A Guide to Startup Equity as Compensation

As you might know, startup equity is a company benefit that many small businesses offer as part of a compensation package. Equity in a company can be a confusing topic, with difficult to understand phrases like RSUs, vesting schedule, and cliff. If this is your first time working for a startup, or you’re confused about how equity and stocks as compensation work, don’t worry! You’re definitely not alone. 

What is equity?

Equity is ownership in a company, and normally comes in the form of a stock option. 

If a company is already public (selling stocks on the NASDAQ or New York Stock Exchange), the value of their stock will fluctuate each business day. The stock already has value on the market.

However, for early-stage startups and private businesses, equity will not have market value unless the company has an “exit,” which usually means going public or getting acquired by a public company. This is true for startup investors as well. 

In some cases, employees receive stock options as a part of their compensation packages. In others, employees need to purchase the shares at their strike price, or the value the share was assigned when they started working for the company. 

Different types of equity as compensation 

Stock options

Startups typically offer equity as part of employee compensation packages. This equity, often managed on a platform like Carta, doesn't have the ability to turn into immediate cash, but can grow exponentially in value if the company becomes successful. 

If you buy company shares at $.10 and the value rises to just $2 when the company goes public or gets acquired, the value increases 20%. This means you have the option to invest in your company at a lower rate than what the fair market price would be after the company goes public, if it goes public at all.

If the company never has an exit, then your shares will be worthless. Keep in mind, only 7% of startups see an exit. 

Key stock/equity terms 

• Shares. This is the total number of shares that employees have the right to purchase once they vest. Employees do not own these shares unless you have vested and purchased them. Most startups allow you to start buying shares after one year, with more shares becoming available every month (read more below).

• Exercise price. This is the cost per share if you decide to purchase them. The exercise price is normally lower than the 409(A) fair market value. This gives you the option to purchase shares in the company at a discounted price. 

• 409A valuation. The independently valued fair market price of the company valuation. This is how the cost of a company share is determined. 

• RSUs. If your compensation package includes restricted stock options (RSUs), you will not need to purchase those stock options and will instead receive the stock at face value. 

• ISOs. An ISO or incentive stock option gives employees the right to buy shares of company stock at a discounted price, with the possibility of receiving tax breaks on the profit.  

• Option pool. An option pool consists of certain shares of stocks reserved for the future for employees of a private company.  

• Equity stake. The percentage of a business owned by the holder of a certain number of shares of stock in a business. This is usually built up through the purchase of equity shares in a company. 

• Equity grant. This is the grant of a stock option at the market valuation. This is one of the ways employers give stock options as part of a compensation plan. 

Vesting

When you receive employee equity in a startup, there will be a vesting schedule. This means that the stock option becomes available to you incrementally for a fixed period of time. 

One of the most common vesting schedules is a four-year vesting period, with a one-year cliff. This typical schedule means that employees receive nothing if they leave the company within the first year. After one year, you will receive 25% of the equity package. Starting in the second year, you will receive 1/48th of your equity each month. Remember, if you leave the company before year four, you will leave behind any of your unvested stock with no capital gain.

How does equity turn into real value? 

Company goes public

When your company finally goes public, this is a day for you as an employee to celebrate. This means that all of your hard work has paid off and your stocks now have more value.  If you have an RSU your stock now has value, and if you have stock options, you now have the ability to purchase publicly traded stocks. If your company offers a great exercise price, you will be able to acquire this stock at a much lower market rate than the average buyer.

Company gets acquired by public company 

The value of the equity is dependent on the success of the acquisition. If the company exited successfully, then the stock equity given to the employees will still be valuable. However, if a merger or acquisition makes the stock price lose value, then the equity value lowers – or worse, it could be worth nothing. 

What happens to your equity if the company goes out of business? 

Venture capital is fraught with risk. 

Once a company shuts down or goes out of business, your equity does not have any value. This is one of the biggest risks of working for a startup and taking equity as part of your compensation packages. While there is the potential for huge payouts, many early stage companies don’t last long enough for this compensation to be worthwhile. 

When deciding whether you want to take this type of compensation, you should strongly consider the company you’re planning to work for. Does the company have the ability for high-trajectory growth? Do you think the ideas of that business are going to last after a few years? Do the employees seem mentally and emotionally invested? Is the product part of a consumer niche or target a need in the market? 

These  considerations should come into play when you decide whether or not to work for a startup. 

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FAQ

What is the typical equity compensation for a startup? 

For non-founders and CEOs of early-stage startups, the going compensation rate is around 7-10% of the overall compensation package. For some founders and C-level executives, the percentage is much higher, sometimes up to 99-100%. The value depends on each role, with engineers and executives  earning the most.

What is typical equity compensation? 

The 4 types of equity compensation for startups are: incentive stock options (ISOs), non-qualified stock options (NSOs), restricted stock options (RSUs), and employee stock purchase plans (ESPPs). 

How much equity should a VP get in a startup? 

A typical equity amount for startup VP’s to be offered is between .5% and 1.5%. Board members will typically determine how company shares are distributed.

Can you get rich off of startup equity? 

With so many startups on the market right now, becoming extremely wealthy off of startup equity is unlikely. Many companies don’t make it, so equity compensation becomes worth nothing. However, some companies do take off and go public, which could make you wealthy after you are employed for more than four years.