When someone starts working at a startup, they often receive a certain equity share as a part of their total compensation. This is due to the fact that startups want to put the maximum amount of the cash inflow back into the company instead of having to pay it all in the form of salaries.
But what if you decide to end your term at a specific position? What happens to your equity and the unvested stock options in your share? Do you still get to keep them, or are they liable to be seized by the organization?
This article gives answers to all your doubts related to this subject.
Employee equity in a startup
Offering equity to employees has been an age-old practice to compensate for the lesser liquid assets a startup owns in its beginning stages. Since equity is further divided into various types and comes bearing tax implications, understanding the term properly is highly important for everyone.
What is employee equity?
Employee equity refers to the non-cash pay that the employees get. This also includes various performance shares, stocks, and options. These small investment skates represent a certain degree of ownership in the firm for the employees of a company.
Many times, employee equity is offered in order to compensate for a below-market salary. This kind of compensation allows the firm members to benefit from the profit as the startup grows. These compensations are mostly only offered by private companies. Another way startups use these compensations is to reward employees.
Types of employee equity
The kind of equity offered depends on the company and the terms of payment that an employer presents once you join a company. Given below are the details about each kind :
1. Stock option
Certain startup equity compensations come with an added bounty of specific stock options. What’s good about these stock options is that they can be used to purchase the company’s shares at one particular predetermined price, also known as the exercise price.
In most cases, this right vests with time. This means that the employees can only gain control of their purchased stock after they have worked for a certain time period or have achieved a certain milestone in terms of performance.
Once the option vests, they have the full right over the stock and can trade it any way they want. This ensures that the employees will stick with the company for the long term. However, it is worth noting that these options themselves do have an expiration date. So the employee must exercise them before that.
Furthermore, let’s say a specific employee owns some options and shares. This does not necessarily mean that they get the same right as shareholders. The tax implications on vested and unvested options are quite different. Thus, employees must check out all the tax rules applicable to their stock to avail of maximum benefit.
2. Restricted stock
Restricted stock can only be exercised once the equity vesting period is complete. This may be either done at once when the term is over or can be unvested in installments over the years as per a vesting schedule that the management finds suitable. This provides certain advantages to the company, such as the ability to retain more stocks for a long time but does not provide any right of stock ownership such as voting in the hands of the employees.
3. Performance shares
These kinds of shares are provided only when an employee hits a certain performance metric. The company management always determines these metrics. Common examples include earnings per share target (EPS), the relative total return of a company’s stock in relation to an index, or a return on equity. However, the performance period may span over multiple years depending on your role and position in the company.
Why is employee-friendly equity important in a startup?
A good team is highly important in building a startup. When an experienced employee joins a newly formed startup in its early days, they constantly search for credibility and want a source of faith that they are investing their time in the correct place.
Offering them startup equity sends a message that the founders have a good level of confidence in their capability and want the relationship to prosper for the betterment of both parties. Therefore, employee equity compensation acts as a mechanism that helps to attract good talent when the company is in its early stage.
The one who was an early believer of the oncoming success of the startup is later rewarded in the form of multiple wealth creation opportunities. But some might even argue that cash incentives are a better way to reward good performance.
While this may hold true for the short term, you have to keep in mind that equity confers ownership. The more your company will grow, the higher the chances of you getting a higher return on your equity. Furthermore, there is always an upper limit to cash incentives aside from the fact that they are pre-decided.
Thus, equity is one of the best ways through which a normal employee can gather a fortune while doing a job.
An employee-friendly equity plan is what will win the startup over time. Here are some of the key features of an equity plan which is also preferred amongst the employees :
- An ideal equity plan should grow with the needs of a company. What works for a startup, in the beginning, might not work as it expands. Thus, having a customizable plan is very crucial.
- The employee pool should be pretty large instead of restricting it to single digits as it leaves out room for diversification when the company grows big.
Things to know about equity before leaving the company
The last thing you would want is to miss out on your equity share due to leaving a company at the wrong time. That said, timing isn't the only factor here that you need to be aware of. Here are a few questions you need to ask yourself before coming to a decision :
What type of equity do you have?
Each kind of equity has different kinds of tax implications; this is why it's important to know the type of equity you are offered. The two main kinds are RSUs and ISOs.
With RSUs, you don’t have to worry about how to exercise your stocks and options. You simply receive them on a regular basis along with your salary or when certain conditions are met ( such as staying in the company for a set period of time).
In the case of ISOs, you will have to exercise the options yourself and determine the time at which you want to purchase the stock at an exercise price.
In order to check out the type of equity that you have, have a look at your grant. Typically though, small-scale startups offer full-time employee ISOs, and when they start to grow, they begin to provide NSOs.
How much you have vested?
Vesting refers to the amount of time you have to stay at a company to earn your equity. The industry norm is around the year, but this may also depend on factors like whether you are working remotely or in-office.
For instance, say your company offers you 10000 ISOs that vest over a two-year course along with a one-year cliff. If you leave the company before one year, then you will not get any equity. If you leave exactly after one year, you will get 5000 ISOs, whereas leaving after the two-year mark will grant access to all the equity options.
Thus, always see your grant and plan your departure date accordingly so that you can gain maximum benefit from your vested equity.
How much you have exercised?
If you have already exercised an option, you have total ownership of that stock regardless of whether you stay or leave the organization (unless stated otherwise in your grant). Look out for terms like ‘company repurchase rights” or ‘clawback redemption”. They indicate that the company can forcibly repurchase those shares from the owner if they leave the company.
If you exercise an option before it was vested, your company also gets the right to buy back the unvested shares when you leave.
How long do you have to exercise your remaining vested option?
You can only exercise your shares before a certain expiry date. This differs for every company and is called the post-termination exercise period or window. Your options can be forfeited if you don’t exercise them within this timeframe.
This period is usually around 90 days in most companies. Always ask your company about their policies or check your grant for details on this.
How to exercise your options?
You will have to ask your company about the way you can exercise your options. In some cases, you will need to write a paper check and transfer it to your company before the post-termination exercise period. To know the amount you need to pay for a certain number of shares, simply multiply that number by the strike price mentioned in the grant.
How liquid is your equity?
You might want to ask your company if you can exchange your stocks in return for cash. Most companies run a liquidity event such as a tender offer in which you can exchange your shares for cash.
What to do when you can’t afford to exercise?
In a case coming up with the money to exercise their options becomes tough for a company, they often walk away from their options. This is due to the following reasons :
- Lower salaries offered by the startup hope to make up the difference in terms of equity.
- Limited-time period to exercise ISOs
- The high strike price for older employees
You can overcome this issue by asking your company if they will allow you to give them a portion of your vested shares to compensate for the remaining shares. Asking for a sign-on bonus can also help you to purchase your shares early on.
How equity and options are taxed?
With ISOs, you don’t have to pay taxes when you exercise them instead of the tax implications on NSOS. That said, if you end up retaining your shares after the first calendar year, you might be eligible to pay an AMT( alternative minimum tax).
Before you go
The equity of an employee is dependent on various factors as opposed to their base salary. The duration for which they stay, their performance, tax implications, etc., all play a significant role in determining what you can get for return in exchange for your equity. Carefully negotiate your starting offer and determine your exit date in accordance with the conditions on your grant to avail maximum benefits from employee equity.