Startup Equity Basics: What to Ask About Your Stock Before You Accept

So you’ve gotten an offer from an up-and-coming startup, and as part of your compensation package, you’re getting company stock on top of your salary. Congratulations! Before you get too starry-eyed, though, you’ll want to evaluate your offer carefully to make sure you're not counting your chickens well before they hatch. You should be able to accurately assess the (potential) value of your equity offer to see how it stacks up against other offers you may have, and use your understanding to potentially negotiate a higher salary. We’ll walk through the basics of startup equity, the questions you should ask, and how to compare offers side-by-side.

If you're looking for more general questions to help you evaluate your startup offer as a whole, go here instead: 33 Questions to Help You Evaluate a Startup Job Offer

Equity basics: Understanding startup stocks

As the name implies, a share of stock entitles the holder to a portion of the company. If a company has 10,000 shares outstanding, each share entitles the owner 0.01% of the company’s acquisition price if there’s a successful exit, 0.01% of shares if the company goes public, or...next to nothing if the startup fails, unfortunately.

Who gets shares in a startup?

Shareholders in private startups typically fall into one of three groups:

  • Founders: In the beginning, the founders control 100% of the company’s shares. Over time, they’ll likely control fewer of them as they dole out shares in exchange for money or labor.
  • Investors: Venture capitalists take a certain number of shares in return for their investment. As the company raises more money, it issues more shares to its investors, diluting the shares of everyone who invested previously. (This isn’t necessarily a bad thing, though, since the company will presumably use the money to grow the pie for everyone).
  • Employees: That’s you! Typically, your shares will be vested - that is, rather than getting all your shares immediately, they’ll be doled out over some period of time to incentivize you to stay with your employer.

How much is a share worth?

If you held a share in a public company, you’d know pretty quickly what it’s worth: All you’d have to do is look up the ticker symbol to see what a share trades for. For example, you can look up the value of an indivudal Tesla stock by searching "TSLA". With private companies, it’s a little more difficult (and jargon-filled). To assess their value, private companies will do a 409A valuation, in which a third party basically estimates what the company is worth. To determine the current value of a share (called the fair market value, or FMV), you divide the valuation by the number of shares outstanding.

For example, if a company is valued at $1 million and it has 100,000 shares outstanding, the FMV of a share is $10. If that same company had 50,000 shares outstanding, the FMV would be $20. As you can see, it’s the relative number of shares that counts, not the absolute number. An offer of 10,000 shares with 100,000 outstanding is worth the exact same amount as 20,000 shares with 200,000 outstanding. Between the 409a valuation and number of shares outstanding, you can determine how much a share is worth.

Grants versus options

In your offer letter, you may get a stock grant, stock options, or a combination of the two.

Equity grant (RSU): A stock grant, also commonly referred to as a Restricted Stock Unit, is pretty straightforward: It means you get the shares outright as you vest. This is more common for very early stage startups, whose shares are worth a minimal amount and therefore easier to give out directly. But lest you fear that any part of startup equity is too simple, there’s a major financial consideration that many first-time startup founders don’t know about. When you receive your shares, you’ll want to think about filing a Section 83(b) Election with the IRS. The 83(b) allows you to be taxed when your equity is granted to you, rather than when it vests. Depending on your financial situation and the startup’s growth prospects, filing an 83(b) may save you thousands of dollars. You can read more about 83(b)’s here; for now, the important thing to note is that you must file an 83(b) within 30 days of being issued equity, so you’ll want to think over the tax implications immediately.

Stock options (ISO and NSO/NQSO): Stock options are commonly divided into Incentive Stock Options and Non-qualified Stock Options (more information on the difference between these). With either of these, have the option to buy shares at a later date. You’ll have an exercise price upfront, which is the amount you can pay for the stock. The thinking is that the company’s value will rise during your tenure as an employee, so you’ll be able to buy shares for less than they’re worth. Sometimes, your exercise price will be lower than the stock’s current value, increasing your options’ worth.

What questions should you ask when evaluating stock options?

Let’s say that you’ve received an offer that includes 10,000 shares. Here are the key questions you should ask your potential employer.

How many shares are outstanding?

As we mentioned before, the absolute number of shares doesn’t matter - you need to know what percentage of the total shares you’ll have. Some companies will issue a lot of shares so that their offers seem more impressive, so don’t be fooled by a big number. If the company won’t disclose the number of shares outstanding, that’s a pretty big red flag.

What was the board’s last common stock appraisal?  

If you’re getting stock options, your offer letter may not explicitly state the exercise price. However, this number will give you a decent guide as to how much you can exercise your options for and the potential upside, assuming the FMV increases in the future.

What’s the company’s current valuation?

This, combined with the number of shares outstanding, will give you an idea of how much your shares will be worth, whether they’re given to you in the form of grants or options.

What’s the vesting schedule?

To incentivize you to stick around, most companies dole out shares or options according to a vesting schedule. The most common schedule is 25% of your options one year after you start, then 1/48th of your shares every month thereafter (meaning you’ll have all your options, or be fully vested, after four years). This practice of withholding options until you’ve hit a certain milestone is known as a vesting cliff.

What will happen if the company is acquired or I leave?

Some companies will allow for accelerated vesting if the company’s acquired, meaning you’ll get all your remaining shares at the time of acquisition or a few months later. This can be helpful if you don’t want to end up at a big company post-acquisition.

