Equity Flashcards
What is vesting?
Vesting means that, while the grantee “owns” all of their stock / options, the company has a right to repurchase a certain amount if the grantee leaves before the vesting schedule is complete. Initially the repurchase right applies to 100% of the stock, but over time this right is diminished, until the company has no right to repurchase any stock (it is “fully vested”). This is a necessary protection for the company in case of termination, resignation, major role re-scoping, etc. Without a vesting schedule, an employee could in theory sign the equity paperwork, never do a minute of work, and walk away with their stock.
What is “vesting over four-years with a one-year cliff”?
Stock grants typically vest over “four years with a one-year cliff.” This means the stockholder vests in zero stock until the one-year anniversary of the vesting start date, when they vest in 25% of the grant. This “one-year cliff” creates a risk-free trial period for the company. After that, the employee vests in 1/48th of the grant per month, until they’re fully vested at the end of year four.
How do I compensate consultants?
Consultant compensation varies widely depending on the stage of the company, type of compensation (equity, cash, or both), scope of project and timeline, expertise of the consultant, etc. Most consultants will prefer to receive payment entirely in cash, although some may be open to an equity grant. Meaningful grants to consultants typically only make sense if there is a substantial vesting period and the company wants to hire the consultant as a full-time employee down the line. Short term or fully-vested equity grants for one-off work does not scale well as the company is growing – equity is best-suited to compensate talent that will be adding value for a long time.
Equity splits: What’s fair between co-founders?
In General
Dividing equity fairly among co-founders is one of the most important tasks for a founding team. Often this is the first “hard conversation” among co-founders, as equity splits dictate economic outcomes, distribute control over the corporation, codify intended contributions to value, and create buy-in on a professional and personal level. Each case is different but there are common frameworks to help founders come to a reasonable outcome.
In general, equity splits should reflect each founder’s value provided and risk taken. One common arrangement is that each co-founder receives an equal share because (i) it’s fair, (ii) value & risk are hard to predict and measure over time (and you’re measuring apples to oranges—fundraising vs. product development, etc.), and (iii) even if one founder “thought of the idea,” each founder’s value provided should converge to equal over a four to five-year time horizon. That said, many companies deviate from equal shares and no founding story or team is exactly the same.
Types of Value: Now and in the Future
There are many categories of valuable contribution. Product, engineering, growth & marketing, fundraising, recruiting, finance & accounting, operations, design & brand, legal & regulatory… This an incomplete list, but gives a sense of some of the many needs of an early organization (or any successful company). Often founders wear several hats, meaning that they may be a “product person who can code an MVP,” or a “businessperson who can lead strategy, fundraising, recruiting, and operations.”
Other questions might prove useful when thinking through value contributions. Were they involved in the initial conception or did they come later? How much later? Is this person an “ideation” person or an “implementation” person? What were their contributions? Can they recruit others to the team? Will they assist with initial fundraising? What will their role be for the first six months? Two years? In five years? Will they be able to grow as their role expands? What’s their expected value over the life of the company?
Risk Taken
Generally, the big driver of this analysis is expected value. When the startup is very early-stage and few milestones have been reached, expected value is low. As the company progresses by building the product, achieving growth goals (users, revenue, etc.), recruiting team members, and raising money, expected value increases.
High-value contributors who join full-time prior to any milestones are typically founders and deserve founder equity. Sometimes, for personal or professional reasons, contributors “moonlight” at the startup while working full-time or part-time for another job. These factors can weigh into the founder equity economics. If a contributor “moonlights” part-time at the startup for six months until the startup raises enough money to pay that person a full-time salary, while the other founders were working full-time without salary, it may make sense for the late-joining moonlighter to receive less equity.
Generally, prior compensation should not factor in to this discussion (e.g., “Co-Founder A is leaving/foregoing a job that pays $150,000 per year and Co-Founder B is leaving/foregoing a job that pays $250,000 per year, therefore Co-Founder B deserves more equity”). A startup should not be viewed by anyone as a vehicle to replace or maintain compensation, it should be viewed as a new enterprise, where founders are getting paid enough to live reasonably (or at least survive), while building as much equity value as possible, with economic and control rights that set the appropriate foundation for future growth and good governance.
Fairness Considerations
What “feels fair” to all involved? Who will work early mornings and long nights? Who will be in the trenches when there is (inevitably) a fire drill on Friday at midnight?
This is a catch-all category for other factors that are hard to quantify or describe. Ultimately, if you really want to work with a particular person, they have a lot of leverage with regard to equity splits. Team health and happiness is one of the most important factors in a company’s success. For example, if Co-Founder #1 really believes that they should have 60% and Co-Founder #2 should have 40%, but Co-Founder #2 is pushing for 51-49 (i.e., #1 still has a majority but the gap is small), Co-Founder #1 will have to carefully consider how important it is to push hard for the extra 9% as opposed to moving forward quickly with a happy second-in-command.
