Startup Equity 101
I am writing this essay because I believe that money is both useful and worth thinking as little as possible about.
No one I know joins a startup to learn acronyms about equity and stock options. But some of those acronyms might have serious impacts on your life (or, at least, your money). The point of the below is to provide clear explanations of concepts that I think everyone who works in tech should understand.
There is a chance that reading this essay will help you make decisions that increase your net worth in the long term. The piece will probably take you at least 30 minutes to read. But, if you have (or may one day have) startup equity, the infomation below may directly or indirectly help you buy the house you want, retire earlier, provide a comfortable education for your children, travel more, or whatever else you want to do that money can help with.
This is not an advertisement for any particular service. It is also not financial, tax, or legal advice. My only unsolicited advice is that you should not blindly take unsolicited advice from strangers on the internet. The information below will probably be most helpful for people who are tax residents in the United States and/or work for American startups.
But if you have questions, or if something below is incorrect (or incomplete), you can email us.
Choosing where to work is an investment decision.
But unlike venture capitalists, your currency is time, and you generally cannot diversify your time across a portfolio of companies. (You could freelance, though this lacks many of full-time work’s benefits.)
Selecting the right startup to join will probably be your single biggest driver of returns (or lack thereof). You can define returns in terms of money, though you could also consider other variables: like fun, learning, ownership, impact, connections, and so on. This essay is about the money.
Compensation is the most straightforward piece of the puzzle. You look at the number and decide if you like it. Maybe you push them higher, and this great essay by Patrick McKenzie argues you should. But beyond savvy negotiating (which you can learn more about here), there is no laundry list of “optimizing” to do. No big tax code. No complicated finance terms. Just a number.
Equity is a different story. If you join a startup, you will likely receive some form of equity compensation. Earlier stage companies (<100 people) tend to offer stock options. Later stage companies offer restricted stock units (RSUs). If you join a very early stage company (<10 people), you may get something called a “restricted stock award.” Usually:
- You are granted equity when you first join. Sometimes you will get additional equity as you remain at the company and advance in your career. You may eventually end up with a mixed bag of equity: some stock options, some shares, and some restricted stock units. It can be helpful to maintain accurate records, using a cap table manager or personal finance manager, so calculating your taxes does not become a nightmare in the future.
- If you are the founder of a startup (and receive founder shares) then you do have a different set of considerations. TL;DR: there’s actually not too much “equity optimization” for you to do. You may want to look into QSBS (explained below).
Private company stock options are annoyingly complicated. I spend the next few thousand words solely dedicated to stock options. As you will see, unless you very reasonably choose to skip the section, this content is not particularly fun to read. But it can be quite impactful, so it’s worth refreshing yourself every so often—like when you start a new job or receive a new equity grant.
Obvious reminder: Even if you perfectly “optimize” your startup equity, your equity could become worthless—maybe even negative, if you include the cost to acquire it—if the company fails. When I say failure, I do not only mean going to zero, which is very common, but I also mean not returning capital to all shareholders, which is even more common.
Stock options give you the “option” to purchase stock.
Purchasing is also called exercising your options. You do not have to do anything when you are given stock options. There are no tax consequences for simply accepting a stock option. There are potential tax implications for exercising your options (which we’ll explore shortly).
As time passes, you unlock the right to exercise your option grant. This is called vesting. The most common vesting schedule for your initial grant reads as “vesting over 4 years, with a 1 year cliff.” This just means that you will unlock 25% of your options after 1 year of working at your company, and then unlock the remaining proportion every month for the next 3 years until you reach 100%. If you leave the company before 1 year has passed, you’ll be leaving with zero equity.
Some companies offer what’s called “early exercising.” This allows you to exercise your options before they vest, and to pre-pay the associated tax implications. We will cover this later.
Options have something called a “strike price” (also known as the exercise price). This is a fixed price, meaning you can exercise some of your options today at that price, and then the remainder of your options years later at that same price. You could then imagine why options can be valuable: if the value of the underlying stock goes up, and you can still purchase for a low price, you have a spread. That spread, in the context of private companies, is also called the bargain element.
Because this is a private company, calculating its value is not straightforward.
There’s no public stock market that sets the price for private companies. So we instead rely on other metrics to determine value. One of those is called the “409A valuation.” This is a process where a company hires an independent auditor (like an accounting firm) to appraise the fair market value (FMV) of a private company’s stock, in compliance with Section 409A of the U.S. tax code. It’s not a completely algorithmic calculation—meaning there’s supposedly an “art” to it—and includes many variables: things like the company revenue, industry, and profitability. Private companies are required to do a 409A valuation at least annually and also around any financing event.