On the other hand, if you leave the company, you’ll typically get to keep the shares and/or options that have currently vested. Usually, you’ll have to exercise those options within a set period of time (often 90 days after leaving). Watch out, though: Some companies retain the right to buy back your options at the exercise price, meaning you don’t get any value out of those options. Another important thing to keep in mind is that you might have to pay taxes on your options when you exercise them (rather than when you actually sell your shares).

Let’s say you have 1,000 shares, currently valued at $5, with a strike price of $1. You leave your company in 2010 and exercise the shares. In 2016, you sell your shares at $7 apiece. In some cases, you’ll be taxed on the difference between valuation and strike price upon exercise - that is, you’ll pay taxes on $4,000 - that is, 1,000 shares * ($5 valuation - $1 strike) - in 2010. Come 2016, you’ll owe taxes on the difference between the price at which you sold, and its valuation on exercise - that’s $2,000, or 1,000 shares * ($7 sell - $5 valuation on exercise).

An extra $4,000 in taxable income - that’s $1,120 paid in taxes under 2016’s alternative minimum tax - may not seem terrible, but if you have substantial equity, the tax burden can be quite heavy indeed. You’re on the hook for not only exercising the options (the strike price times the number of shares), but also taxes on options that you haven’t yet exercised. Make sure you have enough money to meet those expenses; otherwise, you’ll probably have to sell your shares to cover the cost of exercising them, and your tax rate will be much higher. Check out this guide to exercising your options to learn more - it’s a subject well worth your time.

When do you plan to raise your next round of funding?

As we mentioned before, investors demand shares in exchange for offering funding. If your company has 100,000 shares outstanding and offers you 1,000, you’d be getting 1% of the company. However, if the company plans to raise another round, it may soon find itself with 200,000 shares outstanding. The value of your 1,000 shares will be cut in half.

What’s your exit strategy?

If the company plans to be acquired or go public soon, your shares are more likely to be worth something. Not all companies will give you this information, but it’s helpful to know.

This isn’t an exhaustive list of questions, of course, but it’s enough to give you a sense of what your shares or options are worth, and how certain you can be of their worth.

Comparing offers apples-to-apples

Okay, that was a lot of information thrown at you. Let’s walk through a concrete example comparing offers from the startups BookFace and Moogle. We’ll keep a running total of what each offer is “worth.”

BookFace: $100,000 salary, 10,000 shares and 5,000 options

Moogle: $140,000 salary, 6,000 shares and 2,000 options

Salary

This one’s pretty straightforward, and will provide the foundation of our comparison.

BookFace: $100,000 salary

Moogle: $140,000 salary

Shares

Now that you know how to evaluate stock grants, you ask both BookFace and Moogle for their most recent 409a valuation and how many shares are outstanding. BookFace tells you that it has 10 million shares outstanding and is valued at $50 million. Moogle doesn’t tell you its valuation, but does tell you that the fair market value of its shares is $4.

BookFace: $100,000 salary + $50 million valuation  / 10 million shares outstanding * 10,000 shares offered = $100,000 + $50,000 = $150,000

Moogle: $140,000 salary + $4 FMV * 6,000 shares = $140,000 + $24,000 = $164,000

Stock options

Now, you ask the companies what the exercise price on their stock options is. Both set the exercise price at $1. You already know the approximate value of a Moogle share ($4), but to back into BookFace’s, you divide the valuation by number of shares outstanding. This gets you $5 per share.

BookFace: $100,000 salary + $50,000 grants + 5,000 options * ($5 FMV - $1 exercise) = $150,000 + $20,000 = $170,000

Moogle: $140,000 salary + $24,000 grants + 2,000 options * ($4 FMV - $1 exercise) = $164,000 + $6,000 = $170,000

In this (admittedly contrived) example, BookFace and Moogle’s offers are both “worth” the same amount. Let’s dive into the more nebulous factors that alter their value.

Qualitative factors

  • How quickly is the company growing? If you’re on a rocketship company, it’s better to take compensation in stock rather than salary (that’s the BookFace offer). If it’s headed for an acquisition or IPO very soon, your shares are more likely to worth something.
  • Does the company plan to raise funds soon? If so, your shares will be diluted, and you should devalue the grants and options accordingly.
  • What’s the vesting schedule? Be honest with yourself: how long do you plan to stay at the company? The average tenure of startup employees is just 10.8 months, so it’s entirely possible you won’t stay long enough to fully vest. In that case, companies that vest more quickly or ones that prioritize salary over stock are more worthwhile.
  • What other benefits are offered? Health and disability insurance, parental leave, a 401(k) (especially if it’s employer-matched), commuter benefits, and free meals can also factor into your decision.

The last question is one you have to ask yourself: How much do you need income security? Stock is a high-risk, high-reward proposition. Your shares might be worth nothing, or make you a millionaire. Salary, on the other hand, is dependable. If you’re financially insecure, have a lot of obligations (a mortgage, student loan debt, a family), or are simply risk-averse, you may want to prioritize salary over stock.

For all the jargon and numbers that go into comparing offers with startup equity, the decision may come down to softer factors - like how deeply you believe that the company will succeed.

Related article: Money Management for Startup Employees

Captain401 helps startups like Joyable and Buffer help their employees save with a great, scalable 401(k). Click here to learn more.