“Equity Calculators” and Other Formulaic Approaches
In general, we discourage using equity calculators or formulaic approaches for anything other than education or starting the conversation (in other words, equity calculators and formulas should not be viewed as producing “correct” results or as the “end-all, be-all.”) These approaches tend to frame the conversation in terms of right & wrong, and real dollar values, which is misguided at best and counterproductive at worst.
If stakeholders feel like the outcome of the formula isn’t fair or what they expected, they will reject the process, and will often become more entrenched in their position as a result. And any attempt to value stock or talk about it in terms of real dollars is perilous. The stock will either (most likely) be worth very little, or (possibly) be worth a lot, and the founders will not realize that value for five to ten years. The uncertainty is large enough and timelines long enough that the on-paper value of the stock (if any) at this stage has little meaning.
Two Co-Founders
Usually, two co-founders will choose to split the equity 50-50, or 51-49.
Sometimes it is the case that one co-founder truly did develop the idea, technology, or business model independently, and the second co-founder is joining as a second-in-command. Imagine the case of a technical founder who builds the technology and then hires a business co-founder to oversee operations & finance, or, conversely, a business founder who invents the core product and business model and then hires a technical co-founder to build & implement the technology. In these cases, it can make sense for the original founder to own an outsized portion of the company’s equity, perhaps a 60-40 or 80-20 split.
Three Co-Founders
The two most common cases with three co-founders are an equal split 33-33-33, or two co-founders who are the primary co-founders, and a third who was brought on later (after initial ideation, fundraising, product development, etc.). In the latter case, the split might look like 35-35-30, 40-40-20, or 45-45-10.
Example 1: Three equal founders all graduate/leave school or quit their jobs at roughly the same time to work full-time on the company. 33-33-33.
Example 2: Two co-founders quit their jobs and work for six months without a salary, coming up with initial product & strategy, launching the MVP, signing the first customer. The company then raises $500,000 in angel financing. A third co-founder, who has been moonlighting at the startup part-time since month three, quits their other job once the round is closed and joins the startup full-time. 40-40-20.
Four Co-Founders
Similar to the three-co-founder case, four co-founders most likely will split things equally 25-25-25-25 or come to an arrangement with two or three “lead” founders and one or two “secondary” founders, e.g., 40-30-15-15, 35-35-20-10, etc.
Solo Founders and Skewed Cap Tables: A Red Flag?
Being a solo founder—or having a founding team in which, for example, one founder owns 90% of the equity and two other founders own 5% each—is not necessarily a bad thing, but it will raise questions in the minds of early-stage VCs. Is this person selfish, controlling or unable to work well with others? Is this founder able to recruit a talented team with complementary skills? Will the founder be able to work fast enough without a team? Does the founder have legitimate stakeholders to lean on during difficult times? Explicit or implicit answers will be required.
What is “Founder Stock”?
“Founder Stock” is startup slang without legal significance; the term refers to common stock issued soon after incorporation at par value. Par value is the initial share price and is set close to $0 (usually $0.0001/share or $0.00001/share). People call this early common stock “Founder Stock” because the early stakeholders can receive large portions of equity for close to $0.
After each round of outside investment (in which the VCs purchase “Preferred Stock” with special rights & privileges), the company’s common stock will be re-priced in a 409A valuation by a neutral 3rd party to reflect the increase in value. Usually the 409A common stock valuation is 10-20% of the last preferred stock valuation (although this diverges based on a number of factors).
Future equity awards will likely be orders of magnitude smaller than the initial founder equity splits, and will be granted in the form of stock options with an exercise price equal to the latest 409A valuation. Recipients will only benefit from the increase in the value of their shares above the exercise price.
So, when an employee compares their equity grant to “Founder Stock,” they may be comparing 50,000 stock options with an exercise price of $0.50/share with a founder who purchased 1,000,000 shares of common stock for $0.00001/share ($10). If shares of common stock are worth $2 at a liquidation event, the employee’s stock options would have a net exercised value of $75,000 ($100,000 value minus $25,000 exercise price), while the founder’s stock would be worth $2,000,000. The founder’s stock will also be subject to preferential long-term capital gains treatment and possibly the Qualified Small Business Stock tax exclusion, whereas the optionee must wait twelve months after exercise for long-term capital gains treatment and will likely not benefit from Qualified Small Business Stock.
The differences in equity grant size and the stock option exercise price become more pronounced as the company becomes larger and more valuable.
How do I compensate advisors?
Advisors assisting an early-stage startup typically receive 0.10 - 0.50% in equity for working 1 - 5 hours per month, depending on their value add. This grant most commonly vests over 24 months with no cliff, because (i) value is sometimes front-loaded; and (ii) it is usually only fair to begin vesting right away because otherwise the advisor is effectively working for free under the threat of being terminated without compensation.
