If you’ve landed your first gig at a technology company, you may feel overwhelmed about the equity portion of the employment offer. Unlike a public company that may offer the option to buy publicly traded company shares, understanding the nuances of equity for a private company can be complex. In this post, we’ll look at some key elements that every early career tech employee needs to know about equity to give you a leg up on the learning curve.
What Is Equity?
The term equity refers to a share of ownership in a private company that the founder offers to an investor in exchange for capital funding or to an employee as part of a compensation package.
Understanding the Big Picture of Equity
Generally, companies distribute equity to employees based on several factors, including during which stage of funding they joined the company, how senior their role is, and what type of job they have (think software engineer, sales, marketing). Those who join a company earlier are typically offered a higher equity grant in exchange for a lower salary than the market rate for a position elsewhere, like a public company, in exchange for the ability to purchase that equity once it has vested and, hopefully, make a good return.
For this reason, job seekers must understand the market rate percentage for the position they’re applying for and factor in the funding stage. This way, they’ll be able to confidently negotiate and make sure they’re getting the equity they deserve when accepting an offer. Online resources, such as Top Startups, share and aggregate real-time data on what employees at other companies have received for equity.
Assessing the Full Picture of Your Equity Offer
Once you have a job offer in hand, you need to understand the details of the equity portion to get a clear picture of what that equity represents and how you should consider it when evaluating the offer. Although every company is different, these are the most common questions you should ask to understand the equity offer better.
How to Evaluate an Equity Offer
To evaluate an equity offer, you should ask the company to find out all the following information:
- The strike price: This represents how much each option costs to purchase.
- The current fair market value: This is the latest valuation of what the option would be worth if it were sellable and how the government values it and accounts for it during taxes.
- The total percentage of the company the equity represents: Companies normally share the number of options during the offer, but to assess if you have a fair deal, you need to know what percentage of the whole those options represent.
- The option type: Companies can offer different option types to employees such as ISOs (incentive stock options) and NSOs (non-qualified stock options). Understanding what the terms entail is an important part of your due diligence, specifically regarding when and how these options are taxed.
- The vesting terms: Companies can structure their vesting terms in different ways. For example, a company may often offer a four-year vesting with a one-year cliff. This structure means you aren’t entitled to any of that equity if you leave before the first year.
How to Negotiate the Terms of an Equity Grant
Though often overlooked, a highly important aspect of this negotiation is settling the terms of when the employee can purchase equity. For most companies, when employees leave (whether by their own choice or the company’s), they generally have a 90-day window to buy any vested equity they’ve earned. The trick is that departing employees will often owe tax on the difference between the strike price (meaning the initial price at which they could purchase the options) and the current fair market value.
For example, suppose you work at a company that has taken off. In that case, this success can often lead to a vast (think thousands, if not hundreds of thousands of dollars) tax bill generally without the ability to sell the shares at that moment or know what they will be worth when (and if) they are sellable.
For this reason, it’s common for some employees, especially those who joined early, to get “stuck” at a company because they can’t afford to pay the tax bill. An intelligent way to avoid this situation is to negotiate one of two terms for the offered equity grant. The first is to request an 83(b) election. The 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee or startup founder the option to pay taxes on the total fair market value of restricted stock at the time of granting. This might be a great choice if you’re particularly bullish on the company’s success.
The second is to negotiate for an extended window to purchase options. This approach is smart for those who want to wait and see what will happen at the company after they leave and doesn’t burden them with a tax bill until they decide to purchase. In some cases, employees can extend the window to buy from 90 days to up to five years.
Don’t Go It Alone
Although understanding the terms of an equity offer and negotiating the terms is critical, unless you have a background in finance, hiring a certified tax or financial professional is a smart way to ensure all your bases are covered and can help you prepare for any big choices like purchasing your equity or understanding your tax implications if you decide to leave.
