In addition to salaries, a significant component of compensation in startups is in the form of equity issued under a stock plan.
There are two primary forms of equity compensation: restricted stock and stock options.
Startups can either sell shares of restricted stock or give them to people for free. If a startup sells shares below their FMV, the recipient must include the difference between the purchase price and the FMV as taxable income. If they give the shares for free, the recipient must count the FMV of the shares as taxable income.
Some people use the term RSU, short for restricted stock unit, synonymously with restricted stock. However, RSUs are not restricted stock; instead, they are promises to issue restricted stock at a later time. RSUs are not commonly used by early-stage startups.
Stock options (also referred to simply as options) are a type of security that allows people to purchase common stock at a fixed price (known as the exercise price or strike price) in the future. People that own stock options are known as optionees.
Purchasing shares through a stock option is known as exercising a stock option. Until they exercise the stock option, the optionee does not own the shares underlying the stock option. Thus, someone who only owns a stock option and no shares is not a stockholder.
Stock options are typically subject to vesting, similar to restricted stock. Standard stock options can only be exercised to the extent the underlying shares have vested. For example, if a standard stock option is only halfway vested, the optionee can only exercise the stock option for half the shares covered by the stock option.
A special type of stock option, known as an early-exercisable stock option, allows the optionee to exercise before the underlying shares have completely vested. When an early-exercisable option is exercised early, the unvested shares sold to the optionee are subject to a right of repurchase until they have vested. You can read more about early-exercisable stock options in this blog post by Yokum Taku.
With stock options, recipients must pay for the shares but do not need to do so until they decide to exercise the stock option. To comply with a set of tax requirements known as 409A, the exercise price of a stock option must be at least the FMV of the shares at the time the stock option is granted.
How to Choose
Often, startups start off issuing restricted stock to avoid dealing with 409A, and then switch to issuing stock options as the FMV increases. This is because the FMV of a startup's common stock usually starts low and grows over time. As the FMV increases, restricted stock becomes less affordable for employees and consultants. Even if startups give the shares for free, the tax burden can often be too large for people to bear.
Percentages & Shares
When offering equity compensation, startups commonly describe the offer as a percentage. For example, a startup might offer a prospective employee "0.25% of the company". Most attorneys recommend against this common practice (even if the offer is verbal). This is because stating equity compensation as a percentage can lead to confusion and conflict in the future, for a few reasons:
- there are multiple ways to count the total number of shares in a corporation, and consequently multiple ways to calculate a specific number of shares based on a given percentage;
- even when everyone agrees on one method of calculation, the resulting number can change in the time between when an offer is made and when the equity is actually granted; and
- some people may not realize that their percentage ownership can be reduced by future dilution.
By convention, percentages typically refer to the percentage of the startup’s fully-diluted capitalization, measured as of a particular date.
A startup has a fully-diluted capitalization of 10,000,000 shares on a given date. If the startup offers an employee 25,000 shares on that date, the shares would commonly be said to represent 0.25% of the company's fully-diluted capitalization as of that date.
When making an offer to a prospective employee, startups can help illustrate the value of the number of shares being offered, by providing the information necessary to calculate a percentage at a given point in time.
You want to offer a prospective employee "0.25% of the company". The fully-diluted capitalization of your company at this time is 10,000,000 shares. Therefore, the offer should be for 25,000 shares.
You would tell the prospective employee that the equity compensation component of the offer is for 25,000 shares. Then, to help the prospective employee understand the value of that number, you can tell the prospective employee that the current fully-diluted capitalization of the company is 10,000,000 shares, so the 25,000 shares would represent 0.25% of the current fully-diluted capitalization (as of that conversation).