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How to Make Sense of Equity Compensation

This article originally appeared on Fortune.

I’ve hired hundreds of tech employees, and recently started Comparably to make workplace compensation and culture more transparent. Most private tech companies offer equity as part of team members’ compensation package, but employees rarely understand the value and most important aspects of this arrangement.

Stock compensation is complex, and there are many hidden rules. This guide will help you understand the value of your equity compensation and the rules that guide it.

Here’s what you need to know.

You should ask what percentage of the outstanding shares your equity grant represents.

The most basic way to understand the value of equity grants is to know what percentage of the total outstanding shares your grant represents. Basically, what percent ownership of the company will you have? Understanding the percent ownership gives you (1) an understanding of the current and potential cash value of the equity, and (2) helps employees compare equity grants to see how their stock package compares with others. Ask your company what percent ownership the shares represent when being hired.

Over time, there are two primary mitigating factors to your percentage ownership. First, as the company raises more money, your percent ownership will go down. That’s typically a good thing, because you may have a smaller piece, but it’s a bigger pie. As long as you know (1) how many shares you were granted and (2) how many total shares the company has issued and reserved for additional equity awards, you can figure out your current percent ownership.

Another important factor to understand is the type of liquidation preferences (if any) that sit on top of your equity. With any liquidation preference , if the company doesn’t sell for a certain threshold, then the investors get their money (and potentially a multiple of their investment) out first. In those cases, the amount of liquidation proceeds that are available to the common shares (which employees receive as stock options), would get reduced by the investors’ liquidation preference.

Your stock options need to be exercised. This comes at a cost.

Employees eventually have to “exercise” their stock options in order to get their cash value. The exercise price, or strike price, should be at least equal to the fair market value of the stock at the time of grant. Companies fight to keep the strike prices as low as possible for their employees. The hope is for the strike price to be a fraction of the price of the shares underlying the option when the option is exercised. Note: The earlier you join the company the lower your strike price will typically be. Each successive round of capital the c ompany takes in typically raises the strike price of the stock options.

Employees typically have 90 days after being fired or quitting to purchase their stock options.

If an option is not exercised during its “exercise period” it will be forfeited. The exercise period is typically 10 years for an option. But due to ISO rules, employees are typically only allowed 90 days to exercise their stock options and purchase their equity; if they quit or are fired, and they don’t purchase in that window, the shares revert back to the company. This sometimes puts a burden on departing employees who may not have the cash to buy the shares, even at a drastically lower strike price. For example, if you were granted 50,000 shares at a 40-cent strike price, and vested all four years, then upon leaving you would owe $20,000 to your company to purchase those shares. Some companies have recently moved to extending that exercise period, up to 10 years, to be more accommodating to their employees, but those options aren’t eligible to be ISOs. There’s a great conversation from the founder of Quora on expanding the exercise period for employees.

Stock options aren’t granted upfront — they vest over a period of time.
When employees receive stock options, they are put on a vesting schedule, this means they have to be with the company for a period of time before they earn their shares (which still need to be exercised). The most common vesting schedule has typically been four years, with a one-year cliff. The one-year cliff means the employee has to be with the company for a full year before they get the first 25% of their shares. If they are fired or quit before a 12-month tenure, they wouldn’t receive anything.

Most companies then put employees on monthly vesting schedule going forward for the remaining three years, but some companies do a year-long cliff before each full year of employment. There’s been a trend in Tech lately to require more commitment to receive the stock options. Some companies are moving to 5-year vesting, and others are back-loading the vesting, so that employees get a smaller percentage of shares in their first 2-3 years, and then receive a large lump sum in year 4/5 (up to 50%). Large scale growth companies like Snapchat and Uber often have policies like these to be able to retain their top talent longer.

Know the difference between ISOs and NSOs.
Most tech companies award their employees with Incentive Stock Options (ISOs) to the extent possible. ISOs can prove beneficial to employees because (1) regular federal income tax is not triggered upon exercise of ISOs (although the alternative minimum tax may be) and (2) qualifying dispositions of ISOs (selling your stock) enjoy long term capital gains treatment. In order to qualify for long term capital gains, the option must be exercised during your employment and the shares issued upon exercise must be held for at least one year after the exercise date and at least two years from the date the option was originally granted. ISOs can only be granted to employees (not to advisors, consultants or other service providers). Non-Qualified Stock Options (NSOs) are taxed upon exercise (as opposed to when the underlying stock is sold) based on the difference between the strike price of the options and the fair market value of the stock at the time of exercise. Also, NSOs are taxed at ordinary income rates (as opposed to capital gains).

Most people don’t realize how hard it is to take advantage of the full tax benefits of ISOs. Since ISOs must be held for two years from grant and one year following exercise, ISOs that are cashed out in connection with an acquisition don’t qualify for long-term capital gains. In the example above, let’s assume the employee with 50,000 shares, and 40-cent strike price, was still at the company when it was acquired, and that the purchase price of the stock was $4 per share. In this case the total value of the payout would be $180,000 ($200,000 – $20,000). But since the equity is being cashed out and not in accordance with ISO rules, it will be taxed as ordinary income. Depending on the amount of stock and state of residence of the individual, the tax amount could easily exceed 40%.

