Employee Equity and Startups – A Primer

Anyone who takes a job with a startup should be well educated with respect to matters related to employee equity, both to make sure they understand the risks they are taking on and to ensure that they do not wind up in a tricky situation with respect to taxes. In an ideal world startup companies would clearly and correctly explain all of these issues to each of their employees/prospective employees.

However some of them don’t or can’t, and unfortunately some will even deliberately feed bullshit information on the subject to their employees in order to avoid having to actually make good upon their promises of equity. So for the benefit of anyone who has unanswered questions on the subject of employee equity I am providing this article.

Be aware that I am not a lawyer, and do not claim to be. However I have worked with several startup companies and seen the employment contracts and equity agreements used by several others (startups and established firms alike), and invested a significant amount of my time in researching this subject. I think that makes me qualified to speak on it. I’m also not a liar, a bully, or a manipulator, and that ought to count for some measure of credibility as well. If that statement seems out of place to you, feel free to ignore it. Those who should know it to be true and relevant, will. And naturally you are free and encouraged to do your own research and to check the references I’ve used.

Anyhow, all equity agreements vary somewhat as far as the specific wording used. Some features, however, are essentially universal. These are the allocation, a vesting schedule, and a cliff. Many agreements will also include some verbiage around the subject of dilution, what happens if the company is purchased or goes public, and similar topics.

There will be more on all of those shortly, but first let’s discuss a couple of common misconceptions that are related to this subject.

Common Misconceptions
There are a number of myths about employee equity and compensation that you may find perpetuated at the less ethical startup companies. A couple of these are debunked here.

Equity is the “prize at the end of the race”. False. The value that the equity takes on over time is the prize at the end of the race. The equity itself is your incentive to run the race as hard as possible. Because that’s the only way your equity will ever have value. And it only works if you are allocated the equity before you start running. The fact of the matter is that you want to be allocated your equity when it is still worthless. If you wait for the company to become successful you’ll be stuck in one of two undesirable situations. Either 1) you will get hit with a massive tax bill when you finally do receive your equity that will probably force you to immediately sell off a significant chunk of it (which can be very difficult unless the company has gone public), or 2) you will be forced to take your equity in the form of options instead of as shares. Note that option #2 means that your equity will have zero value when you finally do get it (that’s the only legal way around the tax issue), unless your employer back-dates the grant date for you. And do note that back-dating options may be illegal. If your employer thinks you should run hard before they allocate you any equity, you should run all right; run away from your employer as fast as you can!

Market rate is lower at a startup. False. There’s only one market, and only one market rate. Regional fluctuations exist, naturally, but even those are diminishing as distributed teams, telecommuting, and similar practices become more widespread. In any event, a startup does not get a discount on the prevailing market rate simply for being a startup. Wages are virtually always lower at startups, because employees are allocated large chunks of equity to make up for the difference between market rate and what they are actually being paid. If a startup does not give this equity to its employees, then it has no excuse for offering any employee a below-market-rate salary. A correct reiteration of the original assertion would be “your cash wage is lower at a startup because you have been issued equity to account for the difference between your cash wage and your market rate”. If your employer says it any other way, that should be a red flag that something isn’t right. Doubly so if they say it in any other way in defense of not giving employees equity or of not paying employees the full market rate.

If you are unsure about the fair market rate for the job you perform, I encourage you to do some research on Glassdoor.com. For instance, here is the going rate for a technical architect in Australia. Here are some others:

Glassdoor is full of useful information. But it’s time to move on with the rest of the article.

Allocation
With equity agreements, the allocation is simply the amount of equity that a person is being granted. This may be specified as a total number of shares (at an established/well-organized startup) or as a percentage of the company (at a fledgling/less organized startup which has not set up a pool of shares yet). Either approach is fine, although when shares are used you should be sure to ask your employer what the total size of the share pool is, since obviously receiving 10,000 shares out of a pool of 100,000 is quite different than receiving 10,000 shares out of a pool of 100,000,000.

