You’ve probably heard the term ‘equity’ before, but what does it mean and why is it relevant to a millennial working in a startup?
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The perks of working at a startup extend beyond the stereotypical snack selection, unlimited PTO, and ping pong tables. Many employees are extended potential ownership in the business through equity. Equity enables employees at a startup to share in its financial success.
While the salary portion of your compensation package is typically straightforward, equity can be confusing and complicated, especially to someone new to the tech or startup world. If you’re considering a job at a startup, learning equity basics ensures you fully understand what you’re getting into before joining the company.
“Ask questions about best- and worst-case scenarios and how these will impact your equity,” says Margarette Jung of Captain401, a company whose mission is to offer startup employees a secure financial future.
We’re here to help you with these questions. But first
How equity works
Equity, also known as stock, is usually distributed to startup employees in the form of “options” or “shares.” In your offer letter, you’ll receive a specific number of options in the company that you can one day purchase (an action known as “exercising”) at a certain price (“strike price”) after a dedicated time period (“vesting schedule”).
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When founders start a company, they own and control all shares. As they raise money and grow their team, however, others become owners in the company, too. Investors buy shares with financial investment and employees receive shares in exchange for labor.
When startups raise money, go public, or sell to another company, they undergo a “valuation” process. This assigns a value to the company and a value to the shares. Equity provides an incentive to employees to help the business succeed. If the value of the startup goes up, so does the value of employees’ equity.
What’s this all mean?
Most startup offer letters include two key pieces of information: the number of stock options issued to you and the strike price. But this isn’t enough information for you to fully evaluate your offer. The following five questions will help you get the information you need to understand your equity package.
Question 1: How many outstanding shares are there?
Without knowing how many total shares exist, it’s impossible to calculate what percentage of the company you could own. Even a seemingly high number of options, like 15,000, could be a small percentage of the total number of shares. For example, 15,000 shares out of 100,000 total shares represents a larger percentage of ownership (15 percent) than 15,000 shares out of one million total shares (1.5 percent). The number of shares you’re granted divided by the total shares outstanding is the percent of the company you could own.
Question 2: What is the current valuation of the company?
This information helps you determine how much each stock option is worth, also called the fair market value (FMV). If a company is valued at $10 million, and it has one million shares outstanding, the current FMV of each share is 10 dollars. Meaning, your 15,000 options could be worth $150,000 if the company were to exit at the current valuation.
In other words, understanding the company’s value helps you determine the real value of your equity.
Question 3: What is my vesting schedule?
This will help you understand what portion of your options you’ll have control over and when.
You likely won’t own all your shares or options on day one. You’ll have to earn them over time during your vesting schedule. A vesting schedule incentivizes you to stick around until you own all of your options. Startups can have different vesting schedules, but it’s common for vesting schedules to last four years.
Under a typical four-year vesting schedule, 25 percent of your options will “vest” after one year of employment. Meaning, you’ll have the option (hence the term “option”) to buy 3,750 of your 15,000 options after 12 months. After this, 1/48th of your options vest each month—approximately 234 each month. After four years, you’ll be fully “vested” and can buy all 15,000 options.
Question 4: Are you expecting to raise more money?
Investors purchase shares when they invest in a company. Let’s say there are one million shares in a company when you join. With your 15,000 options, this means you will own 1.5 percent of the company when you are fully vested. But let’s say a venture capital firm invests in the company and buys 500,000 new shares. Now, the total shares has increased from one million to one-and-a-half million shares. In turn, your potential ownership has been diluted from 1.5 percent (15,000 divided by 1 million) to 1 percent (15,000 divided by 1.5 million).
This isn’t necessarily bad, though. The venture capital firm will likely (but not always) invest at a higher valuation, so the fair market value of your shares may increase considerably. Let’s assume the venture capital firm invests at a 30-million-dollar valuation. The value of each share is now worth $20 ($20 share price * 1.5 million shares = 30 million). Meaning, the value of your 15,000 options is now $300,000.
If the firm invests at a valuation flat or lower than the previous round of investment the founders raised, the value of each share will go down.
“You want to know what the company’s overall strategy is,” says Casey Marshall, a 26-year-old who has worked at two startups in San Francisco, CA. “Certain paths may change the value of your equity.”
Question 5: Is this offer the right decision for me and my lifestyle?
“Often times companies will provide more equity and a lower salary,” says Marshall. “In terms of whether salary or equity is more important, there is no right answer. It’s completely up to the individual to decide what fits their lifestyle.”
If you’re paying off debt, for example, you may feel more comfortable receiving a higher salary and lower equity. But if the company’s leadership, mission, product, or strategy truly inspires you, and you strongly believe the company will succeed, equity can be a motivating form of compensation.
“My general approach when evaluating equity is to be overly conservative,” says Jung, of Captain401. “Equity is not as reliable or quantifiable as your salary or cash, period. Even with equity from a huge company, play it on the safe side.”
Last tip: Receiving a job offer is an accomplishment worthy of celebration—you deserve it. But don’t let this joy and rush of adrenaline overtake reason. Take some time to think, Marshall says. “Sometimes excitement overpowers logical thoughts, so taking time to collect my thoughts in a clear space, once the excitement had worn off, was helpful.”