Whether you are a new startup founder or a potential startup employee that just got an offer letter – understanding all the terms around startup equity can be confusing. Worry not, brave soul – this post is for you! I will give you a high level overview of the most common terms you need to understand when it comes to startup equity broken down by category – and what it means for you. Let’s begin!
Types of Equity
Incentive Stock Options (ISO) – ISO’s gives employees the ability to purchase a set number of company stock shares at a price that has been predetermined. ISO’s are generally reserved for full time employees of startups and comes with a specific tax benefit: when exercised, you pay tax on the difference between the exercise price and the fair market value of the shares issued at the capital gains rate (15%) rather than ordinary income rate. You do need to report when you exercise ISO’s in your taxes as an alternative minimum tax. ISO’s are usually offered with your employment letter with a strike price (defined below) and a vesting schedule (also defined below).
Non-qualified Stock Options (NSO) – NSO’s are generally reserved for advisors, consultants, or temporary help for companies. NSO’s are not taxed as capital gains – and count as additional taxable income, with the amount being the difference between the exercise price and the fair market value on that date. NSO’s are also be offered at a strike price with a vesting schedule.
Types of Stock
Common Stock – Represents shares of ownership in a corporation and the type of stock in which most people invest, with claims on dividends and voting rights.. This is the type of stock generally reserved for founders and employees of the company.
Preferred Stock – Represents shares of ownership in a corporation generally reserved for investors. Preferred stock generally comes with no voting rights, and a fixed value. The term ‘preferred’ comes in because holders of this stock usually have priority in a liquidation sequence.
Vesting Schedule – The amount of time you should work with the company to earn the right to purchase all of the stock options granted to you. This is a mechanism that is placed into employment agreements to make sure you stick around the company to get your shares. Standard vesting schedule for startups is a 4 year monthly vesting schedule with a 1 year cliff (defined below).
Cliff – The cliff is the period of time before your stock starts vesting. As mentioned above, standard is a 4 year monthly vesting schedule with a 1 year cliff – meaning, 1 year after you begin your employment with the company – 12 months of shares are available for you to purchase. And after that, each month releases 1/48th of the remaining shares that were granted to you. This is a term thrown into your employment agreement. Founders put this in stock grants and employment agreements to ensure that the new employee (or co-founder) doesn’t work for 2 months, vest those shares, and leave the company.
Acceleration – What happens to your stock options if your company is liquidated in a positive or negative way? Acceleration defines this – do you get the rest of your grant immediately? Do you have to continue working at the acquiring company to continue the vesting schedule? Do you lose your grant?
Pre-Money Valuation – The value of the company, overall, before an investment in made. Companies get their valuation by hiring another company to conduct a 409A Valuation.
Post-Money Valuation – The value of the company, overall, after an investment is made. For example, if an investor wants to put $2 million into your company for 20% equity, that means your post-money valuation is $10 million.
Strike Price – The predetermined price you pay when you exercise your options. For example, your employment agreement may say you get 50,000 shares for 0.05% of the company at a strike price of $0.05 per share. So, once your shares start vesting and are available for you to purchase – you pay $0.05 per share for those options.
Spread – This is the difference between what you pay for your ISO or NSO, and what the current fair market value of the stock is. With the example above, if your strike price was $0.05, and the stock is now worth $0.50 – your spread is $0.45 which is what you make in profit, and how much you will be taxed on.
Liquidity Event – An exit, good or bad, of your company. Liquidity events can be an acquisition from another company, a merger with another company, an initial public offering (IPO) the the stock market, or the company plain going out of business because they ran out of cash. The positive outcomes are the ultimate goal of every startup.
Liquidation Preference – What you need to know is your liquidation preference when it comes to liquidity events. That means, at what point do you get your money? Preferred stock holders and debtors are first in line to cash out, followed by common stock holders. Read through your stock purchase agreements, and company bylaws carefully whenever you can.
Let Us Help
This is a very high level overview, and there are many more intricacies involved in startup equity. From having the appropriate documentation in place when granting stock options, to understanding what you are entitled to as a founder or employee – we can help you.
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This post is not legal advice, and does not establish any attorney client privilege between Law Office of K.S. Kader, PLLC and you, the reader.