Comprehensive startup equity guide

For startups, money is often tight, and founders have many tasks to handle for their clients. This is when they face a tough choice: expand the team and risk running out of funds, or juggle everything and risk making mistakes. In such a situation, equity compensation can prove beneficial. Startups can take a safer route by offering equity compensation to employees in addition to their base salary rather than allocating more funds from their already tight budgets.

What exactly is equity in business, and how can startups and their employees benefit from it? The guide below from the top experts of our pitch deck design agency discusses these and related questions, such as who owns equity in a business, so read on!

What does equity mean in business?

The definition of ‘equity’ varies depending on the context. Equity in startup can refer to the company’s value after all debts are settled and assets are sold. It can also denote a person’s percentage of ownership in a company or asset.

For example, when you take out a loan on a motorcycle, you accumulate equity with each monthly payment until the loan is paid off and you own the vehicle. Similarly, investors can purchase equity (or shares) in various businesses, becoming co-owners and eligible to receive a portion of the earnings.

Understanding startup equity: What is it and its types

Whether a business is private or public, equity compensation—sometimes referred to as share-based or stock-based remuneration—is a non-cash benefit that allows employees to own a portion of the company.

Employee equity pay is available in a multitude of formats and plans. Employee Stock Purchase Plans (ESPPs), Restricted Stock Units (RSUs), and stock options are just a few examples. Below, we’ll discuss the following five types:

1. Stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs)
2. Stock Appreciation Rights (SARs)
3. Restricted Stock Units (RSUs)
4. Employee Stock Purchase Plans (ESPPs)
5. Performance shares

Check how each startup equity works in the next section.

How does startup equity work?

Equity pay works by offering team members an equity award. To become full stock owners, such employees have to remain with the company for a predetermined period. There are numerous types of equity, and each has unique features of its own.

1. Stock options

One common type of equity compensation is a stock option. After a vesting period, it gives employees the option—but not the obligation—to buy company shares at the initially agreed-upon price, also known as the exercise price. Vesting is the process of obtaining complete ownership of an award. The value of your stock options will depend on how the stock price performs relative to the exercise price.

Stock options come in two forms: NSOs (Non-Qualified Stock Options) and ISOs (Incentive Stock Options). One of the tax benefits of ISOs is that if you sell your shares at least two years after the grant date and one year after the exercise date, you will only pay favorable long-term capital gains tax (CGT) upon sale. If you decide to sell your NSOs, you may be subject to different tax implications.

2. Stock Appreciation Rights (SARs)

SARs are an equity form that rewards employees based on the performance of the company’s shares without actually granting them stock ownership. Consequently, participants don’t possess voting rights and are not considered shareholders.

Your reward is based on either the entire stock value or the appreciation of the stock value. You may receive either the actual stock or a cash equivalent after the vesting period, which is typically time-based.

When you sell your reward, you may be subject to taxes.

3. Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are usually awarded for free. You aren’t required to purchase them, which makes them a less risky form of equity compensation. Once all vesting conditions are satisfied, you receive the entire value of the shares.

When you vest and sell your RSUs, you will likely be taxed.

4. Employee Stock Purchase Plans (ESPPs)

Utilized mainly by public companies, Employee Stock Purchase Plans allow participants to purchase company stock at a discount, typically between 5-15% off its fair market value (FMV).

This works as follows: Companies deduct contributions directly from workers’ paychecks based on the after-tax income over a predetermined period of time. On the purchase date, the cumulative contributions are used to invest in startups for equity.

ESPPs come in two types: non-qualified and qualified. Owners of non-qualified ESPPs are typically subject to taxes when buying and selling shares, whereas those with qualified ESPPs don’t pay taxes until selling shares.

5. Performance shares

Performance shares are usually awarded to employees when they meet specific performance-related targets. In 95% of cases, these awards are given to company directors and executives as an incentive to achieve particular targets.

Now that you know how startup equity works, let’s move on to another no less important notion—startup equity structure.

How to structure equity in a startup

Equity structure is one of the most crucial aspects of any startup. It refers to how ownership and equity are distributed among the startup’s founders, employees, and investors. This structure is not set in stone and can vary depending on factors such as the stage of the company, the industry, and the specific terms of investment and employment agreements. Below is the most common way to structure equity in a startup:

1. Founders’ Equity: The ownership stake held by the startup founders. It often represents the initial investment of time, money, and intellectual property into the company.
2. Employee Equity: Equity offered to employees, often in the form of stock options, RSUs, or other equity-based incentives. It is used to attract and retain talent and align employees’ interests with the company’s success.
3. Investor Equity: Equity held by investors who provide funding to the startup in exchange for ownership stakes. This can include venture capital firms, angel investors, or strategic investors.
4. Option Pool: A portion of the startup’s equity set aside for future employees’ stock options. This allows the company to attract top talent by offering equity incentives without diluting existing shareholders’ ownership too much.

At the time of funding, startups usually set aside 13% to 20% of their equity pool for employees, distributing it based on the level of seniority. So, when considering ‘How much equity should I ask for?’ these average percentages of equity can serve as a helpful roadmap:

• C-suite executives: 0.8% to 5%
• Vice president of the company: 0.3% to 2%
• Director: 0.4% to 1%
• Board members: 1%
• Company managers: 0.2% to 0.33%
• Junior-level employees & other hires: 0% to 0.2%

However, as a startup scales and moves through funding stages, the equity distribution can change pretty radically. Here’s an example of a positive trend:

Pros and cons of a startup equity

For employees, the primary benefit of equity-based compensation is the possibility of financial gain. If a startup is successful and the stock price rises, the financial gains may exceed fixed cash bonuses because equity value is correlated with the stock price.

• Startups also gain from equity compensation in several ways, including:
• Recruitment and retention of top talent.
• Greater alignment of employees’ interests with the company’s goals.
• Better employee engagement.
• Increased employee productivity resulting in lower absenteeism.
• Better cash-flow management due to the reduced amount paid out in cash.
• Tax benefits from approved plans (e.g., qualified ESPP).

If you are still questioning yourself, ‘Is startup equity worth it?’ weigh these cons against the potential benefits:

• Risk of equity dilution due to the issuance of new shares as the company raises additional funding rounds.
• Equity cannot be easily converted into cash due to limited liquidity.
• The value of startup equity is not fixed and can become worthless if the startup fails to succeed.
• Complex tax implications that can result in unexpected tax liabilities (e.g., at vesting, sale, etc.).
• Long vesting periods, ranging from one to six years.
• Complex negotiations regarding terms such as vesting schedules, exercise prices, and liquidation preferences.

Lastly, if a company owes more money than it owns, its equity can turn negative. This often happens with newly founded startups before they’ve paid off their debts. However, if negative equity persists, founders might need to sell company shares to investors to get more money for the business.

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