How Employee Equity Works: A Simple Introduction
Offering employee equity can give you a leg up in the battle for top talent — especially when cash flow is tight — and it’s an awesome way to reward top performers and encourage an owner’s mindset by giving your team some skin in the game.
But believing in the power of employee equity doesn’t make it any easier to understand. While you should definitely lean heavily on your lawyer and accountant for help through this maze, here’s a simple introduction to how employee equity works.
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When it comes to employee equity, there are two types of stock you should understand well enough to describe to your early employees: preferred stock and common stock.
- Preferred Stock is typically sold to investors. It’s “preferred” because it has additional rights attached to it, like voting on certain corporate governance matters and selecting board members. It’s also first in line for payout (aka liquidation preference); upon an exit, those who own Preferred Stock are typically paid out before anyone else.
- Common Stock is primarily for employees. Since Common Stock doesn’t have additional rights or liquidation preference, it’s seen as less valuable (when the company is still private) and it’s priced at a discount to the Preferred Stock.
When a company goes public, Preferred Stock is typically converted into Common Stock. The result is one type of stock, with one price, that anyone can buy or sell on a public stock exchange.
How Common Stock gets distributed
Since we’re talking about equity for employees, let’s zoom in on Common Stock. There are two common ways to grant Common Stock to employees: Through stock options or restricted stock.
If you’re an early-stage startup, stock options are by far the most common way to grant equity to employees. However, it’s important that you understand the alternative so you can make the best possible decision.
- Stock options are the right (or option) to purchase stock in the company at a specific price, which is called the exercise price, or the strike price. Just for clarity’s sake: stock options aren’t stock, they have to be purchased (or exercised) first.
- Restricted stock is the right to own stock, with specified restrictions. Once the conditions of the removal of the restrictions have been met — which could be fulfilling predetermined performance goals or staying with the company for a specified period of time — the restrictions are lifted and the employee fully owns the stock.
A NOTE ON RESTRICTED STOCK: Restricted stock can be purchased at the fair market value or granted outright. As a warning: If the stock is granted (without the employee purchasing it), then that person will need to pay taxes on the stock when it vests, which can be very expensive.
How is Common Stock valued?
The price of Common Stock is determined through something called the 409A process. During this period, you’ll hire an outside firm to evaluate your company’s financials and market data to determine the value of your Common Stock. According to the IRS, the 409A valuation needs to be refreshed at least once a year (and more often if there’s a significant financial event, such as fundraising).
The exercise price, or the strike price, is what employees must pay to take ownership of the stock. Each employee option grant that is issued has its own exercise price, which is the fair market value (FMV) of the Common Stock on the date the grant is approved by the board.
Stock options can become extremely valuable because the exercise price of an employee’s option grant is fixed. When the value of your high-flying startup rises, the value of the stock increases with it. If everything works out according to plan, the fixed exercise price will likely represent a big discount when employees exercise their options.
If the employee is issued more options at a later date (after a promotion, for example), the new options will have a different exercise price — the FMV of the Common Stock when it’s approved by the board.
LET’S PLAY THIS OUT FOR A SECOND
Pretend Company A hired a rockstar engineer named Lucy a few years ago. The exercise price for Lucy’s stock options was set at $0.48 per share, based on the FMV at the time she started. As the years go by, Company A becomes a smashing success and the FMV (as determined by the periodic 409A valuations) grows well above Lucy’s exercise price:
Assuming Lucy’s options have vested, they give her the right to acquire stock for a small fraction of its value. Keep in mind that the difference between Lucy’s FMV and stroke price will become taxable when she exercises her options.
Unveiling vests and cliffs
When you grant stock options or restricted stock to employees, it’s standard to give it out in installments over time. Breaking down grants into installments brings two more concepts to light:
Vesting is when an employee gains the right to exercise the stock. A vesting schedule lays out the timetable in which an employee gains the rights to the options. Linear vesting is the norm, which translates to the same amount of stock vesting periodically — whether that’s every month, quarter, or year.
A cliff is a milestone when the first portion of the stock vests, meaning the employee doesn’t get the rights to the options until the cliff. Most companies have a one-year cliff.
LET’S PLAY THIS OUT AGAIN
To explain further, let’s bring Lucy back into the picture. Company A offered Lucy options with a four-year linear monthly vesting schedule. Her grant also has a one-year cliff. With this schedule, Lucy’s options would be fully vested after four years (48 months) of being with the company. After one year (once they’ve passed the cliff), 25 percent of her options will be vested.
If Lucy left the company after 11 months, none of her options would be vested. If she left after exactly 24 months, half of her options would be vested: 25 percent after year one, then 1/48th for each of the 12 months following the cliff (quick math: 12/48 = another 25 percent).
Why don’t we just ditch the cliff and vesting schedules all together? More stock for all!
There are a few reasons why cliffs and vesting schedules typically follow a standard pace:
- They are in line with a person’s growing contributions to a company over time. When a stock option grant is given at the start of employment, the employee hasn’t done anything to earn it yet. Vesting ensures that the maturing maverick gets equity commensurate with their time at the company.
- They ensure the employee is a good fit for the company before they get a piece of it. If you or the employee decides the company isn’t the best place for the employee, you haven’t given away loads of equity.
- They incentivize people to make a long-term investment in your business by rewarding them with equity over time.
If you decide to accelerate your vesting schedule or have no cliffs, investors will often ask you to adjust both to a more standard structure when you receive financing. Investors will also expect founders to have vesting schedules: It signals to everyone involved that the founders are in it for the long haul.
And there you have it: A whirlwind intro to how employee equity works, from the type of stock employees get to how it’s granted to them over time. It’s also a good idea to educate your employees and team members on how stock options and equity works.
If your team needs a bit of an equity education, feel free to share this article with them. And of course, lastly, when structuring an equity package for your company, you should always rely on legal and accounting help.