The attraction of working at a startup is hard to ignore. Working for these types of companies is alluring because employees can have a direct impact on the company’s product suite, mission, and future. It’s also exciting to work for a rapidly growing startup not only because of the day-to-day problem solving, but also for the opportunity to gain equity in the company.
If a startup is successful and grows its valuation, then an employee’s equity will also appreciate. The success of the startups is important to employees because they often accept a reduced annual salary in favor of more equity in the company. The hope is that the company will do well, which will buoy their shares’ value.
Some prospective startup employees may be surprised by the tradeoff in salary versus equity, but all of the information is included in an employment offer letter. Oftentimes, the letter outlines the granted first-market value on the grant date and vesting information.
Here is a more comprehensive look at what employees need to know about salary versus equity.
What to Expect From a Liquid Salary
The advantage of working for a liquid salary is that an employee will know exactly how much money they will receive as a base salary and can estimate for bonuses — cash payment is easier to anticipate than equity.
The bonus will be less predictable at smaller companies, but sometimes a target bonus is provided in the offer. Sign-on bonuses are an additional incentive for employees to switch to a new job. They’re given at the time to compensate for relocation or other inconvenience expenses a new employee may encounter.
How Equity Works
If employees sign on to work with a startup, chances are they’ll receive equity from the company. This means the employee will own private shares of the company and can liquidate their shares if and when the need arises. The company will compensate its employees with equity in the form of a stock option plan. Company-granted options will give employees access to buy a fixed number of shares at the market price from the time of the grant.
Typically, standard options are subject to four-year vesting with one-year cliff vesting where 25 percent of the options vest with in the first year (cliff) with the remaining 75 percent vesting proportionally on a monthly basis over the next four years. Even though employees are tied to the company for the vesting period, they will profit if the shares appreciate in the future.
If employees leave the company before their options have fully vested, then they lose whatever hasn’t vested. However, employees may be able to purchase any vested options within a certain period of time after their termination date. Also, every company has different restrictions on the amount of time employees have to exercise their vested options.
What Employees Need to Know About ISOs
Typically, companies offer ISOs, NSOs, or RSUs.
An ISO (incentive stock option) is exclusively for employees, not outside directors, advisors, partners, or contractors. ISOs are a specific type of option with special tax treatment if everything meets certain requirements.
ISO Tax Features: In general, ISOs aren’t taxed until the sale of the underlying security for which they were exercised. At that point, the taxable amount is equal to the difference between the sale price and the exercise price.
Despite this long-term capital gain, ISO exercises can trigger an alternative minimum tax (AMT) upon receipt. An AMT is placed if the tax liability of someone is calculated to be relatively low to their income. In addition, ISOs come with specific rules and requirements that employees must abide by in order to take advantage of the favorable tax treatment, including if an employee holds stock over two years from the grant date and one year from exercise. Selling sooner will result in a “disqualifying disposition” and they will be taxed similarly to NSOs.
An NSO (nonqualified stock option) is an option that doesn’t qualify for ISO treatment. They come with tax disadvantages if an employee waits to exercise.
NSOs are typically for contractors, board members, and advisors. An ISO turns into an NSO if disqualifying events happen such as “extended exercise period.”
NSO Tax Features: Employees pay ordinary income tax for exercising NSOs and pay taxes for capital gains when they sell shares.
Getting Know RSUs
RSUs (restricted stock units) are a commitment to give the value of a specific number of shares after IPO. The settlement can either be in shares or equivalent cash.
Recipients only become shareholders if they choose settlement via shares. Settlement (via cash or stock) is a taxable event. This almost always occurs after vesting.
RSU Tax Features: The taxable income is the market value of the shares at vesting. Employees with RSUs who choose to become shareholders could benefit from a loan or profit-share forward contract to finance the anticipated taxes on vested RSUs.
Working for equity is higher risk than working for a typical cash income. If employees are working for the next Google, then their stocks will appreciate — making them millionaires when the company goes public.
However, if an employee’s company goes down in value, then their stocks depreciate and they’re at a loss.
But employees of private startups have the opportunity to sell their private shares on a secondary market before IPO. This helps bring down the risk for employees to work for equity because their assets are not as tied up in the company.