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THE ULTIMATE GUIDE TO EMPLOYEE EQUITY COMPENSATION

August 23, 2021

Communicating Total Rewards

If you have wanted to work in a startup before, especially a tech startup, then
chances are you have heard of the word equity compensation thrown about. It is
the strategy that many businesses use to compensate employees and have them
participate in the growth and upside of the business. 

If you have been approached by a business that is offering equity compensation
as part of their pay, you might be confused about the whole thing. Here is what
you need to know about it and whether it will work for you.


WHAT IS EQUITY COMPENSATION?

In simple terms, equity compensation is when a company offers to compensate you
in non-cash form. Most companies offer you a chance to buy shares of their
business and the rules for this will vary based on the business you are working
for. Many companies used this mode of compensation, but it is commonly used to
compensate, retain, and align incentives with employees. 


GENERAL

WHAT IS A STOCK OPTION?

Companies may offer you stock as part of your compensation package. Depending on
the type of stock option you receive, there are differences around when or how
you have to pay taxes and whether you have to purchase the shares.


A stock option is the right to buy a set number of shares at a fixed price, also
known as the strike price. This price is typically the market value of the
shares when you receive your option grant and is determined by what is called a
409A valuation. If the value of the shares increase over time you can make money
on the difference between your strike price and the eventual sale price. Note
that you’re not required to exercise your options, hence the name options.


HOW IS EQUITY GRANTED?

A company’s board of directors or board committee will typically approve and
grant equity to employees subject to the terms and conditions of the company’s
stock option agreement or equity incentive plan.


When you are granted equity, you’ll often expect to receive details on: 

 * The type of stock
 * The number of shares
 * Your strike price (if applicable)
 * The price per share (if applicable)
 * Your vesting schedule and conditions
   

WHAT TYPES OF OPTIONS ARE THERE?

The most common types of options that are granted to employees are ISOs
(Incentive Stock Options) and NSOs (Non Qualified Stock Options). 


WHAT IS AN INCENTIVE STOCK OPTION (ISO)?

ISO stands for Incentive Stock Options (ISOs). ISOs give an employee the right
to buy company shares with the added allure of a tax break on the profit. The
profit on incentive stock options is taxed at the capital gains rate, not the
higher rate for ordinary income. Unlike other types of stock options, you
usually don’t have to pay taxes when you buy ISOs.


WHAT IS A NONQUALIFIED STOCK OPTION (NSO)?

NSO stands for Non Qualified Stock Options (NSOs). NSOs give employees the
right, within a designated time frame, to buy a set number of shares of their
company’s shares at a preset price. With NSOs, you pay taxes both when you
exercise the option (purchase the shares) and sell the shares, and are taxed as
ordinary income.


DO COMPANIES OFFER DIFFERENT TYPES OF SHARES?

Yes, sometimes companies offer restricted stock (or shares) instead of stock
options, often in the form of Restricted Stock Units (RSUs) or Restricted Stock
Awards (RSAs).


WHAT IS A RESTRICTED STOCK UNIT (RSU)?

RSU stands for Restricted Stock Units (RSUs). An RSU is a promise from your
employer to give you shares of the company’s stock (or the cash equivalent) on a
future date if certain restrictions are met. RSUs have no tangible value until
the vesting is complete, and are assigned a fair market value when they vest.
Unlike with stock options, with RSUs you don’t have to pay anything to get the
stock. Upon vesting, they are considered income, and a portion of the shares are
withheld to pay taxes. You then receive the remaining shares and can sell them
at your own discretion.


WHAT IS AN RESTRICTED STOCK AWARD (RSA)?

RSU stands for Restricted Stock Units (RSUs). An RSA is a grant that permits you
the right to purchase shares at the fair market value, a discount, or at no
cost. RSAs are given to the employee on the day they are granted. They do not
have to be earned via a vesting schedule like RSUs do. However, they may still
have to purchase them, depending on the nature of the offer. RSAs are more
common with early employees at a startup before the first round of equity
financing.



VESTING

WHAT IS VESTING?