The 409A valuation is also known as fair market value (FMV) or common stock valuation. As an employee (or founder), you typically get access to common stock.
Raising money is a popular term but it is also somewhat misleading. It may be more accurate (and less romantic) to call the activity “selling shares.” When your company raises money, they are selling shares of the company. Most of the time they are creating new shares to be sold off, but sometimes they are also selling existing shares.
One reason to sell existing shares is to give cash to current shareholders. Getting cash for your equity is also called getting liquidity. This rarely happens at early stage companies, but is pretty common nowadays for companies with tens or hundreds of millions of revenue to have a private market liquidity event for shareholders (like early employees and founders). We will cover more of this shortly.
There’s also something called preferred stock. As an employee, you probably don’t have it.
When a startup does a financing event, they get a “preferred valuation.” This is the kind of valuation you will see if you read a TechCrunch article headline about a recent fundraise. The preferred valuation is generally much higher than the 409A valuation (something like 3-5 times as high). When investors buy shares in a private company, they are buying preferred stock. As the name implies, it comes with a number of preferences. For example, investors who have preferred stock get paid out in an acquisition before employees who have common stock. This is not a problem for holders of common stock until it is, usually if your company sells for less than what investors are owed.
As a (successful) company approaches a successful IPO, their 409A valuation becomes closer to the preferred price until eventually the two converge and you are left with just one price: the public stock price.
You should also be aware of the term liquidation preference. The liquidation preference dictates the order in which people are paid out upon a liquidity event. The liquidation preference can be expressed as a multiple of the initial investment (e.g., 1x, 2x). A 1x liquidation preference means preferred shareholders get back their original investment amount before common shareholders receive anything. A 2x liquidation preference means they get twice their original investment before common shareholders receive anything.
But why care about valuations anyway?
One good reason is that the strike price for your stock options is set by taking the most recent fair market value (FMV), which is the 409A valuation per share, at the time you are granted your stock options.
The timing of when you are going to receive your grant sometimes creates a bit of confusion. The date you sign your offer is not the date you get your stock options. Granting of your options generally happens at a board level. To be more efficient, startups tend to batch grant options at some sort of regular interval (often quarterly following a board meeting). This timing difference can create some challenges—imagine signing an offer letter, and then the company goes and does a 409A valuation. Suddenly, you have to spend more money to afford exercising your stock options than you thought you would have had to.
There’s not a great way around this other than being proactive in understanding when the next 409A valuation will be. Startups sometimes cannot tell you what your strike price will be upon signing an offer because they don’t know if the 409A will still be relevant by the time you join the company.
There are two weird timing-related things you should know about.
Your options also have something called the vesting commencement date. This is the date your options begin vesting. They can backdate this to whatever date specified in your contract, even if the option is taking a while to be granted.
Something called ‘dilution’ can also happen. When your company raises more money, they are often increasing the total number of fully diluted shares outstanding—ii.e. they are creating more shares and then selling those to new investors. By increasing the denominator, they are diluting you.
People have different reactions to dilution. Some people are happy, because the value of their company is increasing and they are raising capital to increase the odds of success. Others have more of a negative reaction and try to then negotiate with leadership to get “topped up” or a “refresher.” Personally, I do not worry all too much about dilution—all common shareholders get diluted equally. What is most important is increasing the value of the stock as much as possible.
Some companies will reward you for delivering lots of value in the form of additional equity. These are called refresher grants. They are typically smaller than your initial grant but can still be meaningful.
So what is your equity really worth?
There are two ways to look at it.
- The difference between the most recent FMV (409A) valuation and your exercise price. This is called the “bargain element”. When you exercise your stock options, this is the spread that is used to calculate your tax liability.
- The difference between the Preferred Price and your exercise price. This is probably the prettier number of the two, since preferred valuations tend to be much higher than 409A valuations. This is the potential value of your shares if you are able to purchase for the lower exercise price and sell one day at the Preferred Price at IPO or another type of liquidity event. When you get an offer letter, they will typically calculate the value of the equity using this spread. This is slightly misleading in that a) it doesn’t include taxes and b) you really own common shares which, if you include the whole liquidation preference discount rate, should be valued less than preferred shares. In a successful liquidity event, though, they will just converge to the Preferred Price.
Pausing for everyone to take a super deep breath here. Go read my collection of surprising but true facts if you need a mental wake up.
We are about to get to an important section: TAXES.
Your taxes change based on the type of stock options you have.
You may be given incentive stock options (ISOs) or non-qualified stock options (NSOs). You may be taxed two times: 1) when you exercise your options and 2) when you sell the shares.
