Key Takeaways:

  • When offered equity as part of a compensation package, employees need to know the basics, including what type of equity, how many options or restricted shares, and the current value.
  • Startup employees should also ask potential employers about equity vesting schedules and exercise prices in the case of stock options, as well as QSBS eligibility.
  • By knowing the type of employee equity being granted, employees can plan in advance, with a tax advisor as needed, for actions such as exercising options, 83b elections, QSBS qualification, and tax planning.

Table of Contents:

  1. The Basics: Startup Equity Compensation
  2. 5 Questions to Ask About Your Equity Offer
  3. Additional Questions to Ask About Your Equity Offer
  4. Potential Drawbacks to Consider When Accepting Employee Equity
  5. Help Navigating Equity Decisions

The Basics: Startup Equity Compensation

When offered equity as part of a startup compensation package, employees need to know the basics, such as what employee equity is and the typical types of employee equity compensation packages. 

What is Employee Equity in a Company?

Employee equity refers to an ownership interest in a company, often offered as part of a compensation package. Employees receive the ability to earn a stake in the company, typically through stock options or restricted stock, as a way to incentivize them to contribute to the company’s growth. 

Startups frequently use equity compensation to attract and retain talent, especially when they may not have the cash flow to offer competitive salaries. The idea is that if the company succeeds and grows in value, the equity provided to employees grows in value as well. But keep in mind that much of the time, employee equity has little value until a liquidity event such as an acquisition or initial public offering.

What are Typical Equity Offers from a Startup?

Typically, startup companies create an employee equity pool of about 10% to 20% of outstanding equity used to incentivize staff. This equity is commonly offered using four types of equity compensation, with each type used for different situations by a company: 

  1. Incentive Stock Options (ISOs)
  2. Non-Qualified Stock Options (NSOs)
  3. Restricted Stock Units (RSUs)
  4. Restricted Stock Awards (RSAs)

The exact number of stock options or shares of restricted stock an employee receives varies by the situation. It’s more common to look at the overall percentage of company shares the compensation represents, which can range anywhere from 0.05% to 1.00%, with higher exceptions for early or key employees. 

5 Questions to Ask About Your Equity Offer

Employee equity compensation can be complex and vary widely depending on the company. Below are five general questions that may be beneficial to ask when you get a job offer from a startup. Once you know the details of the offer, consider talking with a tax advisor, especially if the company gives you multiple offers to choose from, to help understand your situation.

1. What is the type of equity (ISOs, NSOs, RSUs, RSAs)?

An equity compensation offer will likely be one of the following four types. Be sure to ask which type and clearly understand how your specific equity compensation offer works.

  1. Incentive Stock Options (ISOs): These are often granted only to employees as an incentive to contribute to the company’s growth. They allow you to buy stock at a fixed price, known as the strike or exercise price, after a specified period. ISOs have favorable tax treatment but must meet specific IRS requirements. 
  2. Non-Qualified Stock Options (NSOs): Unlike ISOs, NSOs can be offered to employees, directors, contractors, and others. Similar to ISOs, they also allow you to buy stock at a fixed strike price. They do not qualify for special tax treatments but are more flexible in their usage. NSOs are taxed as ordinary income upon exercise. 
  3. Restricted Stock Units (RSUs): RSUs do not require you to purchase stock. Instead, they represent a promise to grant shares of stock once certain conditions are met, such as a vesting schedule and liquidity event. They are taxed as ordinary income when they vest. RSUs are more common at later-stage companies with higher fair market value.
  4. Restricted Stock Awards (RSAs): RSAs involve the actual grant of company shares, which may be subject to vesting conditions. Unlike RSUs, with RSAs, employees will own the shares on the date the grant is issued, and they satisfy any purchase price requirements, which are often very low or zero. RSAs are taxed when the stock vests unless an 83(b) election is filed, which allows for taxation at the time of the grant, potentially reducing the tax burden if the stock value increases. RSAs are more common at early-stage companies with lower fair marketing value.

Extra: For a detailed overview of types of equity compensation, see our guide for founders and employees.

2. What is the number of options or stock units, and at what percentage of the company?

When offered equity compensation, it’s important to understand both the number of shares your options or stock units represent and what percentage of the company this represents. This helps you gauge the potential value of your equity.

3. What is the vesting schedule?

With nearly all employee equity compensation agreements, a vesting schedule will determine when you actually own your equity. Common schedules include the following details:

For example, a typical vesting schedule for startups is four years with a one-year cliff, referred to as 4/1 vesting. This means you would earn 25% of your equity after one year of employment and the remaining 75% monthly over the next three years. Depending on the equity type and agreement, there may be other stipulations before you actually own the shares, such as double-trigger vesting for RSUs, or in the case of ISOs and NSOs, you would need to exercise your options.

