Working at a startup? Take time to understand salary vs equity
The following is not legal, tax or investment advice, and is intended neither to provide a full or exhaustive discussion of any topic discussed herein, nor to discuss all topics that may be pertinent to any individual situation. Any questions with regard to your own individual situation should be discussed with your own legal, tax or investment advisors.
The attraction of working at a startup can be hard to ignore. Working for these types of companies can be alluring because employees can have a direct impact on the company’s product suite, mission, and future. It can also be 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 employee equity will generally also appreciate. The success of startups is important to employees because they may 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. Here is a more comprehensive look at what employees need to know about salary versus equity.
Equity vs. Salary
Some prospective startup employees may be surprised by the tradeoff in employee equity vs. salary, but all of the information is generally included in an employment offer letter. Oftentimes, the letter outlines the granted fair market value on the grant date and vesting information.
Here is a more comprehensive look at what employees need to know about equity vs. salary.
What is a Liquid Salary?
Your liquid salary is your net salary or what you actually take home after deductions for taxes, social security, benefits, etc. The advantage of calculating your liquid salary is that you will know exactly how much money you’ll receive as a base salary. Your liquid salary is a regularly issued cash payment from your employer and is far easier to anticipate than equity compensation.
An annual bonus might 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 often given at the time to compensate for relocation or other expenses a new employee may encounter.
What is Equity?
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 (or the option to purchase private shares) of the company and may be able to liquidate their shares if and when the need arises in the future. The company will generally provide equity compensation to its employees under what is called an equity incentive plan. These plans can be called other names, like a stock incentive plan or just stock plan for short, with the main takeaway being that these plans set forth the general rules on how the company will grant equity to employees. Stock options are the most common type of equity granted to employees at startups. These typically give employees the ability to buy a fixed number of shares at affixed price established on the grant date, and is usually the fair market value of the company’s stock on the grant date. This fixed price can be called a number of things, including strike price, grant price, and exercise price.
Typically, standard employee stock options are subject to four-year vesting with one-year cliff vesting where 25 percent of the options vest after the first year (the cliff) with the remaining 75 percent vesting proportionally on a monthly basis over the next three years. However, each company sets their own vesting schedule which may differ from this, so it’s important to clarify this when joining a startup. Even though employees are tied to the company for the vesting period if they want all of the options to vest, they have the potential to profit if they exercise those options and the resulting 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 stock options within a certain period of time after their termination date. Every company has their own potentially unique restrictions on the amount of time employees have to exercise their vested equity options, with the most common being 90 days after termination.
Types of Equity
Typically, companies offer ISOs, NSOs, or RSUs. However, each one of these types of awards varies and offers different benefits. Let’s dive into these stock options and their potential benefits.
Understanding ISOs
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.
ISO exercises can trigger an alternative minimum tax (AMT) upon receipt. An AMT applies if the tax liability of someone is calculated to be low relative 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.
Understanding 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 can be granted to employees, contractors, board members, and advisors. An NSO can be the original intended grant, or an ISO can turn into an NSO if disqualifying events happen such as exercising an ISO more than 90 days post termination
NSO Tax Features: Employees pay ordinary income tax for exercising NSOs and pay taxes for capital gains when they sell shares.
RSUs vs Stock Options
A RSU is a restricted stock unit, with each unit equaling one share of stock. Like stock options, RSUs vest on a vesting schedule. However, there are some key differences between RSUs and stock options.
Stock options represent a right to purchase shares at a set price. So, if an employee holds a stock option to purchase 100 shares at $1 per share, they do not own the shares until the stock option vests and the employee exercises their right to purchase the shares. As a reminder, taxes will be owed upon exercise of the stock option.
RSUs automatically vest and settle over time – they do not need to be purchased. So, if an employee has an RSU grant for 100 shares, they automatically own shares after the RSU vests and settles. RSUs are taxed on the settlement dates not the vesting dates.