give the employee an opportunity to buy and own the shares, but restricted stock awards are automatically owned by the employee when the company issues them.

An example of a restriction is that an employee may need to meet a vesting schedule and remain with the company for a certain amount of time before they can receive a percentage or all of their shares. Another common stipulation is a transfer restriction, which requires an employee to request permission before they can transfer shares.

Restricted Stock Units

While stock options are often used for early stage startup equity compensation, restricted stock units are typically more common for more established or profitable startups to offer to employees, as stock prices can become too high for employees to purchase outright. 

RSUs are grants of stock that the company agrees to issue at a later, specified date. RSUs also typically include additional stipulations for employees to meet before they are vested.

Unlike restricted stock awards, which employees can typically buy at fair market value, RSUs usually come at no cost (aside from tax liabilities).

Calculating Startup Equity Compensation

On average, startups are reserving a 13% to 20% equity pool for employees. This is important for startups to consider before they pursue series funding or other investments, in which they may be offering percentages of equity to investors.

Of the equity pool for employees, shareholders may receive the following average percentages of equity in the company by level of seniority:

• C-suite executives: 0.8% to 5%
• Vice president: 0.3% to 2%
• Director: 0.4% to 1%
• Independent board members: 1%
• Managers: 0.2% to 0.33%
• Junior-level employees and other hires: 0% to 0.2%

Startup Equity Compensation Benefits

Offering equity compensation isn’t always the right fit for startups. For instance, if a startup wants to limit the amount of equity it is giving away or founders want to retain more control over the business, equity compensation may not align with the business plan. 

However, in other cases, equity compensation can offer many potential benefits for both the startup company and its employees.

Benefits for Companies

Equity compensation offers many benefits for young companies, especially when money is limited. For startups, offering equity to employees means the company can:

Stick to a Budget

One big reason for startups to offer equity compensation is to save money. This form of non-cash payment allows startups to provide more competitive job offers without stretching or exceeding their budget. That’s important, since cash flow problems is a top reason for startup failure.

Attract Top Talent

When a startup is strapped for cash, leaders can feel stuck with offering lower-than-average salaries for new hires. With these lower salaries, they may not be able to entice top talent, who can find higher salary offers elsewhere. With equity compensation, employees have an opportunity to earn more money in the long-run and become an established part of the company as a partial owner.

Reach Lower Turnover Rates

When employees have an opportunity to gain equity in the company by meeting certain timelines or milestones, they may stay longer and feel more motivated to work toward the company’s success.

Benefits for Employees

Equity compensation can also be attractive to potential employees, especially if they are dedicated to a company mission and believe in the long-term vision. For employees, startup equity compensation can provide:

Earning Potential

If the company succeeds, the equity compensation could exceed what a higher salary without equity could have paid. But the caveat is that if the startup fails, you may be stuck with minuscule earnings or even capital losses from your shares.

Ownership

Although the percentage per employee is often small, once shares are vested, the employee becomes a partial owner in the company. This may mean they earn voting rights and can help influence the company over time.

Motivation, Alignment, and Fulfillment

When employees are spending forty or more hours per week at work, it can help to feel a sense of purpose and passion during that time. Employees may more seriously consider taking equity compensation when the job and company align with their own values and goals, leading to more fulfillment, motivation, and overall satisfaction at work. 

Startup Equity Compensation Considerations

Before accepting an equity compensation offer, employees should consider several different factors around this form of non-cash payment. Equity compensation must follow many regulations and often come with additional tax considerations. In the long-term, employees will also need to have an exit strategy in place to sell their shares.

Exit Strategy

An exit strategy refers to how a founder or employee will sell their ownership shares in the company. First, shareholders will need to meet any predetermined conditions set out in the employment contract and by law. After that, each person should have a plan for how and when they will sell their shares. 

Employees could gain more money for their shares by selling at the right time, but startup equity ownership also comes with risk. With 90% of startups failing, 

Taxes

Owning shares in a company, even when they are offered as part of startup equity compensation, means that employees become investors. So when employees enact their exit strategies and sell their shares, they will be responsible for paying the accompanying taxes. For instance, when investors sell their shares, they will need to pay a short-term capital gains tax, which varies based on income, or a long-term capital gains tax of 0%, 15%,  20% or more on investment profits.

However, if employees sell at a loss, they will also need to consider capital loss, which will also need to be reported on taxes. Employees should consider taxes when determining whether startup equity compensation is the right fit for them.

Equity Vesting Schedule

Some equity compensation terms may adhere to an equity vesting schedule, meaning employees will receive portions of their total ownership percentage after staying with the company for certain periods of time. 

As stated earliers, this schedule typically follows a four-year plan with a one-year cliff. According to Founders Space, the average equity vesting schedule vests 25% of an employee’s shares after one year, then gradually vests the rest, until 100% of the shares are vested by the four-year mark.

Employees should consider whether the proposed equity vesting schedule is right for their career plans. If they expect to leave the company before the proposed milestones, they could leave with money on the table.

When to Offer Equity Compensation

Because equity compensation must follow legal guidelines, startups should consult with financial and legal professionals to determine how to proceed. One of the top requirements is to determine the company’s fair market value for its stock through a 409(a) valuation. This information is necessary before optioning or issuing stocks. Typically, startups will need to undergo the 409(a) valuation once per year and any time after they raise funding.

Is Equity Compensation Right For Your Startup?

When startups are looking to bring in new team members without breaking the bank on competitive salary costs, they can bridge the gap with startup equity compensation. By offering partial company ownership to employees, startups can gain top talent and dedicated employees that are invested in the long-term success of the company.

But equity compensation isn’t always the solution for startups. Leaders and employees need to consider any legal requirements and tax liabilities that could limit how beneficial this method of compensation could be. Not only that, but if the startup fails, it could lead to financial losses. Equity compensation may also not be a good fit for founders who aren’t looking to give away any control in the company.

Ultimately, startup executives will need to consider if equity compensation benefits are worth the additional work to offer to employees, and potential hires will need to weigh the pros and the risks of accepting this form of compensation before signing an agreement.

For companies and employees that do settle on a stock agreement, startups should consider providing educational resources to help employees take full advantage of their stock options and ultimately build employee trust and satisfaction.