Equity is marketed as everything from a lottery ticket that will make you millions to a direct path to help employee’s benefit from a company’s success – yet most employees don't understand how equity works. Stock programs are full of nuance, including different types of shares, tax requirements, and how your company's funding and valuation factors into your total compensation.
Being in compensation management for over a decade, and now the founder of a compensation management software company, I have a unique view of how equity affects compensation. So, let me shed some light on the top things you probably don't know about your stock program but should definitely be aware of.
1. How Your Stock is Issued
Let's get our Magic School Bus vibe going and dive into the world of stocks, starting with some key terms that will make the rest of this section a lot easier to comprehend.
Different Types of Stock:
Options - financial instruments that give the holder the right, but not the obligation, to buy or sell a specific number of shares of a company’s stock at a predetermined price within a certain timeframe. Read options as “you have the OPTION to buy” – which means you usually have to put up money to access these.
RSUs (restricted stock units) – units of company stock granted to employees that typically vest over a specific period, subject to certain conditions or performance milestones, and converted into actual shares upon vesting. They are “Restricted” in that the shareholder is unable to sell the shares until a specified period of time or events occurs as spelled out in the agreement – e.g. a 4 year vesting period and an IPO. These are not to be confused with restricted stock, which are typically for executives.
PSUs (performance stock units) - PSUs are similar to RSUs, except PSUs are contingent upon the achievement of predetermined performance goals or targets.
When you are issued stock as an employee, it’s typically in the form of options, RSUs, or PSUs. The most common types are options and RSUs.
If you’re issued Options, and you choose to “exercise” or buy them, you have to pay a set price called the “strike price.” The strike price is typically a discounted or more favorable price than the current Fair Market Value – or that’s the goal. Your bet as an employee is to buy these shares at the lowest price, with the hope that the company will become the next Google or Facebook.
Options are a popular choice among early-stage companies and start-ups as the potential outsized upside of options is used to offset a lower base salary, which can help lure in top talent. Additionally, Options are thought to help motivate employees to focus on the right metrics, by treating the employees as owners themselves. Options also have certain buying and selling rights with them that make this form of equity more controllable for the employee.
As an employee, it’s important to know your strike price, and to make a plan for when you want to exercise your shares, as usually you have a limited exercise window to buy them if you leave the company – the standard is 90 days. So if you have $30,000 worth of options, and you leave your startup, you may have 3 months to pay that money to keep your equity. Often, employee’s will choose to exercise their shares as they vest to ensure this expensive dilemma doesn’t happen.
Conversely, RSUs you don’t have to pay for, but you also have fewer rights around when you can benefit from these options, and they are usually associated with more established companies that are, or are about to, offer IPO.
2. How You Will be Taxed
🚩**We are not tax advisors, this does not constitute tax advice, just references to our experiences as compensation professionals**🚩
Your stock type will have different tax treatments and responsibilities associated based on the different types of shares. For example, with stock Options, you will need to exercise or purchase your stock within a certain period of time, and at the time of exercising you may be taxed on the difference between what you paid and the current Fair Market Value.
Now within Options, there are typically two types – Non Qualified and Incentive Stock. If you have Non Qualified Stock Options, you will be taxed upon exercising or purchasing the shares, as well as when you sell the shares. If you have Incentive Stock Options or ISOs however, you won’t be taxed when exercising, but you will be taxed when you sell. It’s important to note ISOs are only eligible for US citizens.
RSUs, on the other hand, are taxed when you receive the value of the stock. So, for example, if you are vesting RSUs, but your company is pre-IPO, you often won’t pay taxes because under your grant rules, your stock is not fully vested until the stock becomes liquid. If your company is public, however, you will be taxed upon vesting, and sometimes the company will offer to “withhold” a certain portion of the stock to cover the tax cost. In either event, you need to prepare for taxes on receiving stock.
There are different tax treatments for each type of share, and while it’s probably something you dread hearing, it’s important to do your homework to find out how your type of share will impact your taxes. Luckily, there are a lot of great tax-related resources out there, like this article on how to report different types of stock on your tax return from the folks at TurboTax. Or, for a more individualized look at your situation, it’s always a good idea to consult with a financial advisor.
3. How Company Valuation Impacts Equity
A company can be valuated in many different ways, which in turn makes determining what shares are worth even more difficult.
Most valuations are based on revenue, especially annual recurring revenue (ARR). For example, in Silicon Valley, most investors agree that a subscription based tech company’s valuations will be 8-15 times the ARR. The multiple they choose is based on what they see other companies in similar spaces achieving and how quickly they attain it. It can also be influenced by things like Cost of Goods Sold, Gross Margin, and Revenue Churn.
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This information is significant because the valuation of your company directly correlates to the revenue the company believes they can bring in and also the amount of work the team will need to do to reach that valuation.
For example, say your company is at $10M in ARR (congrats btw, that’s amazing!) and the leaders raised money at a $200M valuation. $200M is 20 times the $10M of actual ARR-which means to grow into that valuation, your company will need to bring in approximately $13.5-25M in ARR. Think about that. Your company will need to, or get close to, doubling their ARR. Now think about the impact that that additional amount of needed ARR will have on employees and leadership. If you have options in this company you can buy, you need to ask “do I believe this company can achieve this before they run out of money?”
Let's go back to the worst house party of our lives, COVID, when companies were raising money like Scrooge McDuck on the high-dive. The multiples they were raising at were staggering; we’re talking companies that had $10M ARR but raised at $1 BILLION valuations. That’s a 100x multiple, so their ARR in this hypothetical situation would need to jump from $10M to $130-250M to meet that valuation. Which is a HUGE jump and a lot of work to accomplish. Again, as an employee receiving the option to buy equity in this company, you have to ask – do I want to spend money on these shares? Do I believe in their vision?
Once you understand how valuation affects the amount of revenue your company needs to bring in, it is not difficult to see why some companies are in trouble when they raise too large of a round.
The main trouble is now the company with the colossal multiple number has to hit that valuation or sell for less. Which, selling for less than $1 Billion, but still hundreds of millions, may not seem like a big deal–if it weren’t for liquidation preferences.
Liquidation preferences are the order in which money from the sale of a company gets distributed to shareholders. The order can vary slightly, but generally it goes in order from majority investors (who often have their own order based on when they invested in the company), minority investors, then founders, and employees.
Let's pretend your company fundraised at one of those wildly high valuations, is now being sold, and so we’re following the liquidation preferences roadmap. Investors need their money back first. So say you raised a total of $200M in capital over several rounds of fundraising at a $1B valuation, and investors across all rounds now own 50% of the company, employees own collectively 20%, and the founder(s) own the remaining 30%. If you sell at $500M, or half of the valuation price during funding, an expected breakdown would be 50% or $250M to investors, $100M to employees, and $150M to the founders. Which, all in all, sounds like a win! Except, you are an employee with 100 shares that were issued to you at $50 per share based on the valuation price, and you exercised at that price.
This means your shares were issued to you after fundraising when the company was valued at $1B. So when the company is sold for half that value, your shares are also worth half, so now your shares are worth $25, or even less. This means depending on your strike price, you may have paid more for the shares than they are worth. This is what is referred to as being “underwater” on your stock – and at best you are looking at a tax write-off.
Education is Key
As you can see, all kinds of factors impact your equity's value including taxes, the results of your company's valuation, and fundraising. Stay informed about your equity program, know what your responsibilities are, and don't be afraid to ask for help.