The bottom line with any allocation is that you should be able to work out what portion of the business, as a percentage of the company, that you are being granted. This is useful for answering questions like ‘if the company is sold tomorrow for $1 billion, how much of that would I get?’ ($10 million per each percent allocated). There is no “standard” allocation, however your allocation should be appropriate to 1) your amount of experience/expertise, 2) the importance of your role to the company, 3) your market rate and the amount of salary sacrifice you take on, and 4) how early (or late) you joined the startup. Depending upon these factors, allocations may be anywhere from 1% to 20%, with exceptions made in exceptional cases.

When joining a startup company early in its life and/or at a significant salary sacrifice you should be reticent about accepting any offer that is below 1% of the company. Never sell yourself short; if you’re going to be working for a fraction of your normal/market rate you deserve to have full confidence that you will win big if/when the company is successful. Otherwise you are just wasting your time.

Vesting / Buyback
The allocation specifies how much of the company you get. However, you will virtually never receive your full allocation up front (and if you are offered such a deal and aren’t a founder/co-founder, it’s a sure sign that the company you’re working with is very inexperienced in these matters; you should do the right thing, and let them know that they really ought to be using a vesting schedule). The reason for this is simple. If the entire allocation is ‘paid’ immediately, an employee can join a company, resign the next day, and walk with their entire allocation. That’s very bad for business, for obvious reasons.

To solve this problem, you will typically receive incremental portions of your allocation over time. Should you leave the company (due to resignation or any other reason), provisions in your equity agreement will only permit you to retain those incremental portions that you received up to your final date of employment. That portion is referred to as the vested shares (or vested equity, if working off a percentage).

In essence, vested shares are the shares that the employee now owns, while unvested shares are shares which have been allocated to the employee but not actually handed over to them yet (the employee will get them eventually if they stay with the company, but doesn’t own them yet). Unvested shares gradually convert to vested shares based upon the vesting schedule. A vesting schedule will specify a timeframe over which vesting occurs, and at what increments unvested shares will convert to vested shares.

A typical vesting schedule will specify a timeframe of 4 years (this is basically industry-standard), with the allocation vesting in equal increments across that span of time. Increments are usually handled on a monthly or quarterly basis, although half-yearly and yearly increments are sometimes used. So for instance, if an employee is given 4% of the company and has a 4 year vesting schedule with quarterly increments, they will receive 1% of the company per year they remain employed, at a rate of 0.25% per quarter. Usually a vesting schedule will not prorate partial increments (i.e. if your last day of employment falls in between two increments, you will not usually receive vested shares for the partially completed increment).

Buyback is a feature unique to Australia (or at least, not seen in the U.S.; it’s possible other countries use similar provisions). In the U.S. a tax loophole exists (known as an s83(b) election) that allows the recipient(s) of equity to avoid owing tax on it incrementally as it vests. An equivalent loophole does not exist under Australian tax law, and so some companies will use a buyback provision to work around this fact for their employees.

Buyback works almost like an inverse of the standard vesting schedule. Instead of the allocation being held by the employer and then incrementally transferred to the employee as it vests, under a buyback arrangement the employee will receive the entire allocation up front and the employer will retain a right to buy back a portion of the allocation from the employee for some nominal (close to zero) value. This buyback right diminishes incrementally, such that at the end of the vesting term it has been reduced to zero and the employee now has full control over their shares. Separate provisions will generally prevent the employee from freely trading any shares that are still subject to buyback, typically by the employer retaining right of first refusal over any such shares, or other prohibitions on trading.

Recent changes to the tax code in Australia may have removed some or all of the taxation benefits associated with buyback provisions, so they may be less common now than in the past.

Cliff
The simplest possible vesting schedule will convert unvested shares to vested shares in equal increments across the entire vesting timeframe. Few businesses will use that approach, however, again due to the (entirely legitimate) desire to prevent people who stay with the company only a short while from walking away with chunks of equity. To mitigate that possibility, most startups will include a cliff in their equity agreements.

A cliff is essentially a modification of the vesting schedule to delay the vesting of some portion of shares until some timeframe has elapsed. For instance, a cliff may specify that no shares shall vest until an employee has been with the company for a total of six months, at which point any shares that would have normally vested during that timeframe (as specified in the vesting schedule) will vest all at once.

