disclaimer: I’m not an attorney or financial advisor, I’m only expressing my views and opinions and in no way am I offering financial or legal advice. Please seek financial advice and/or legal advice from professionals before making any decisions or signing any legal documents. Ok with that out of the way, on to the post.
A lot of friends and colleague over the years have asked me to explain this to them and I figured it was time to write a blog post about it so that more people can see how I personally approach equity offerings presented with an employment contract.
Most of this stuff applies to tech startups but it can be applied broadly to any industry or position at any company, big or small. Its just that most of my experience here is in the tech startup world so my examples will all be from that point of view.
Options vs RSU’s
What are options and what are RSU’s? Great question!
Stock options are the traditional form of equity compensation and are the most common for private companies like startups. Options are an “Option” to buy stock at a set price (called the strike price). If you are awarded 1,000 shares with a strike price of $1.00, you will be able to buy those options for $1,000 at anytime. The term for this is “Excersizing” your option.
So if the company’s valuation dictates the stock price to be valued at $2, you will be able to purchase the shares for $1,000 and then immediately sell those shares for $2.00/share netting you $1,000 in profit!
The big thing to watch for is that options expire (usually after 10 years from the grant date). If you don’t exercise the option in that time you will lose it and have nothing.
If your options strike price is higher than the current value of the stock, you will need to pay the difference to get the shares and if they expire before that changes, you will have to decide to purchase at the strike price and wait of it to become profitable or let them expire and forget about it.
Most investment companies will handle it all for you by exercising the options and depositing the profit in your account. Talk to a financial advisor before doing this because taxes can be a bitch!
RSU’s are getting popular with publicly traded companies because the carrot is much more attractive. RSU stands for “Restricted Stock Unit” and boils down to raw stock on award date. If you are granted 1,000 shares of RSU’s, you are given 1,000 shares (less income taxes on the value of the stock at the vest date). If you sell those shares when the stock price is $2, you will get $2,000 in your pocket.
The trick with this is that they are income and taxed as income. So if you vest 1,000 shares and the price per share is $2 on the day of vest, the company usually automatically sells enough to cover paying the taxes on the $2,000 income provided by the vest. So you may have vested 1,000 shares but your account will show 800 because 200 will have been sold to pay for the income tax associated with the stock given. The gotcha here is that when you sell the shares, any gains over that initial value will also be taxed as capital gains… Again, talk to a financial advisor about this before you start selling shares and buying cars!
Calculating the Points
First things first, we need to figure out what our equity position in the company will be. Is 10,000 shares a lot? How about a million? Just because a company is offering you a million shares, it doesn’t mean you are getting all that much if the company has 10 billion shares allocated.
So your first question should always be:
How many authorized shares does the company have?
You will need this number to calculate how much of the company you are actually being granted. Be careful here, CEO’s like to give the “outstanding shares” number because it skews your view. Make sure you’re getting the “authorized shares” number.
(if you would like to read up about authorized vs outstanding vs issued shares… here’s a quick overview.)
Ok so now that we know how many shares the company has (or how many slices exist), we can figure out how much of the pie we are being offered by simply dividing the number offered by the total:
1,000,000 / 10,000,000,000 = 0.0001 *100 = 0.01%
So in our million shares example, you can see we have 0.01% of the company being offered.
side note: you can and should calculate the offered amount with the outstanding shares number too to understand where you are in the landscape of other investors in the company. Both percentages are valuable to know and consider. A financial advisor can help you with true value when you have both numbers.
Outstanding stock will be closer to what your stock is worth in the real world but is prone to dilution, whereas authorized stock is usually a constant and will illustrate a stable number that should be pretty immune to dilution. Authorized stock based calculations are really a worst case scenario. Knowing both numbers can also help reveal how leveraged a company is because you can see how much of the pie has been given out… but we’ll keep that for another post.
How much money is the package worth?
This is a pretty tricky question because you probably aren’t getting fully vested equity. (if you’re getting that, congrats! You’ve found a unicorn). You’re probably getting a package with a 3 to 4 year vest period… more on this later. First we’ll start with converting points to monetary value.
Now that we know the point value of the offering, let’s turn that into a monetary value. For this you’ll need the second question you should ask:
What’s the company’s current valuation?