Non-qualified stock options (NSOs)
When you exercise the options: the bargain element is considered compensation income, which is subject to ordinary income tax. Ordinary income tax depends on your overall taxes. Here’s a calculator that can help you understand the impact of a progressive tax system. You owe ordinary income taxes immediately.
When you sell the shares: If the shares are sold within one year of the exercise date, any gain (the difference between the sale price and the FMV on the exercise date) is considered a short-term capital gain and is taxed at ordinary income tax rates.
If the shares are sold more than one year after the exercise date, any gain is considered a long-term capital gain and is taxed at the more favorable long-term capital gains tax rates.
Incentive stock options (ISOs)
When you exercise the options: You do not have to worry about ordinary income taxes. But you do have to worry about something called the Alternative Minimum Tax (AMT). The bargain element is counted as income for calculating AMT. AMT is a pretty complicated calculation but you can read the tax code here and/or ask ChatGPT and/or ask a professional. Me writing out the formula would be less helpful.
- One thing about AMT is that anything you pay towards AMT this year can be used as a credit in future years where you are not liable for AMT.
- You owe AMT when you pay taxes, not at the time of exercising.
When you sell the shares: If you sell the shares at least two years after the ISO grant date and at least one year after the exercise date, the difference between the sale price and the exercise price is taxed as a long-term capital gain. This is also called a qualifying disposition. Otherwise:
- The bargain element (the difference between the FMV at exercise and the exercise price) is taxed as ordinary income.
- The additional gain (the difference between the sale price and the FMV at exercise) is taxed at short-term capital gains (which is basically your ordinary income tax rate).
There are two other tax details that may apply to both ISOs and NSOs.
The first is something called early exercising. Some companies allow you to exercise unvested stock options. The purchased shares are still subject to the vesting schedule (meaning if you were to stop employment, the company would “claw back” your purchased shares and you would return them). The key benefit of exercising all your options (or at least some of them) before they vest is that you can get a tax advantage. If you file something called an 83(b) election within 30 days of the time of your exercise, you are basically sending a letter (recently made possible digitally) letting the IRS know that you’d like to prepay taxes on your shares. You would do this to lock in a lower bargain element, and therefore owe less taxes as opposed to waiting until the bargain element was much higher before exercising. The other reason you would do this is to kickstart the long-term capital gains clock that we previously described.
Note: forgetting to file an 83(b) election after you have early exercised is pretty terrible. It creates a giant mess and there is not a good solution to this that I know of—so take this as an extra reminder to please do an 83(b) election on time. You only need to do this when you exercise early, i.e. when you are purchasing your shares before they have vested. You do not need to file an 83b election when you are just exercising options normally.
The second detail is something called the qualified small business stock tax exemption (QSBS), also known as section 1202 of the US tax code. If your stock qualifies for QSBS, you can receive tax-free gains from the sale of your stock on the greater of up to (i) $10 million, or (ii) 10x your original investment. This is $10m tax-free for federal tax purposes and sometimes also at the state level depending on where you are. To qualify for QSBS, your stock must pass a number of tests, including criteria like needing to acquire stock while the business has no more than $50 million in aggregate gross assets (just note that this is different than the valuation being $50m) and also needing to hold onto acquired shares for at least 5 years before selling. This applies at the time of stock issuance, not option issuance, meaning to start the clock, you actually need to exercise your options.
There’s other fancy things you can do to potentially increase the amount you can receive tax-free. You can read about “qsbs rollovers” (basically what to do if you need to sell QSBS eligible shares before they reach the 5 year hold period mark to still preserve the QSBS status) and “tax stacking” but beware that it can get quite complicated, risky, and distracting.
To summarize…
- One benefit to exercising early is that you are less likely to owe as much taxes at the time of exercise (as opposed to waiting to exercise later on when the bargain element is higher).
- The other benefit is that you start the long term capital gains clock, which means that you could qualify to pay less taxes on your eventual sale of stock (long term capital gains can be something like 17% less than ordinary income taxes).
- You should be aware of early exercising and QSBS. Both can help you optimize your taxes.
This can all become extra complicated because, if you exercise your options, you may owe taxes (today) well before you can get liquidity (maybe years from now).
Liquidity is complicated because you can really only sell options when there is a permitted place to do so. Most companies do not allow you to sell shares whenever you want—they often have rules in place called transfer restrictions which prevent random people from being on their cap table.
Some companies do allow employees to sell through company-sponsored events known as “tender offers.” Tender offers can take a few different shapes—for example, sometimes they are only available to current employees—but in general they allow you to sell a portion of your shares.