So if our employee from the previous example (who was granted a 4% allocation vested quarterly over 4 years) is also subject to a six month cliff and resigns after five months, they will not be able to take any equity with them. Similarly, if they instead resign after 7 months they will have satisfied the cliff, and be entitled to take their first two quarters’ worth of equity (0.5% of the company) with them.

Typical cliff durations range from six months to 2 years. Some startups may not use a cliff at all, and you should be wary of accepting any cliff that is more than a year or so in duration. Also note that a cliff may have tax implications (particularly when the cliff timeframe is longer than one year in duration), as it causes you to receive a larger block of equity all at once. When an equity agreement involves options rather than shares (i.e. when joining an established company instead of a startup), a cliff is not typically used as the allocation is generally much smaller and its real/immediate value is significantly less than when dealing directly with shares.

Dilution
Shares in a company don’t appear out of thin air. As new allocations are granted, the equity being allocated to the new employee needs to come from somewhere. This necessarily means taking some portion of equity away from at least one existing shareholder (or out of a preallocated pool, if one exists). When this happens, it is referred to as dilution.

Dilution is a relatively straightforward subject in and of itself, but failure to understand it can lead to disaster. For instance, let’s say that Alice and Bob are co-founders at a startup, and that Alice holds 80% of the equity and Bob holds the remaining 20%. If a new employee is allocated a 10% stake in the company, the following scenarios are possible; 1) all shares dilute equally, meaning that Alice’s holding will be reduced to 72% and Bob’s will reduce to 18%, 2) only Alice’s shares will dilute, meaning that she is left with 70% and Bob retains his entire 20%, or 3) only Bob’s shares will dilute, meaning that he is left with only 10% while Alice keeps her entire 80%. In all cases the new employee ends up with 10%, at least until the next employee comes along. Note that a 4th scenario is also possible, in which the company maintains a pool of unallocated shares to cover new hires coming on board; this effectively prevents dilution, at least until the pool is exhausted.

It should be apparent from those example scenarios that being the only person with dilutable shares is a bad idea. As The Social Network so entertainingly underscores, if you are the only person with dilutable shares you will quickly see your equity evaporate. Note that in scenario #3 Bob lost a full 50% of his original allocation due to a single new employee coming onboard. It would not take many more hires to reduce Bob’s shareholding to essentially nothing.

When dealing with an equity agreement that is specified in terms of shares (i.e. with an established/well-organized startup), the terms of the agreement should state whether the shares allocated are Common (which they will be 99% of the time), Preferred, or any other special type. Any special dilution rules that apply should be mentioned, although it is always wise to ask about how many different classes of shares the company has issued, and about whether or not any class of shares has preferential treatment with respect to dilution. In the vast majority of cases, all shares will simply dilute equally.

Conversely, if your equity agreement is specified in terms of a percentage of the company (i.e. with a new or disorganized startup) you should ensure that your percentage is specified as being non-dilutable until such time as proper shares are allocated. This provides incentive for the business to allocate actual shares swiftly, and protects you from any number of shady behind-the-scenes things that might be done when dealing with a dilutable percentage.

Generally speaking, it is fair and commonplace for everyone’s shares to dilute equally once shares have been allocated. Prior to that point, it is fair and commonplace for only the founders’ holdings to dilute up until the moment when actual shares are allocated. If your equity agreement is significantly different than this, think twice. And if it tries to make you the only person with dilutable equity, run.

Options vs. Shares
Depending upon where the company is at the time you join it, your equity agreement may deal either in options or shares (if your equity agreement deals in terms of a percentage of the company, expect your portion of the company to be delivered to you as shares). Shares are quite simple, and the norm when dealing with an early-stage startup. Each share has a value that is determined by the company’s net-worth/market cap, and the value of an allocation is simply the share value multiplied by the number of shares. Simple.

The problem with shares is that they have a real value at the time they are allocated, and this means that share allocations are taxable as income (though note that when a vesting schedule is used your shares will be taxable as they vest and not when they are allocated). This can cause some very significant issues. For instance one share of Google is currently worth a little better than $1,100. If Google were to give 500 shares to an employee, that employee would owe taxes on some $550,000+ in income, probably forcing them to sell 30-40% of their shares just to cover the tax bill.

