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The Very Most Basic Things You Need to Know About Startup Equity | Customers, Etc

The Very Most Basic Things You Need to Know About Startup Equity | Customers, Etc
By Ben McCormack • Issue #33 • View online
If I mostly write about customers, put this issue squarely in the “Etc.” column. Most people I know who work in CX/Success/Support do so at some kind of technology startup, so this article will dive into an area of compensation that can often feel opaque and confusing: equity. Just to get this out of the way, I’m not a financial advisor—and I’m not your financial advisor—so please consider consulting a tax professional or financial advisor when making financial decisions. And if anything I’m saying is wrong or sounds off, please let me know so I can correct it.

It’s your third year at a technology startup and you wake up one morning to the news that your company has been acquired. There’s lots of excitement among your fellow coworkers, if not a bit of nervousness, but by the end of the day, you learn that you’re getting a nice little payout as a result of the acquisition. Maybe you’re not getting a huge payout, but it’s something that lets you take a nice vacation or put a serious dent in your student loans.
How did you get here? When you were hired, you were given a grant in the form of stock options, which is the right to purchase shares of stock at an agreed upon price at a future date. We’ll get into the weeds of what that means in a second. The rest of this newsletter is going to go into the very most basic things you need to know, as an employee, about how to think about startup equity. How does something that can feel like monopoly money—your stock options—become real?
Photo by Tron Le on Unsplash
Photo by Tron Le on Unsplash
The Basics
Is this going to cover everything you need to know about startup equity? Not a chance. You can exhaust yourself thinking about this stuff, and if you’re considering a new job, perhaps you should spend some time jumping down that rabbit hole. I’m not writing for founders, or VCs, or even “key hires” that might be well-versed in the world of startup equity—there’s plenty already written with them in mind—my main goal right now is to cover some basics that can help you, the employee, think about equity.
So to begin, let’s dive into the definition of a stock option, the right to purchase shares of stock at an agreed upon price at a future date:
“right to purchase shares of stock” - This means you have the option to purchase shares, but you’re not obligated to do so. Options, rather than direct stock grants, are the main way that startups give out ownership in the company.
“at an agreed upon price” - Your options will have a “strike price” or “exercise price” when you get them. For common shares, which is usually what employees get, the strike price is usually a lot less than the value of all the shares. This is the price you will pay if you decide to exercise your options in the future (more on that later).
“at a a future date”- You usually get option grants that vest over time. You might hear, for example, about an option grant “that vests over 48 months with a one year cliff”, which is very common. What this means is that you don’t get the right to exercise your options until the beginning of your second year at the company. Each month after that, and until you’ve been there 48 months, you get 1/48th of your original grant that you’re able to exercise.
Stock options usually have an expiration date as well, usually something like “10 years or 90 days after you no longer work at the company.” The last bit about 90 days is something many companies have as a way to incentivize you to stay. It’s risky to exercise stock options at a company when the stock isn’t yet worth anything, so you might stay if you don’t want to part with the cash to exercise your options or risk losing them. If you decide to leave, you have 90 days to decide if you want to spend cash to turn your options into stock.
Neat. That’s stock options. But how much are they worth?
How does a stock option turn into money?
If you exercise stock options, that means you now own stock in the company (yay!), but if there’s nobody to buy the stock—the stock isn’t being sold on the public stock market—there’s no way to convert the stock into cash. In a certain sense, it can be healthy to think of options as having zero value. Most startups fail, which means yours probably will too (sorry), so it’s best not to get too attached to equity. Don’t go and buy a new house based on your options being worth something in the future.
Stock options become worth something in most instances when there is a “liquidity event”, also called an “exit”. The main two ways that startups exit are by being listed on a public stock exchange (think NASDAQ, NYSE) or by being acquired by a larger company. It’s also possible for a company to go private (in which case you’d make money in the form of dividends), but this tends to be less common.
When there’s a liquidity event, you hope that the value of your shares when exercised will be worth considerably more than the strike price. So if you’re going public and your share price is going to be $10, but the strike price of your options is $0.10, you definitely want to purchase 1 share for $0.10 so you can sell it for $10, earning you $9.90 on that share.
How much are your options worth?
Like I said, you don’t want to get too attached to stock options, but you also want to have a basic sense of what they’re worth. They’re part of your compensation package after all, so think of them with the same level of importance as you think of your salary.
You can think of stock options in two ways: relative to the total number of shares (your share of the company as a percentage) and in an absolute sense (how much it would be worth if you went public).
