An Introduction to Startup Equity for Software Developers
Working at a startup often comes with a nice little perk called equity.
It's a percentage of ownership in the company you work for so that you have an incentive to do meaningful work and make an impact on the company's success.
It can be a somewhat risky form of compensation since the value will change over time and it's impossible to predict what exactly it might be worth.
But if you're able to secure equity in a company that does well, it can certainly result in a nice payday down the road.
Here's everything we will cover:
- Public vs Private Stock
- Preferred Stock vs Common Stock
- Types of Equity
First, let's talk about company size and the difference between public and private shares.
Public vs Private Company Equity
Private startup equity works slightly differently than at public companies.
The biggest difference is your ability to actually sell your shares.
If you work for a public company that company's stock is listed in the stock market. You can theoretically sell it whenever you want. In practice, you still need to be careful though. For example, if you know material nonpublic information or company secrets that would affect the stock price, selling your stock might be considered insider trading. Very bad.
But at least you can sell your shares.
If your compensation includes shares in a private company, that company's stock won't be listed on the stock exchange.
This makes it much harder to sell and comes with buckets of additional complexity. It's not impossible, but the process of selling private stock is done on what's called the secondary market. Typically other investors, shareholders, or even the company itself will buy your shares from you directly.
If your compensation includes equity, it would be smart to look into how liquid your equity is.
Or in other words, can you actually sell it and if not what would the process be to cash out on the secondary market.
When you work for a company for a few years, you will probably have a significant chunk of equity. The responsible thing to do would be to make sure you understand its value and how you can capture it.
Preferred vs Common Stock
As an employee, your equity compensation is most likely in the form of common stock.
You should understand what this means because there are subtle differences in how it works relative to preferred stock.
Benefits of Preferred Stock
Just as the name sounds, preferred stock is preferred.
Investors who give your startup money to grow and expand will usually get equity in the form of preferred stock.
Their preferred stock gets preferential treatment.
If the company is ever forced to liquidate its assets to repay creditors, the preferred stockholders are paid back before common stockholders. Only after the preferred stockholders are paid are any remaining assets divided between common shareholders.
Meaning if the company only has enough cash to pay its preferred stockholders back, common stockholders will probably get nothing.
This makes preferred stock typically less risky.
What's Not Great About Common Stock
As illustrated above, common stock can be riskier than preferred stock.
Employees are almost always compensated with common stock. Meaning if your company declares bankruptcy or has to pay creditors, you're pretty much last in line to get a share of any assets sold.
This has an effect on the value of your common stock as well.
If you attempt to sell your shares on the secondary market, buyers will see your common stock as riskier and will typically buy it at a discount compared to preferred stock.
As your company establishes itself and raises further rounds, common stock will typically increase in value and eventually almost meet preferred stock prices. The implied risk of common stock decreases as a company's financial health improves.
How Vesting Works
A critical part of the compensation puzzle is how you actually obtain ownership of your shares.
This is done through a process called vesting.
You most likely won't get all of your shares upfront, but every month a portion of your shares or options will vest.
The timing of this vesting and specifics will be determined by what's called a vesting schedule. It's basically an agreement that tells you how many shares or options vest and when.
There's usually a cliff date involved, meaning nothing vests until a certain date.
Once your cliff date is reached, typically all of the shares that would have vested will be granted at once. So if you have a 1-year cliff date, nothing would vest for the first year, but then 25% of your shares might vest immediately. It will depend on the specifics of your employment contract, but this is what I have seen most frequently.
Cliff dates are used by companies to make sure you don't quit as soon as you receive your shares.
An Example Vesting Schedule
Most vesting schedules I have seen typically look something like a 4-year vesting schedule with a 1-year cliff date. So in total 1/48th of your shares vest every month, starting after 1 year, where the first 25% of your shares vest all at once.
Let's assume you started working in January 2020, a common vesting schedule might look something like this:
- January to December 2020, 0% vested.
- January 2021, cliff date reached, 12/48th of your shares vests.
- February 2021, 13/48th shares vest
- March 2021, 14/48th shares vest and so on, until January 2025 when all shares have vested.
What this means, is if you leave the company early and decide to sell your shares or exercise your options, you only own however many have vested by that date. It will of course depend on the specifics of your employment agreement but this is the general idea.
Quit in the first year before your cliff date, and none of your shares will have vested.
Quit halfway through your vesting schedule and half of your shares will have vested.
And that's how vesting works.
Common Types of Equity Compensation
Companies may choose to give employees equity in different ways.
This can make everything a little more complicated since each form of equity works differently.
Let's go over the 3 most common equity grants I have seen throughout my career.
ISOs, RSAs, and RSUs.
You will likely see one of these acronyms if your compensation includes equity.
Incentive Stock Options
ISOs are Incentive Stock Options.
Stock options are not the same as shares in the company. They are basically contracts allowing you to buy shares at a certain price. This might seem like a drawback since you still have to purchase the shares at some point if you want to sell them, but there are some serious tax advantages included with ISO.
Stock options come with other complexities too though.
For example, as they vest you don't own the shares immediately. You must exercise them if you want to purchase the shares at a certain time. Your ISOs will have a strike price, telling you what the cost per share is to exercise your options.
The good thing about options is that you don't have to exercise them unless you know you can sell them for a profit. In other words, if they are worth more than the strike price that you can buy them at, you can make a profit.
Restricted Stock Awards
RSAs are Restricted Stock Awards.
Restricted Stock Awards give you the right to purchase shares on the grant date, either at fair market value, at a discount, or at no cost. It will depend on your offer and the terms of your RSA grant.
Basically, you own all of your RSAs from the very beginning. But the company usually has what's called the right to repurchase. They can repurchase your unvested stock if you leave the company before your vesting schedule completes.
As a whole, RSAs give you ownership over a set number of shares at the grant date. Unlike ISOs, where you don't own the shares until you exercise them after they have vested.
Restricted Stock Units
RSUs are Restricted Stock Units.
They are another form of Restricted Stock, similar to RSAs. They are a promise by the company to grant the employee a certain number of shares.
You do not have to pay anything to own your RSUs, besides taxes. You typically own the shares as soon as they vest.
No need to worry about strike prices or exercising anything, they are already yours.