4. What is the latest strike price, and when was the last 409A valuation?

If you have stock options (ISOs or NSOs), the strike price and 409A valuation are critical to understanding the current and potential value of your options.

5. What did the last funding round value the company at?

The valuation from the latest funding round provides insight into how investors, such as venture capital and angel investors, view the company’s potential.

Additional Questions to Ask About Your Equity Offer

Depending on the equity compensation offer you are looking at, you’ll likely have various other questions arise. Below are a few of the more complex but valuable questions to ask when reviewing a job offer.

Do you allow early exercise of my stock options?

If your company allows you to early exercise stock options, that means you can purchase shares before they fully vest, which can have tax benefits. 

If your company allows early exercise, you can file an 83(b) election with the IRS, which may reduce your taxable income when the shares vest and potentially lower your long-term capital gains tax. See our article on 83b elections and consider working with a tax advisor to understand if an 83b election is right for you.

Am I required to exercise my options within 90 days or less after I leave or am terminated?

Many companies require employees to exercise their options within a short window after leaving the company, typically 90 days. If you don’t exercise your vested options within the exercise window, you’ll likely lose them.

It’s essential to know this timeframe so you can plan accordingly and avoid losing your vested equity compensation. Keep in mind that any options not yet vested will likely be lost regardless of the exercise window, in most cases, if you leave the company.

Is there any acceleration of my vesting if the company is acquired?

Accelerated vesting can be very beneficial if the company you work for is sold or acquired. Accelerated vesting allows your options to vest immediately upon the company’s acquisition. This means you could own all your equity sooner, which is particularly valuable if the company is bought at a high valuation.

Are the company shares QSBS eligible?

Qualified Small Business Stock refers to the shares of a Qualified Small Business (QSB) that meet specific requirements outlined by the Internal Revenue Code. QSBS offers significant tax benefits to entrepreneurs, startup founders, early startup employees, and investors by providing either an exclusion from capital gains tax or a deferral of capital gains tax when a qualifying company’s shares are sold.

For more information on QSBS, see The Guide to Qualified Small Business Stock (QSBS).

Potential Drawbacks to Consider When Accepting Employee Equity

Receiving company stock as compensation can be valuable if your startup succeeds, but it is important to know the potential financial ramifications of an equity grant.

Equity Time Stipulations

As discussed in this article, equity compensation often comes with specific time-based requirements, such as vesting periods and expiration dates. These can prolong the time it takes to see any value from your equity compensation and, in some cases, force you to lose equity if time stipulations are not met.

Equity Tax Liabilities 

Equity compensation can lead to complex tax situations. There are distinct tax differences between ISOs, NSOs, RSUs, and RSAs. And within each type of equity, there are different tax outcomes depending on how and when you exercise stock options or if you can file an 83b election. When it comes time to exercise stock options or restricted stock units/awards vest, consulting with a tax advisor can help to reduce your tax liability.

Equity Compensation With Lower Base Salary

Some startups offer lower base salaries compared to larger, more established companies but compensate with equity. Additionally, some startups may offer you a choice to have equity with a lower salary or less equity with a higher salary. Accepting a lower salary means less immediate cash in hand. If the startup fails or the stock doesn’t appreciate, you might end up with less overall compensation compared to a job with a higher salary and no equity. These are personal decisions, and you should understand how your startup job offer compares to the larger job market.

Startup Equity is Often Illiquid

Startup equity shares are often illiquid, meaning they can’t be easily sold or converted into cash like publicly traded stocks. For employees with stock options or Restricted Stock Units (RSUs), this means they might not be able to cash in their shares until the company goes public or is sold. Until such an event occurs, employees can’t access the value of their equity, even if the company is doing well. There is no guarantee that a company will go public or be sold, resulting in a complete loss of stock options or RSUs if the triggering event never happens or the company goes under. In some cases, there are secondary markets where employees can sell their pre-IPO vested shares to interested investors. However, not all shares may qualify, and there will likely be additional fees and taxes to consider.

Harness Can Help Navigate Equity Decisions

At Harness, we connect you with hand-picked tax, financial, and estate firms around the United States to help you find a tax advisor with experience in your equity compensation situation. An advisor can help you strive to avoid costly mistakes and aim to make the most of your equity compensation with pre-emptive equity tax planning, stock option exercise advice, and 1:1 education. Get started with Harness today.

Tax related services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.