One small nuance is that it is not logistically possible to sell options directly. You can, however, exercise and sell your options at the same time. People sometimes do this around a liquidity event. This is called a cashless exercise. It’s not tax-optimal (it’d be better to exercise and hold onto your shares to get long-term capital gains), but it may be liquidity-optimal.
Sometimes I talk to people who are so obsessed with optimizing their taxes they forget to weigh factors such as liquidity. Cash today may be worth a lot more to you than illiquid startup equity which may or may not ever become liquid.
Dealing with liquidity challenges can be annoying.
Something not being liquid is challenging for a few reasons. One is the direct part—you cannot buy things in exchange for private startup equity. The second is that most financial institutions are not designed to underwrite your equity in some important processes, like giving you a mortgage or a personal loan. (And for good reason, because how are they supposed to underwrite the risk of a private company?)
Having a high net worth on paper but low liquidity is the type of problem most of your friends will not feel bad for you about. I do not feel that bad for you, but I do recognize that it is complicated and a tricky position to be in. There’s no great solution for this.
Even at very highly demanded companies (the blue chip private companies of the world), there are not many company-approved liquidity events. Thus, because there is so much demand from a) employees who want liquidity (so they can go buy things or so they can decrease risk) and b) investors who want exposure to the stock), there have emerged a number of gray area tactics. I say gray area because they are the types of solutions where I really do not know if they are approved or legal or whatever. I am not suggesting you do them. I am just saying people do them all the time. There are big companies that have facilitated hundreds of millions of dollars of private market transactions (also called secondary market transactions), many of which do not have company approval.
To be honest, I don’t know of a great liquidity solution in the private markets. There is a pretty wide graveyard of startups who have tried to fix this problem. The challenge is fundamentally that many companies do not want to make it super easy for employees to get liquidity. Companies have some good reasons for this, but it’s the sort of thing that can create complicated situations.
This liquidity problem is extra really complicated (I’m running out of extreme adjectives here) when you are put in a position where your options are set to expire. Expire means your options are returned to the company and go to zero. When you are issued stock options, they come with an expiration date. The default expiration date (and also maximum allowed timeframe by the IRS) is ten years from when the options are granted. You could imagine the challenge when companies now are starting to take > 10 years to go public. There’s not a great solution here (unless maybe we invent a new form of compensation?).
You should also pay attention to something called the post-termination exercise window. The default post termination exercise window is 90 days. This means you have 90 days from the time you depart your company (either voluntarily or involuntarily) to purchase your vested but unexercised stock options before they expire. Anything expired gets returned to the company and you get nothing.
It is becoming more popular for companies to amend stock options to contain an “extended post termination exercise window” (beyond the 90 days to something like 10 years). This gives employees more time to come up with the cash needed should they want to exercise their options. It creates some other challenges though. For example, to extend beyond the 90 days you need to convert any ISOs to NSOs. Also, as a startup you may end up with a lot of “dead equity” on your cap table.
This is a highly debated topic. Will leave that to the fancy people to debate, for now, though figuring that out would probably be meaningful.
If your options are set to expire, you may want to explore non-recourse financing.
The idea behind non-recourse financing is to allow you to exercise your options and pay the associated taxes without using your own cash upfront, while limiting your personal liability to only the collateral (the shares themselves) if things don’t work out.
These things—also called private financing contracts, also called prepaid variable forward contracts—can be confusing. Most of the people who sell them also are confusing (which is a nicer way of not seeming like the most trustworthy of people). Maybe you can find one you trust, though. Maybe they are out there. I could write several pages about the mechanics of these non-recourse financing options, and perhaps I should, but that day is not today. In general, just know they are quite expensive—generally more expensive than the benefit of long term capital gains but less expensive than the cost of losing your equity.
You could also explore getting recourse financing.
But I would not recommend that unless you have extreme conviction in the company. I define extreme conviction well beyond merely liking the product or thinking the founder is smart. What I mean is that you would quite literally bet your home (and the bed you sleep on) that the company is going to return your capital at some point. Even then, I’d encourage you to compare this to the risk-adjusted opportunity cost of other options.
If you have made it this far, you have learned the startup equity fundamentals.
Congratulations. You may find yourself in a position simply wanting answers, though.
Should you exercise your stock options?
My answer is maybe. Fun, right? While I wish I could give you some more clarity, there’s no right answer. Do not believe anyone, no matter how senior they seem to be or how many acronyms they have next to their name, who tells you otherwise.
Deciding to exercise your stock options is a multi-variable-optimization.
