Startup Equity: How It Works & Best Practices

learn about your startup equity options

There are many perks to enjoy when working for a startup, including owning a piece of the company. Having equity in a company means you have a stake in the business. Startup equity motivates many workers to build and grow the business. These equity packages come in all shapes and sizes, and it is vital to understand them before you sign up with a startup. Here are a few ways startup equity works and the best practices for you. 

Are you a startup owner struggling to overcome the various tax-related obstacles? At TaxRobot, we are here to make the process easier with our AI-powered R&D tax software at value-based pricing!

 

Is This the Right Company for You?

Many investors buy equity in a company with their own money. You will be earning equity through your investment of time and effort. While this is not the traditional investment, you still need to view it from an investor’s standpoint

Anyone should evaluate the startup based on their own analysis, including looking at the valuation and capitalization of the company. While you might not be privy to the capitalization table, you can still check out the company’s valuation. Ask the company’s founders about their valuation. With that, you can get a clearer picture of the equity. 

Consider the big picture when accepting a job offer. A lucrative equity stake should not be the only reason to take the job. You will want to make meaningful career experiences and receive other benefits, such as health insurance and cash compensation from your job. 

 

Consider an Exit Strategy

If the company is taken public or sold, you want to know your options. When you are evaluating a company, ask about its overarching exit strategy. Do they plan to go public in a few years or sell it? Should the startup exit at a great valuation, all of that equity could turn into cash. However, if the startup does not make it, that equity could be worthless. 

Related: Startups Can Get $250,000 From The IRS: Here’s How

Your Percentage of Ownership with Startup Equity

One of the most important things you should know is the percentage you will own. When offered shares or other options, you should also ask about the total shares outstanding. The number of options or shares of your own is divided by the total shares outstanding. Take those figures to get the percentage of the startup that you own. The employee equity pool will be between 10% and 20% of the total outstanding shares for a typical venture-backed startup. All employees will receive their equity out of this pool. 

there are several stock options available in a startup

Stock Options or Restricted Stock?

After you know about your percentage of ownership, ask about the type of equity that you will receive. If you get stock options, the most common form of compensation, then you have the right to buy the stock at a set or strike price. When you “exercise your options,” take means you are purchasing at the strike price. What’s that? The company has a legal obligation to set its strike price to the fair market value of its stock. 

When the strike price equals that fair market value, your options are called “in the money.” For example, if you have “in the money” stock options with a strike price of $1 and exercise your options on the same day, you pay $1 for each stock and own stock valued at $1. That means you have a net gain of $0. When the company grows, your stocks’ values will rise. Typically, exercising your options on the same day is not a common practice. You will likely have to vest, meaning working at the startup for a set period before exercising your options. 

On the other hand, restricted stock is granted to you, but here are a few restrictions. You don’t have to buy the stock; it is given to you. This stock is granted when the stock value is extremely low, hoping that it will build over time. 

Related: Business Startup Costs & Tax Deductions

Know Your Vesting Schedule

Ask about the startup’s vesting schedule to know how much you own and when you can access those funds. Vesting means you usually have to earn your equity in partial amounts over a period of time. For example, if you start on day one with granted shares on a vesting schedule, you will not have any equity on that day. 

One of the most common vesting schedules is a four-year vesting period with a one-year cliff. A one-year means that you are not vesting in the first year of employment. You will get zero startup equity if you leave the startup before your first anniversary. This option protects the startup. If an employee turned out to be a bad fit and walked away, they would not own a piece of the company. However, if you have been with the company for an entire year, a quarter of your total equity grant will be yours. After that, the equity vests on a quarterly or monthly basis. 

What About Taxes?

If you have received a paycheck, you know that the ordinary income tax ranges from 10% to 39.6% of your total income. According to the IRS, both equity compensation and cash are taxable income. There are special rules about how these types of revenues are taxed. To avoid surprises, you always want to speak to a tax professional about your startup equity.

A common form of stock options is called incentive stock options, or ISOs. If the specific holding requirement or limitations are met, you can exercise your options and get a few tax advantages. 

understand your tax options

Selling Shares

When you exercise your fully vested options or have fully vested stock, you can hold your stock until an exit event or sell the stock in a private transaction. Keep in mind that a sale may require the company’s approval, and there are restrictions under federal law. You can always keep your stock options until the company goes public or is purchased by another entity.

Related: 5 Best Startup Business Tips You Need to Know

Know All Your Options with Startup Equity

Understanding startup equity can be complicated. When you know as much as you can about the equity offering, you determine the value and make the right decision about joining the company. 

Are you struggling with your taxes? They can be difficult and time-consuming to complete, especially for those startups and their employees. At TaxRobot, we have  AI-powered R&D tax credit software to simplify the process and help you earn bigger refunds!

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