The way around this tax issue is to use options. An option is not a share; instead it is the right to purchase a share at a set price at some time in the future. The price associated with an option is generally (unless the company has back-dated the option) the market price on the date the option is issued. This means that when options are granted they have zero real value, which solves the tax problem nicely and is why established companies use options in their equity agreements almost exclusively. It also means that unless back-dating is involved, options are completely worthless when you receive them.

To return to our previous example, Google could issue an employee options on 500 shares, granting them the right to purchase those 500 shares now or in the future for $1,100/share. The options have no immediate value (the employee can get 500 shares of Google, but only by paying $550,000 for them; the same as buying them on the open market). If the value of Google increases to, say $2,200/share, at that point the employee can buy 500 shares for $1,100/share, and then immediately turn around and sell them for $2,200/share, netting a $550,000 profit (which is taxable as capital gains). So options only attain value if the company’s share price continues to rise. If it remains the same or goes down, the options remain completely worthless.

If you’re joining a newly founded startup, you do not want to receive options unless the strike-price is fixed on or against your hire date (meaning that it is <= $0.01/share, since the startup should be close to worthless when you join). You should be offered shares in the company. If you are not then that's a good indication that you should seek other opportunities elsewhere. Words are Trivial
Now that’s all a fair bit to take in. And this is a good moment to underscore the importance of always getting a written equity agreement from your employer. Verbal agreements are notoriously unreliable and subject to differences in interpretation and perspective. Particularly when dealing with subjects like vesting and dilution that are extremely nuanced and virtually impossible to adequately capture in a verbal agreement.

If the startup company you are working with will not provide a written equity agreement, or fails to provide one in a timely fashion, that’s a strong indication that you should seek another employer. There is little reason for a startup company to not provide written equity agreements, unless the managers of the startup company simply do not intend to actually give anybody any equity (some people just don’t like to share; but thankfully their actions make them easy to spot). And you really don’t want to end up working at startups like that.

If your employer cannot tell you (in exact terms) your allocation, your vesting schedule, your current vesting status, or exactly what will happen in the event of an acquisition, resignation, or termination, they haven’t given you a real equity agreement!

Example Equity Agreements
For reference, I have included a some example equity agreements here. All are real agreements that have been used in practice, although any identifying information has been obliterated. Note that although some are far more verbose than others, all agreements cover essentially the same subjects.

The equity agreement that you get from your employer should be reasonably similar to these agreements. You should be able to easily pick out the allocation and the vesting schedule. If you cannot, be wary. Or if you have only a verbal equity agreement from your employer, be triply wary.

Thought Exercise
Now let’s consider a hypothetical example company, Transnational Application Production Services. At this company, employees are routinely offered salaries that are significantly below prevailing market rates. The typical “discount” is in the range of 50-75% off of market rate, which means that some employees are even asked to accept offers that are below the legal minimum wage. In exchange for this salary sacrifice, employees are offered equity in the company as part of their compensation. However, this offer of equity is only ever stated verbally, and although several employees request written equity agreements both before and after signing their employment contracts, no written equity agreements are ever provided by Transnational Application Production Services. Nor does the company provide any statements relating to vesting schedules, allocation size, or other issues typically covered in an equity agreement.

Can you guess what happens if/when an employee leaves the company? Do you think they will get to take any portion of the equity that was promised to them when they leave? If you answered ‘absolutely not‘, you are probably correct. In a normal startup company, every employee would have a document the specifies their cliff terms (if any), and what happens should they leave the company before or after the cliff period has elapsed. An Transnational Application Production Services employee has none of those things; and since their equity agreement relies upon a verbal contract, it would be very difficult for them to ever prove otherwise. A verbal contract is about as good as having no contract at all.