Exercising stock options is risky for many reasons we mentioned earlier, but it’s worth emphasizing: most startups fail and, given you already work at the company, you already have concentrated employment risk. [0]
But if you do have the capital—and ideally a far excess of the minimum capital you need to both exercise the stock options and also afford the tax consequences—there is upside to exercising earlier on in the lifecycle of the company. A lower bargain element generally means lower tax implication, and a longer time horizon could mean that a higher proportion of your gains would be taxed at long-term capital gains or QSBS instead of ordinary income tax rates.
You do not have to exercise all your options at once. You can exercise them in tranches.
I would encourage you to think about exercising your stock options in the context of all of your other investment decisions. People sometimes forget that you have lots of options (no pun intended). You do not have to exercise your stock options just because you work at a company. You could invest in your startup, yes, but you could also invest in the public market. Or in real estate. Or in things that will make you happier today. What you are missing out on by not exercising is A) not starting the long-term capital gains clock and B) the optionality/freedom that comes with not having to worry about the post-termination exercise window. Yes, these things are valuable, but they are not worth potentially going bankrupt over.
To actually decide what to do, here’s one approach you can try:
1. You should see math. Model out the different scenarios. Figure out the best case scenario and the worst case scenario. Try to develop a strategy that you are happy with in both cases.
2. If the above sentences grossed you out, you can pay another human to do this for you. Probably a CPA, not a financial advisor (though some financial advisors may know this stuff).
3. You should test any professional before you hire them. Do not just trust them because they wear a suit and/or have acronyms next to their name. Look for proof of good work.
Beware there are many advisors who are not helpful. Yes, there are some great advisors who can make a difference in you and your family’s life. But most do not meet that bar. Any advisor that gives you prescriptive advice around what to do or talks in broad strokes is probably not the type of advisor you really want to trust. Also, any advisor who pulls out fancy technical charts telling you that they can predict future stock market prices is lying to you. Beware.
4. Make a decision. Crystallize this by writing yourself a short memo describing why you are making the investment decision. What are your motivating factors? Make it explicit. This will help you minimize regret for your future self. Note that not making a decision is also a decision.
5. A lot of people see the disclaimer that “past performance is not an indicator of future results” as simple legalese they can skip over. I would internalize that message. So many friends of mine who worked at startups that eventually went public saw their share price bounce up and down like the type of roller coaster ride no one really wants to get on (although I do love a good roller coaster).
Write the memo to yourself. Be explicit about the risks you want to take. Putting things in writing should make a difference.
If you just want a TL;DR, here is my lazy answer for what to do with your equity.
If you join an early stage company and you have a decent amount of excess capital, early exercise everything and file an 83(b) election. The reasons for doing this: starting the QSBS clock, starting the long term capital gains clock, not needing to worry about your options expiring.
If you join an early stage company and you don’t have much capital, don’t do anything just yet. Try to negotiate for an extended post termination exercise window.
If you can get liquidity at some point, and you think liquidity would improve your life, you probably should.
If you have restricted stock units (RSUs), everything is pretty straightforward. You do not have to purchase RSUs. You just get them at no cost as they vest. Most private companies do something called double-trigger vesting. That just means you are also not taxed as they vest. Instead, you get taxed for your RSUs at some second trigger date, which is usually set to be the date of the future big liquidity event (at ordinary income). One big drawback with double-trigger RSUs is that you are not really able to sell them in tender offers or other pre-going-public liquidity events.
* * *
The above is basically everything you need to understand about stock options. It is complicated, but it is not that complicated. You most definitely do things at work that are at least of similar levels of complicated. And now that you know this information, you can make more informed decisions about which companies to join and how to manage your equity.
Private startup equity is probably the most complicated part of personal finance for people who have it. At least the most complicated part I have seen so far.
There are at least a few other topics that more people in tech should understand. Like investments (public and private), philanthropy, estate planning, borrowing, how to interview an advisor before you hire them, personal finance specifically for startup founders, and others. Perhaps one day I will write essays about those topics. Until then, best of luck.
Reminder that this is not an advertisement for any particular service. It is also not financial, tax, or legal advice. My only unsolicited advice is that you should not blindly take unsolicited advice from strangers on the internet. But if you have particular questions, you can email us.
[0] There’s a related thing here which is that if you work at a company you don’t believe in or don’t enjoy, I would encourage you to think about leaving the company. This is obviously a privileged perspective, and sometimes you need to work to cover the bills and you do not have other options. If you do have alternatives though, or at least think you do, I would consider trying to find something that gives you more energy. Life’s short, ya know.
* * *
Enjoy these essays?
Or, if you have any feedback, contact us.