For startups, this is usually based off of a round of funding and not easily discoverable. Sites like Crunchbase can tell you how many rounds of funding and what was raised by whom, but they usually don’t report the valuation from the round. This you’ll have to get from the company directly and you’ll probably have to trust the answer. (private equity valuations are pretty tough to nail down because they’re private and established by funding rounds)
So carrying our million shares example over, let’s say the CEO tells you the company’s last valuation was $500,000,000 and that was based off of the last round of funding (let’s say series B). Well we can take that number and apply our percentage to it to figure out the value of the package today:
$ 500,000,000 * 0.0001 = $50,000 (not bad, not great.. but not bad)
(if you’re interested in what funding rounds mean.. here’s a great write up)
This is further complicated by the vest schedule.. Remember, you will get this amount over a period of time (usually 4 years on a quarterly or yearly basis). This may mean that you make more money or lose it all depending on the company and how long you stay there. If you amortize $50,000 over a 4 year period you end up with $12,500 a year. (50,000 / 4 = 12,500) This doesn’t consider valuation changes and fluctuations in stock price. Will the company value go up, down, or stay the same when the time comes to cash out? That’s for you to try and predict. Does it feel like gambling yet?
Dilution is simple. Its the devaluation of your equity position. Dilution events happen when the percentage of the stock gets reduced by additional investments (usually from more rounds in funding). Remember, each round of investment means that more investors are buying preferred stock and cutting to the front of the line for payouts when the company is acquired or goes public or pays dividends.
Its probably good to know what preferred stock vs common stock is. Check this out for a quick rundown.
Dilution usually happens when the company issues more stock out of the authorized stock pool and increases the number of outstanding stock. This devalues all the issued stock proportional to the amount of new stock being introduced from the authorized pool. If you are basing your value on the authorized stock number, dilution won’t matter unless the pool is increased (which is rare). If you’re basing your package value on the outstanding number, dilution is a very real thing that you need to pay attention to! (This is why both numbers are important to know)
You have no control over this (usually) and its something that can really cut into how much you get when the time comes to cash yourself out. You just need to ask yourself, “how many more rounds of funding will this company need before they are generating their own cash?”
Acquisitions are good right? Well not always. You need to know how unvested stock works when the company you work for is acquired.
Let’s say you were granted 1 million options with a 4 year vesting schedule and a cliff at 1 year. (This means that you’ll get the first 25% of the options at your 1 year anniversary)
So on month 11 the company is acquired by a big public company for $100 million… time to celebrate right? Well, hold your horses there. Unless you have an acceleration clause (usually only reserved for founders… if that).. you may not be as happy. This is because your unvested shares will most likely be rolled over to the new company’s stock and the vesting schedule will be reset to the acquisition date. Yes, you read that right.. Let’s continue the example shall we?
There is actually a bunch of complicated finance math that you can look up on your own, but essentially your options will be converted to the new company’s stock and valued properly in proportion to the share you had in the startup to the acquisition price and re-granted on the day the deal closes. Well, guess what… you will need to work another full year at the big public company to hit that 1 year vest cliff. (that is if you get to keep your job or manage to not get fired or laid off)
However, if you did vest some stock, the stock that is vested will be converted and be yours immediately because you’ve already earned it.
So ask yourself, “what’s the end game for the startup? Do they want to IPO or are they going after acquisition? When will they likely get acquired and how does that fit with my vesting schedule?”
If you had that mythical acceleration clause, all your stock would vest immediately! It would be converted to the new company’s stock at the acquisition valuation and be given to you to do with what you want.
Example: If you owned 25% of the company and the company was acquired for $100 million, you would be given $25 million worth of the new company’s stock, what ever the amount of shares it would take to equal that value.
Bottom line… try like hell to get an acceleration clause in the event the company is acquired.
Equity is a tricky place where things can get pretty shady pretty quick. Know the numbers and do the math to get the full story so you can make an educated decision.
Someone once said “equity offers are like mystery boxes, you get to open one after years of work, but investors get to open many of them a year”. This always stuck with me. Remember, you’re the one on the short end of the stick and you always need to know how short the stick is.
Lastly, I’m not a financial advisor or attorney and the information in this post is not guaranteed accurate or correct and is not meant to serve as any sort of financial or legal advice in any way. I strongly encourage you to consult with financial advisors and attorneys when contracts and equity are involved. Don’t go it alone!
I hope this helps clear some stuff up for you when you’re getting fat looking equity packages. Caveat Emptor.