Founders often choose advisors with particular expertise that can help guide the founders on a particular set of questions or strategic concerns, and this expertise tends to “phase out” of usefulness after about two years, because the company will (hopefully) progress to a point where those strategic questions have been answered or the capability has been built internally at the company through another hire, a business or technical process, or from the founder’s own learning. This “two year window of usefulness” is why most advisor equity grants vest over two years.
Why is it so important to issue “Founder Stock” before outside investment lands?
It’s hard to claim that the company’s common stock is still worth only $0.00001/share if the company has received significant third-party investment. While there might not be an updated 409A valuation yet (this usually happens at the first equity round, but not after, e.g., a $500,000 SAFE financing), a co-founder who joins after angel financing may need to pay much more for their common stock, e.g., $0.01 per share instead of $0.00001/share. If the co-founder is receiving 1,000,000 shares, they would need to write a check to the company for $10,000. Or, more likely, the company will establish a stock option pool and grant this founder 1,000,000 stock options with a strike price of $0.01/share to save the founder from the initial cash outlay.
There are two issues with receiving this equity as a stock option grant:
First, the shareholder still loses $10,000 of value, because it will cost $10,000 to exercise the option grant. Second, the co-founder loses preferential tax treatment. Until the co-founder exercises their stock options, the Qualified Small Business Stock and Long-Term Capital Gains clocks will not start. For example, Long-Term Capital Gains treatment only applies to stock that is held for at least a year, so the grantee would need to hold their shares for at least a year after exercise to receive preferential treatment.
We recommend making all equity grants under the guidance of an experienced startup attorney.
Should two co-founders avoid a 50-50 split to prevent deadlock?
50-50 is a common split between two co-founders. However, until there is a third shareholder, there is a risk of deadlock, so sometimes founders will choose to make one person the “tie-breaker” and split the equity 51-49 or 50.1-49.9. But consider: deadlock is only a risk until a third shareholder comes on Board, which is usually a relatively short period of time, and, if the two co-founders are diametrically opposed to each other on a particular issue and aren’t able come to a reasonable compromise relatively quickly, the company probably has much bigger problems.
What is the Section 83(b) tax election and why is it so important?
The Section 83(b) tax election (“83(b)”) is filed with the IRS to allow a founder to pre-pay taxes on equity the date their equity was granted rather than pay ordinary income tax on the value of the equity as it vests over time. If the 83(b) filing window is missed (within 30 days of the transfer/purchase of stock) and the startup does well, the equity could be worth millions of dollars, which means that a founder would be responsible for paying tax on millions of dollars of ordinary income without being able to sell stock to cover the cost. This is doubly painful if the startup eventually fails, as the founder will have paid large tax bills for nothing. As such, the 83(b) is a critically important step in the formation of a new enterprise.
83(b) elections are just required for stock subject to vesting for US-taxpayers. If not all three of those conditions are met, an 83(b) is not required (e.g., not required for option grants, non-US taxpayers, or stock that is granted fully vested). Proper 83(b) filing is on the legal diligence list of all lawyers who represent venture capital firms.
Seeking the advice of experienced corporate attorneys when issuing common stock to the founders and filling 83(b)s, as they can walk you through the process (or do it on your behalf). Ideally, you will have a file-stamped copy in your records showing that a copy of your signed 83(b) was received by the IRS, filed, stamped, and returned to you for your records.
How do I compensate early employees?
As a founder, your goal is to incentivize contributors appropriately to create value. Overcompensation can be as problematic as undercompensation, as reducing compensation after hiring decreases motivation, raises fairness concerns, and creates relationship stress, not to mention being costly to the business’s bottom line.
Typically the first handful of early employees who are relatively skilled hires receive 0.25 - 3% equity, vesting over four years with a one-year cliff. Usually they are taking a significant pay cut, or no salary, and a meaningful equity stake helps offset their risk.
The same logic applies here as to the co-founder equity splits question. As the company reaches milestones (MVP launch, fundraising, users, revenue), the value of the equity increases so the size of the grant will go down. When the company increases in value from $10,000,000 to $20,000,000, equity grants for employees #3 - 6 might fall to 0.10% - 1% range.
Note: Because the potential future realized value of this equity is highly uncertain and distant, this will primarily come down to what is fairly negotiated. It is only when the company is much further along and the stock is (close to being) more liquid that you can use deterministic calculations when putting together offer packages (e.g., $100,000/year salary + equity with an expected value in 12 months of $100,000, vs. $125,000/year salary + equity with an expected value in 12 months of $75,000).