In order to understand the value of your stock options in a relative sense, you need to know the total number of shares (Fully Diluted Shares Outstanding, technically). Take the number of shares in your option grant and divide it by the total number of shares and that gives you the percentage of the company that you would potentially own if the company had a liquidity event and your shares were fully vested.
You can’t really understand what your options are worth in the absolute sense without knowing the total number of shares, which is the denominator of your equation. For example, let’s say you have 1,000 shares and your company is purchased for $10 million in cash. If there are 100,000 total shares, that means your 1% of the company would equate to $100,000. But if there are 100,000,000 shares, that means your 0.001% of the company would be worth just $100¹. The point here is that you can’t do the math on what your options are worth if you don’t know the total number of shares.
Why your company may not be talking about equity
There are two main reasons your company may seem to be a bit guarded in explaining how to think about equity.
The first is that they have to be careful about overselling the value of the stock. I’m not a lawyer and I don’t understand the nuance and risk from a legal perspective, but I know that, in general, it’s bad for a company to lure people to work for them based by hyping stock options being worth a ton of money in the future. This promise of hyperbolic future gain is usually paired with depressingly low salaries. I’d guess the majority of startups these days aren’t sleazy like this, but companies still have to be careful not to oversell the value of their stock, so they’ll sometimes be a bit guarded when it comes to offering advice about how to think of equity.
The other reason your company may not be talking about equity is because equity is their most precious resource. If your company were a dragon, equity would be its pile of gold (it’s a fitting analogy, because you can get so obsessed about equity that you forget about your customers, and then your gold is worth zero and you’re just a dragon sitting on a pile of shiny metal).
While the company can grow and make more revenue (cash) in the future, it can’t create a % of the company greater than 100%. So each time someone stakes a claim to that % of the company, either by bringing on a new investor or employee, the size of the pile of equity shrinks a little bit.
These two factors are pretty reasonable, but they can put employees, especially junior employees with less career experience, at a disadvantage when it comes to thinking about equity. I say this not to blame companies for guarding equity, but rather so that you’re not surprised when find yourself having to ask a lot of questions to understand equity.
An extra photo because wow this is getting long. by Gary Bendig on Unsplash
An extra photo because wow this is getting long. by Gary Bendig on Unsplash
How to talk to your company about equity
If you’re newer in your career or otherwise don’t have a lot of experience talking about equity, it’s worth practicing the conversations about equity with your current and prospective employers, as well as with peers in your network. In a somewhat odd way, your ability to communicate to your employer about how you value equity can say a lot about your experience and how you value your work at the company.
Here’s a negative example to illustrate the point: let’s say you join a very young startup near the beginning of your career. You get some equity, but you’re not really paying attention because you really just want to expand your role so you can do basic things like pay rent and put away a little money in savings. Salary is what’s most important to you. But then the startup gets really large and it’s becoming clear they’re heading for a big exit. If you have a conversation with your boss and are leaning heavily into getting a higher salary because you believe you’re worth it but you’re completely discounting the value of your equity (which, if you were an early employee, could be worth quite a bit), your boss is likely to notice. Maybe you should be getting a raise, but you want to put it in the context that you’re aware that your equity has value. I share this story because I’ve gone through this exact scenario and I didn’t do a great job valuing my equity. In hindsight, I wish I had.
I’m of the opinion that it’s okay for you to know what your stock options are worth, meaning you should know both the size of your grant (the number of options you’ll have a right to exercise at a future date) as well as the total number of fully diluted shares outstanding. This will help you to calculate your potential percent ownership of the company and estimate the upside in the case of a liquidity event. Apparently not all companies give out this information and there are people on the internet with opinions, but my stance is that you should be able to ask for the information that helps you calculate what your options are worth.
If you get an offer from a company and you’re not sure how to ask about the total number of shares, here’s some copy you might use:
Knowing the number of options in my grant is really helpful, but I also need something that grounds the number a bit more concretely in absolute terms, especially when I’m comparing offers in the broader market. Is 10,000 shares 1% of the company or 0.01% of the company? I need to know where I would stand. Happy to sign any NDA if that’s helpful.
Sometimes startups want to know what you place more weight on, cash or equity. You want to know where you stand before you head into the conversation, but here’s a talk track if it comes up:
While I have certain fixed costs I need to account for in order to provide for my family, I can probably be flexible when it comes to cash compensation, especially early on. I’m really excited about [company]‘s mission and want to align my long term incentives with the company’s success. To that end, I’d place more weight on equity.
There’s of course nuance to how and when these sorts of things come up, but hopefully this gives you a feel for how you might want to talk about equity. And practice! Practice with industry peers, other friends in the tech space, your current company. It takes practice getting comfortable talking about equity, which is important if you plan to ask for it.
