Primer On Startup And Equity As New Hires

March 6, 2014

**Disclaimer: [1] is good article. This article is mostly based on it. It has been rephrased mostly to simplify and explain some steps in more details since not every employee knows about the INs and OUTs of startup equity and the impacts of some events on your equity. Here is a little guide. **

**Disclaimer 2: I am in no way responsible for anything you may do based on the information provided here. This is not legal advice. **

Rule 1: Get it in writing

Whatever agreement you come to, MAKE SURE you get it IN WRITING. This protects both parties and ensures that everybody leaves the conversation with the same understanding.

Rule 2: You may get market rate salary and still have equity

In the past, startups were generally associated with significantly lower salary than market rate for a position at a Big Co. Now:

  1. VC funded companies pay now close to market rate as per [1]. [1] recommands to ask close to market rate.
  2. Non VC funded companies / seed staged companies:
    1. Raised little capital AND are not generating revenue.
    2. They usually don't have full salaries budgeted into them.
      1. You should expect to work for less than market rate until a larger round is raised.
      2. You should ALSO be compensated with increased equity.
      3. Bonus point: Ask what your salary would be after Series A and to avoid suprises down the road.
      4. Be prepared though, it is difficult to estimate since:
      5. You have not shown your worth/skills.
      6. Funding timeline is uncertain.
        1. [1] recommands to have something written stating market rate for you right now, "this way, if it takes two years to raise a Series A and you’ve grown into a bigger role during that time, you aren’t boxed into a number that you arrived at two years earlier and whose value you’ve surpassed, but you do have a quantitative starting point for determining what your salary will be.
      7. Other methods of compensation and risk adjustment may also arise. Eg: Structured employment offer in such way you get 30% bonus upon the raising of a Series A (subject to “outstanding performance” per my manager’s discretion).
      8. Get the offer to state that at that time, salary would be raised to a market rate. But don't specify what that market rate would be. Before joining, I informed the founders via email of the other offers I was prepared to pass on, and they told me that what I cited was “in a reasonable range.” The entire process from initial offer to post-Series A adjustment went very smoothly and without any surprises for anyone.

Rule 3: No Bonus

Startup don't do bonuses in general [1].

Rule 4: Understand what your Equity is worth

By far, both the least and most important depending on how you value them:

Startup equity aka "the golden handcuff"

This section describes a very realistic scenario. You got hired and where given the following:

The objectives are:

You as employee may have different financial interest than the company you joined in

Sometimes, you will encounter honest startups. They will explain you the basics so that you understand what yourself get into. Other times you will join dishonest startups or with no understanding of equity resulting in suboptimal equity for you. So EDUCATE YOURSELF.

Equity as OPTIONS

When a startup says they grant you EQUITY, they most LIKELY don't give you shares (a piece of ownership in the company) but OPTIONS (a possibility to buy a number of shares at a some discounted prices: the strike price).

Context: You got options and your contract states:

Let's do the math: How much do you think you will get ?

You have the option to buy 0.5% of the company. At current valuation, it is (5M * 0.05 = 250000). Now you get to have 250000 in value at 70% discount. So (250000 * (1-0.70) = 75000) you get to pay 75000 of you OWN pocket to have 250000 in the future, if the company has a successful exit.

At this point, you have 3 options:

If you know it will be a big hit, you would buy the OPTIONS. But you don't know, right ? As a rationale being, you will want to see if placing 75000 is a good investment.

How ? Doing the math of course. Why ? As with any investment, you need to know how much you put in and how much you will get in relation to the risk you take.

You are going to be rich... or mostly likely NOT!

You choose Option 2. You invest and two years later the company sells for 20M. Not bad, euh ?

Context:

Let's do the math: How much do you think you get ?

You had 250000. That gets you 4x250000=1000000. Not bad, you will still have to work for most years of your life.

You made 1000000, in theory ...

Here is why.

Your stock is NOT prefered ...

Your stock was most likely common, not preferred. What's that ? Investors have “preference,” which means they get reimbursed for what they put in before anybody else (including you) sees a dime.

Assuming, the company raised $18M in combined seed, Series A and Series B investments. First, those Series A and B investors get their $18M back. That's 2M left. That's $2M to be distributed proportionally among stakeholders (you included).

Context:

Let's do the math: How much do you think you get ?

Use the rule of three:

250000 |     5M
---------------
X      |     2M

(250000*2M)/5M=X
    100000 =X

You would get 100000. Now, you have spent 75000. So you really have gained (100000-75000=25000). This is pre-tax profit.

# Your ownership has been diluted ... [3]

When raising fundings in Series A and Series B, your shares got diluted. Assuming you got 0.35% diluted. You had 5% ownership and now have a 0.35% ownership.

Context:

Let's do the math: How much do you think you get ?

You have 0.35% ownership on 2M. You will get (2M * 0.35 = 70000). Now you have spent 75000. So you have gained (70000-75000=-5000). You LOST 5000!!!

You pay tax on any gain ...

If you had a gain, your government will tax it.

Context:

Let's do the math: How much do you finally get ?

You have X and it is taxed at 30% rate. You will finally get (X*(1-0.30).

How much do you make upon selling your option (without dilution) ?

Here is the magic formula:

Profit = (% ownership * shares outstanding )* (Sell price - Strike price)

Assume you have:

Pre tax Profit = (0.01*100000) * (16 - 0.80) = 15200

How much do you make upon selling your option (with dilution) ?

How much you will get diluted is hard to predict. Assuming you got diluted by 50% , then the formula is:

Equity payout = (Equity Percent * Sale Price of Company) / 2

How much equity should you get ?

CEO: 5-10%
COO: 2-5%
VP: 1-2%
Director: 0.4-1.25%
Lead Engineer: 0.5-1%
5y+ engineer: 0.33-0.66%
Junior/Manager: 0.2-0.33%

What are the equity informations to ask for ?

From most important to least important:

What to watch out for ?

References

[1] http://rob.by/2013/negotiating-your-startup-job-offer

[2] https://www.quora.com/Should-a-startup-contract-granting-an-option-to-buy-shares-at-a-preferred-price-have-a-termination-date-even-if-I-do-not-leave-the-company

[3] http://avc.com/2010/10/employee-equity-dilution/

Discussion, links, and tweets

I'm a developer at IO Stark.