However, let’s say that we’re wrong, and that Transnational Application Production Services agrees to make good on its verbal promises of equity. Can you work out how much equity the employee will receive? If you answered ‘absolutely not‘ again, you are most definitely correct. Because the verbal agreement from Transnational Application Production Services never specified an allocation or a vesting schedule, there’s absolutely no way of knowing how much equity a given employee should or will receive, or how much equity they possess at any given point in time. Without a written agreement, everything is left up to the whim of Transnational Application Production Services.

Contrast that with a standard startup company, in which each employee’s contract specifies an allocation and vesting terms. This makes the task of determining how much equity a departing employee gets to take with them trivial, since it’s all there in black and white. By not having a written equity agreement, employees at Transnational Application Production Services are exposed to a significantly larger amount of risk than their counterparts at virtually any other startup. One hopes that the hypothetical management at Transnational Application Production Services would at least take the time to explain this extra risk to employees as part of their hiring talks. Though you may use your own imagination to decide whether or not that happens in our hypothetical world.

But surely there’s an upside‘, you say. And that’s a reasonable thought. Taking on increased risk is supposed to result in increased rewards, after all. But unfortunately no, that’s not how it works in this case. Because no allocation has been specified, each employee’s rewards have been left entirely up to the whim of Transnational Application Production Services and its management. There’s no minimum amount of equity that an employee at Transnational Application Production Services can count on getting. There’s no maximum amount either, but that’s not an added benefit because the same case exists at every other startup. Having an allocation specified does not preclude management from allocating additional equity to people it feels deserve it, it simply provides a minimum amount that every employee can be confident that they will get.

So employees at Transnational Application Production Services are taking on more risk than their counterparts at other startup companies. While at the same time they have less certainty about how much of a reward they will receive. There is no upside; the employee loses on both counts.

Things are quite a mess over at Transnational Application Production Services. Our hypothetical company is most definitely not a shining example of how real companies should be run. If Transnational Application Production Services reminds you of your own employer, you’d be wise to start seriously seeking out other options.

Of course, it’s entirely possible that the management at Transnational Application Production Services is simply uninformed about how to best handle equity allocations, as it is a startup company after all. It’s important to always give people the benefit of the doubt.

However, imagine that at our hypothetical company multiple employees have raised the issue of getting written equity agreements in place. And that some of them have even gone so far as to discuss the very issues covered above with their employer. And that our hypothetical company has made repeated promises with respect to getting together a written agreement but not delivered upon a single one. And that at Transnational Application Production Services the only person who has been given an actual allocation is a manager who takes home a six figure income while his colleagues work on below-minimum-wage salaries, while simultaneously and routinely asserting that everyone is being paid market rate and that there’s no money available for pay increases. And that those employees on below-minimum-wage salaries have repeatedly brought up the issue of their low rate of pay. And that the only employees to successfully petition for a legal wage were the ones who pointed out that their wage was in fact illegal. And that all of this has gone on for years with no corrections being made.

A certain pattern of inequity begins to emerge at our hypothetical company. Will this pattern of inequity exist at every startup company that doesn’t provide written equity agreements? No, probably not. But the lack of one should be a red flag that you may be working at Transnational Application Production Services. And that is not a company that you want to work for.

Ignorance is understandable, if deplorable (and also 100% correctable). Deliberately taking advantage of people, on the other hand, is just plain despicable. Companies which operate like our hypothetical Transnational Application Production Services are taking advantage of their employees and wasting everyone’s time. The company is getting work at a significantly discounted rate, and not providing anything whatsoever in return. ‘Thievery’ and ‘exploitation’ are words that come to mind.

Our hypothetical startup is about as bad as they come. We should all be grateful that such companies rarely exist in the real world.

This example further underscores the importance of always getting a written equity agreement that specifies your allocation, vesting schedule, and cliff whenever dealing with a real-world company.

Random Quote
No matter how you spend your life, your wit will defend you more often than a sword. Keep it sharp!

Disclaimer
All characters, companies and events in this blog–even those based on real people–are entirely fictional. All celebrity voices are impersonated…poorly. The preceding blog post contains useful information and due to its content should be read by most people. But not the elderly, people with heart conditions, or CEO’s of disreputable startup companies.

References

This entry was posted in banter, editorial and tagged , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>