When you vest, you earn the right to buy your shares over a specified period of
time, which is often tied to your continued service at the company. You
typically have to reach what is called a cliff date before you can exercise your
options, which is typically 1 year from the date the option is granted. 


Generally, you can only exercise your vested options. If you leave your company,
your unvested options will go back into the company’s option pool. Depending on
the term of your company’s option plan, you may have the ability to exercise
your options early. Early exercise can have certain tax implications depending
on your individual situation. Note that in addition to time based vesting, RSUs
may also be subject to additional vesting conditions based on your individual
performance, company performance, or a market condition (such as a sale or IPO).


WHAT IS A CLIFF?

A cliff is the date at which the first portion of your option grant vests. After
the cliff, you typically vest the remaining options each month or quarter,
though that can vary depending on the company or structure of the option grant
or shares. 


WHAT IS A VESTING SCHEDULE?

A vesting schedule shows you when you’ll earn your options or shares. It defines
the length of your cliff and how your shares continue to vest once the cliff has
been reached. Cliffs are typically 1 year and stock options will typically vest
over 4 year periods, often monthly or quarterly. 


Note that for RSUs, vesting may be tied to length of service or a milestone that
the company must hit. However, you don’t need to purchase the RSUs–you just need
to wait for them to vest.


WHAT IS A GRANT DATE?

The date your equity is granted by the board, which may be before or after the
vesting start date, and is often the same as your start date at a company. 


WHAT IS A VESTING START DATE?

Your vesting start date is the date at which the vesting period begins for an
option grant, and is typically the same as the grant date.


WHAT ARE VESTED SHARES?

The total number of shares that have vested and that can be exercised at a given
point in time based on your vesting progress to date. 


WHAT ARE UNVESTED SHARES?

The total number of shares that remain unvested if you have either not hit your
cliff, or that are still vesting subject to your vesting schedule after your
cliff date. 





VALUATION AND PRICE

WHAT IS A STRIKE PRICE?

A strike price is the price at which you can purchase your shares, and is
typically based on the fair market value of the stock at the time of your grant.


HOW IS A STRIKE PRICE DETERMINED?

A strike price is determined by what is called a 409A valuation, which is an
independent appraisal of the fair market value of a company’s stock.


WHAT IS THE COST TO EXERCISE?

The cost to exercise represents what it would cost you to exercise your option
and purchase the shares. It is calculated by taking the number of shares and
multiplying that by the strike price that is set for the option grant. 


WHAT IS A PRICE PER SHARE?

The price per share is what investors paid for one company share during the
latest investment round, and is calculated by taking the current estimated
valuation and dividing it by the total number of shares outstanding. 


WHAT IS THE ESTIMATED NET VALUE?

The estimated net value of your equity includes your vested and unvested shares,
and is based on the net value per share, which is the difference between the
estimated price per share and strike price of your options. Note that for RSUs
and RSAs, the estimated net value of your equity includes your vested and
unvested shares, and is based on the estimated price per share (since RSUs and
RSAs do not have a strike price).


WHAT IS DILUTION?

Dilution occurs when a company issues new shares that result in a decrease in
existing stockholders' ownership percentage of that company, which typically
happens when a company raises additional rounds of funding or when stock options
are exercised. However, if a company uses the funding for growth, you may have a
smaller percentage in a more valuable company resulting in a potential increase
in the value of your equity. 




This post and information is not to be construed as legal, financial, or tax
advice, and is not representative of the specific terms of any offer,
employment, compensation, option grant, or any equity incentive plan. This is
for informational purposes only and is not intended as a recommendation, offer
or solicitation for the purchase or sale of any security. Welcome or does not
assume any liability for reliance on the information provided herein. We
strongly encourage you to consult a tax advisor or lawyer before making any
employment, equity, or compensation decisions. Nothing herein is intended to
create an offer or binding agreement of any nature. Option grants are subject to
all required approvals. There is always a possibility that the tax laws
affecting equity and stock option tax treatment will change, and the information
explained in this guide is subject to change at our discretion.

Written by
Rick Pereira
Equity
Compensation


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