As stock options vest, employees typically have the ability to exercise their vested shares, starting the clock on the time period they’re hold the underlying equity interest, and creating the potential for capital gains treatment. However the potential tax benefits need to be weighed against the possibility that the shares may never be liquid and have no value. Many angel/venture-backed companies go under without liquidity for stakeholders. In that case, the price paid to exercise the shares would be losses the individual would take.

All stock option grants get approved at the board level.

Employees are granted equity out of a designated “ option pool.” Typical ly after a round of financing, venture capitalists will require companies to set up an option pool ranging from 10–20% of the outstanding shares. Company leaders tend to be judicious with equity grants because they may not know how many employees they’re going to hire on that round of capital. While the board of directors can issue more stock the pool if it runs out, that would mean dilution for all existing shareholders. The board of directors must approve all stock grants, and so the negotiation for equity compensation is a bit more complicated and involved than cash compensation, which is approved by the officers of the company.

Additional equity grants are rare, unless accompanied by a significant promotion or as retention for employees who’ve already vested their options.

In many cases, companies set the expectations with their team that the original grant will be the extent of their equity compensation. They’re typically two expectations. First if the employee is promoted to more senior roles, it’s typical that their equity compensation reflects those roles. Also additional equity grants are often offered as retention for top talent, company leaders want to retain. In this case either at the 2-year mark or the 4-year mark (when the employee is full vested), companies may give a “refresher” grant to keep the employee incentivized to stay at the company longer. Those refresher grants typically have 4 year vesting schedules, although many companies in that situation, forgo a one-year cliff on the refresher grant and keep to all monthly vesting.

An equity grant could include acceleration provisions.

In some cases, equity grants will include acceleration provisions for the employee. The most common types of acceleration are “single trigger” and “double trigger” acceleration. Single trigger usually refers to acceleration upon a sale of the company. Founders sometimes negotiate for single trigger acceleration in rare situations; it almost never granted to other employees. Double trigger is the most common type of acceleration. It requires the occurrence of two separate events: (1) a sale of the company and (2) the involuntary termination of the employee. For example In this case: (a) if your company was purchased and you were fired soon after (without cause), (b) your stock wasn’t fully vested, and (c) if you have a “double trigger”, then you would receive the remainder of your stock grant at time of termination. Double triggers are most often reserved for senior executives in a company. Just like they underlying equity grants, acceleration provisions need to be approved at the Board level.

Companies almost always have the Right of First Refusal to buy shares employees want to sell before an acquisition and can block sales before an IPO.

Nearly every venture-backed company’s common stock will be subject to a Right of First Refusal in favor of the company and will typically include transfer restrictions on the stock. The Right of First Refusal means that prior to selling vested shares an employee must give the company the ability to purchase the shares on the same terms as a third party that would like to buy the shares. Typically, if the company doesn’t want to purchase the shares, some or all of the company’s investors will have the chance to buy the shares before they are sold to a third party. Many companies also include blanket transfer restrictions on common shares so that they can’t be sold before the company goes public without the company’s consent. The idea behind these transfer restrictions is to give the company’s existing stakeholders the ability to assess whether outside/unknown parties should become stockholders of the company (early-stage companies usually have very small stockholder bases). Unvested shares almost always include a provision that prevents their sale/transfer prior to being vested.

Additional resources

If you’re looking for more information on equity compensation, here are a couple particularly helpful resources:

— Tech equity calculator https://www.comparably.com/equity-calculator

— Equity definitions https://hackernoon.com/equity-101-definitions-distribution-methods-and-potential-issues-ad4b9f71a369#.m2z2v1m3j

— A guide to startup employee equity https://medium.com/@founding/a-guide-to-startup-employee-equity-567dea2707e9#.a3ll69ckz

— How much equity for employees?http://avc.com/2010/11/employee-equity-how-much/

— Understanding employee equityhttp://blog.samaltman.com/employee-equity

— More about tech equity https://github.com/clef/handbook/blob/master/Hiring%20Documents/Guide%20to%20Your%20Equity.md

— Types of equity compensation https://medium.com/@kenjikuramoto/types-of-equity-compensation-5b6feb11b4fa#.t9kl698f5

— How to discuss stock options with your team https://bothsidesofthetable.com/how-to-discuss-stock-options-with-your-team-d903304e4dde#.psyxpthle

— Infographic: Are you satisfied with your stock/equity compensation? https://www.comparably.com/guest/culture/tech/all-departments/37-are-you-satisfied-with-your-stockequity-compensation

This guide was compiled with the help of attorney David Ajalat at Cooley LLP.

Jason Nazar

Jason is the Co-Founder and CEO of Comparably and the current Entrepreneur in Residence for the City of Los Angeles. Before Comparably, Jason was the founder/CEO of Docstoc, the largest content site for Small Businesses aqcuired by Intuit in 2013. Jason is a popular writer on Forbes, Wall Street Journal & Business Insider. And writes about topics of compensation and culture transperancy on our Comparably Blog.

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