Should I exercise my options?
If you’re working for the company when there’s a liquidity event, first off, congrats! Second, you’re probably not having to think too hard about whether to exercise your options because either the company’s stock is worth more than the exercise price of your options (good) or it’s worth less (bad). If it’s worth more, you exercise².
But what if the company hasn’t yet had a liquidity event? I think most people are probably going to sit on their options and just wait for the liquidity event to happen while they’re working at the company. Honestly, that’s probably fine. There are valid tax reasons to exercise early, so if you have the cash and the company’s prospects are rosy, it might make sense. My personal advice (again, I’m not your financial planner, so consult a professional) is that you shouldn’t exercise options with money that you wouldn’t want to lose. So don’t use your emergency fund to exercise your options.
Even if you don’t exercise all of your options while working at the company, consider exercising some of them. Similar to how it’s important to go through the process of talking about equity, it’s valuable experience to go through the process of actually exercising your options. So maybe you set out to exercise however many options you can for $100. Who do you need to talk to at the company to make that transaction? There may be tax implications to exercising, so do your research first and consider talking to a tax professional³.
Very Most Basic Equity Calculator
I’m not your financial adviser and I don’t know your situation when it comes to equity, so please don’t take this as legal or financial advice. But if you’re looking for something to get a feel for how to value your equity, here’s a basic spreadsheet you can use to start:
The point of getting a feel for your equity is to give you a sense of how to value it. This is especially important if you’re considering making a career move that could have a different salary and it’s own equity math. Before you make that move, you want to have a sense of what your options are worth.
You’ll notice that the first four fields in the spreadsheet are all things we’ve discussed in this newsletter, and you have to have all the pieces of the puzzle in order to do the math. You have to know the strike price to calculate the cost to exercise (and whether it’s worth it to do so) and you have to know the total number of shares in order to ultimately calculate your profitability from an exit.
One thing that’s on this spreadsheet that I didn’t cover previously is dilution, which in the spreadsheet is labeled as “Dilution from Previous Round”. When a company raises capital, it essentially creates a bunch of new stock, which gets added to the number of fully diluted shares outstanding. This makes your original grant worth less, relative to the whole, but you’re hoping that the investment pays off and allows you to reach a higher valuation faster than if you didn’t raise money (this is the whole point of venture-capital—backed companies). Even though your share of the pie may get smaller, the entire pie may get a whole lot bigger, so it’s a net win.
You’ll notice the last line of the spreadsheet is “equivalent salary per year”, which is sort of a big part of this exercise. If you get an offer to work at another company for a higher salary (or a lower salary with greater equity), or even if you’re just planning to ask for a raise, you want to have some sort of way to estimate the salary equivalent of your equity. It’s just an estimate—you can’t predict if or at what amount the company will exit—but this can put you in the ballpark.
More than just numbers
One final note. Equity is about more than just numbers on a spreadsheet. Just like it’s important for a growing company to be picky about who its investors are in addition to the valuation, it’s also important for you, as an employee, to consider who the company is that you’re joining. Who are the founders? What is its mission?
Your options grant is ultimately just a contract, but unlike your cash compensation, which is guaranteed to hit your bank account every few weeks, your options can change in weird ways. The internet is full of horror stories of people who didn’t read the fine print or otherwise got the raw end of a deal when the company exited. There’s no bullet-proof way to protect yourself from a sour exit, but the best thing you can do is have boundaries and be picky about who you choose to work for. Doing options math can really open your eyes to a new way about thinking about your career, but don’t let it be the only way you think about your career. Choose to work with good people and for companies that have a mission you care about. That’s the best way to align your long term success with the success of the company.
  1. I am grossly oversimplifying. There are things like liquidation preference for preferred shareholders and other sorts of other factors which can make the math a lot more complicated, but in a directional sense, the basic math works.
  2. Usually. Talk to your tax planner or financial adviser.
  3. If you’re researching whether you should exercise, you’ll probably learn that you pay the alternative minimum tax (AMT) on the spread between the strike price (what you pay) and the current value of the stock as determined by the company’s 409a valuation. If the company is worth a lot more now than when you joined, this can be a really large number and you could have a surprisingly large tax liability. Let’s say your strike price is $0.10 and the stock is currently worth $10.00/share and you want to exercise 10,000 options. It only costs you $1,000 t0 exercise, but you’re subject to AMT tax on the spread in value, which in this case is $99,000. If there’s currently no market for the stock, that could be a lot of money to pay taxes on when the stock ultimately could be worth zero. This is not financial advice. Talk to a tax professional.
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Ben McCormack

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