Understanding Startup Equity

Understanding startup equity can be confusing, this post attempts to explain what I've learned about it over the years.

Fundraising

To kick off the discussion on fundraising, I'm going to first illustrate a basic example of what a fundraising round might look like. Company A has 1000 shares. The founder of the company owns 100% of the shares (1000 shares). Now, the founder is seeking an investment to expand the business. She finds an investor that is willing to purchase 100 shares of the company at $100 each. To accommodate this investor, the business will increase the number of available shares to 1,100 and give 100 of these shares to the new investor. In exchange, the company will receive $10,000 (100 shares $100 each). The company now has a post-money valuation of $110,000 (# of shares price per share).

Dilution

The founder of the company in the example got diluted as a result of a new fundraise. Prior to the fundraise, she had owned 100% of the company. After the fundraise, she owns about 90% of the company and the investor that invested in the company owns the remaining 10%. This is known as dilution during a fundraise. Because the shares issued to investors are added to the pool of existing shares in the company, the percent ownership of existing shareholders is reduced.

A typical fundraise has between 10 - 20% dilution and multiple fundraises continues to reduce the percent owned by a company over time. If the founder of the company in the example decided to raise money again, she would likely need to issue 110 - 200 new shares of the company, which would bring her ownership percentage down from 90% after the first fundraise to 82% after the second fundraise. All existing shareholders (existing investors, employees) get diluted in a similar way.

Valuation and Stock Class

After the fundraise, Company A now has a valuation of $110,000. The valuation is the value of the company that investors have assigned it based on what they are willing to pay per share. The amount the investors are willing to pay per preferred share multiplied by the number of shares in the company is equal to the company's valuation.

Investors in a startup are typically given a special class of shares called preferred shares, as opposed to common shares which founders and employees generally get. What is the difference? The difference is mostly liquidation preference. When a startup exits, the preferred share holders can choose to either take back all the money they have invested or convert their preferred stock into common stock and receive their share of the exit based on the percentage of the company they own. Here are a couple examples illustrating when this liquidation preference matters:

Say Company A is not doing well and gets sold for $10,000. The investor in Company A, as a preferred share owner, has the option of recouping her initial investment in the company ($10,000) or converting her preferred shares to common stock and receiving a percentage of the sale price. In this case, the investor had purchased 100 shares which is about 10% of the company. If the investor decides to convert her preferred shares to common stock, she would receive 10% of the sale price in the sale which is $1000. In this case, the investor would choose to recoup her initial investment and would get all $10,000 back. The founder of the company, although owning 90% of the shares, would get $0.
Say Company A sold for $50,000. The investor in Company A has the option of recouping the $10,000 investment or getting 10% of the sale price ($5,000). The investor would choose to recoup the $10,000 investment and the founder would receive the remaining $40,000. Typically, the founder is not the only other shareholder in a company. If there was another shareholder, the remaining $40,000 would get split among the shareholders appropriately based on their equity percentage.
Say Company A does great and sells for $200,000. The investor in Company A has the option of recouping the $10,000 investment or getting 10% of the sale price ($20,000). The investor would choose to convert their preferred stock to common stock and receive the $20,000. The founder would receive the remaining 90% of the share price which is $180,000. As you can see, owning 90% of a company as a founder / employee (or other common stock shareholder) doesn't always translate to 90% of the exit price. It only does when the exit price exceeds the company valuation.

There is also another class of share that companies can give investors called participating preferred shares. These shares have even more power than classic preferred shares in that participating preferred shares not only give holders the ability to recoup their initial investment, but also receive their share of the remaining exit price. Using example #3 above, the investor that holds participating preferred shares would make $29,000 ($10,000 to recoup the initial investment and $19,000 which is 10% of the remaining exit price). The founder would receive 90% of the remaining exit price which is $171,000. Make sure you know what class of shares your company offers to investors, it can greatly impact your financial outcome as a common shareholder.

Given the distinction between the different stock classes (common, preferred, participating preferred), it seems that there should be a price difference between them! In fact, there is. When company A receives a post-money valuation of $100,000 after the investment, it doesn't mean that the founder now has equity worth $90,000. This is because the founder has common share while the investor has preferred shares. For an early stage startup, the price of common stock is heavily discounted from the preferred share price (can be 80% in some cases) since there is still a lot of risk involved and likely no sign of an exit soon. In other words, if you own 10% of a startup valued at $10M, you're not a millionaire...yet. The common stock price will eventually converge to the preferred share price assuming the company is doing well and is getting close to an exit.

Stock Options

As an employee or founder, you'll typically get stock options as part of your compensation package. Stock options are the ability to purchase a stock at a specific price (often known as the strike price). Below are some important tips that will help you understand how things work.

Tips for Founders / Early Employees

Remember to exercise your stock options early if you can afford it! You may be allowed to exercise even unvested stock options ahead of time. However, upon termination of employment at the company, you will need to give back unvested stock options.

If you choose to exercise your stock options, remember to file an 83b election. This is a form you send to the IRS which inform the IRS that you are electing to pay taxes on the fair market value on the date of the stock grant instead of on the fair market value of when your stock options vest. Remember, you need to file the 83b days within 30 days of when you exercise your stock options!

You should also be aware of QSBS (Qualified Small Business Stock). The stock a company gives you is QSBS if at the time you receive your stock (time you exercise your stock options) the company's assets total less than $50 million and you hold the stock for 5 years after. The benefit of having QSBS is that federal capital gains tax doesn't apply on gains up to $10 million. This can save you 20%! There's no actionable item to take advantage of this apart from exercising your options early and holding it for at least five years.

Tips for All Stock Option Holders

If you're evaluating a compensation package that includes stock options, it is important to understand your strike price, tax implications of exercising stock options, and how long you have after termination of employment to exercise your vested stock options.

Your strike price is the amount of money it costs to turn your stock option into common stock. Typically, your strike price isn't determined at the time you sign the offer, or even your first day on the job. It is determined by the next company valuation after your start date. You want a low strike price because you will likely be able to exercise your options earlier (taking on less risk by exercising cheaper options) and don't have to pay as much money to exercise them.

When exercising stock options, you should also understand the tax implications. Just like there are different classes of stock, there are also different classes of stock options, ISOs and NSOs. What's the difference? The difference is that, if you have NSOs, you are taxed on the difference between the strike price and fair market value price of the stock at the time of exercise. If you have ISOs, you are not taxed at all at the time of exercise. Once you decide to sell the stock, if you have NSOs, you pay taxes on the difference between the value at exercise and the current share value. If you have ISOs, you pay taxes on the difference between the strike price and the current share value. This typically matters a lot if you plan to exercise the options before the stock is liquid (you can sell the stock for money) since you may be paying a lot in taxes before you are able to make cash gains from the stock.

Finally, as an employee evaluating a compensation package with stock options, it is important to know how long the company allows you to exercise your vested stock options for in the case that your employment at the company is terminated. I have seen some companies only offer 3 months of an exercise window while others have offered a several year window. If your strike price is high and you aren't able to afford the stock options immediately, then, if you don't want to give up your vested stock options, you may be stuck at the company till you are able to afford exercising your options.

Conclusion

There are a lot of details involved when understanding startup equity and I hope that this post demystifies some of it for you. This is mostly information I wish I had when deciding how to evaluate stock options as part of a compensation package. I hope it was helpful!