Sometimes founders can create value for employees by offering different compensation packages between which the company is indifferent, and allowing the employee to choose their preferred arrangement. Again, because equity value is so uncertain it is hard to reduce this to a perfect formula, but one might approach it in the following way:
This person is making $150,000/year with no equity at their current job.
We can afford to pay them between $80,000 and $100,000.
We closed $500,000 on SAFEs with a $10,000,000 valuation cap.
We’re willing to grant this person up to 0.5% equity, which in a very rough sense is worth $50,000 on paper ($10,000,000 * 0.5%). (This is “very rough” because a SAFE is not a firm valuation of equity, value depends on factors such as equity type, exercise price, expected future equity value, expected timeline.)
Offer 1 = $80,000 + 0.5%; Offer 2 = $90,000 + 0.4%; Offer 3 = $100,000 + 0.3%
What does “fully-diluted” mean?
“Fully-Diluted” means percentage ownership of all granted shares (not authorized shares) plus the conversion of all convertible securities, plus the grant exercise of all reserved stock options. Stated differently, it’s the ownership total if everyone who has been given present or future rights to equity gets the full benefit of those rights.
Example: Let’s say a company has granted 9,000,000 shares of common stock (3,000,000 to each of three co-founders) and has reserved 1,000,000 shares under a stock option pool to grant to future employees and consultants. Let’s say that employee #1 receives 100,000 options and the other 900,000 remain in reserve. Each co-founder owns 33% of the stock outstanding, but owns 30% of the company on a fully-diluted basis (assuming all stock options will be issued & exercised). Employee #1 owns 0% of the company because their grant is in the form of unexercised options, but owns 1% of the company on a fully-diluted basis (assuming all stock options will be issued & exercised).
How many shares should be granted?
In order to compensate early contributors, companies grant some portion of the shares authorized. For example, if there are three co-founders dividing the company equally and the Certificate of Incorporation authorizes 15,000,000 shares, the company may issue 4,000,000 shares to each founder, with 3,000,000 held in reserve. The reason some shares are held in reserve is that if the company decides to grant more stock (e.g., add another co-founder who owns 2,000,000 shares), the company has the shares to do so without amending its Certificate of Incorporation.
How many shares should be authorized?
The number of shares authorized in the Certificate of Incorporation is the total number shares that the company can issue. Once it issues these shares, the company must amend the Certificate of Incorporation to increase the number of authorized shares. Most law firms and software tools use an initial default number of either 10,000,000 or 15,000,000 shares authorized.
What is the difference between “single-trigger” and “double-trigger” acceleration of vesting?
Single-trigger acceleration is the partial or full acceleration of the vesting of your options or stock based on the occurrence of one event, the “trigger.” Double-trigger acceleration is acceleration based on the occurrence of two distinct events, often in sequence. Example triggers include a change in control of the company (e.g., M&A sale), and involuntary termination.
While single trigger acceleration is rare, founders and other key early employees often receive double-trigger acceleration. This makes sense because founders are at risk of termination after their company is acquired and double-trigger acceleration provides them with some protection. (For example, if one of the founders’ primary duties was handling the CFO/COO responsibilities, but the acquirer already has a CFO/COO, then that founder will likely be terminated after the acquisition and may want to receive accelerated vesting in that case to balance the risk.)
What are the most common vesting schedules for equity compensation?
The two most common vesting schedules for equity compensation are monthly over four years (48 months) with a 1-year cliff, and monthly over two years (24 months) with no cliff. The former is most often used for employees receiving a salary and benefits, where the cliff period creates a “trial period” within which the employee vests in nothing, and the company may terminate that employee and repurchase all of their equity. The latter is more often used in the case of advisors receiving small equity grants as their only compensation. In this case a cliff would create a fairness concern, as the advisor is at risk of early termination, in which case they would have provided services up to that point in return for zero compensation.
While relatively rare, other models do exist. For example, sometimes vesting periods are quarters, or years, rather than months. Some other companies choose to do back-loaded vesting such as 10-20-30-40, so that if an employee leaves or is terminated after two years they are only vested in 30% of their grant instead of 50%. Given that these schedules are less common and also less generous to the employee, a startup offering these packages will be at a competitive disadvantage in recruiting and may only be able to get away with these offers if it has appeal, such as significant momentum (rocket ship) or if it is willing to compensate in other ways (higher salary, better benefits). Ultimately, the variables in a vesting schedule are the length of time of the total schedule, the vesting periods, and the existence and length of a vesting cliff. All elements are customizable.
A quick word on milestone-based vesting: While it can sometimes work, beware of milestone vesting for two key reasons: First, milestones can be difficult to describe in legally precise language, which can lead to misunderstandings. Second, milestone vesting can create perverse incentives to achieve milestones when those milestones are no longer the most valuable goals for the company. This is especially common in the startup world, where companies must rapidly change course in order to maximize value and survive.
We recommend standard-issue time-based vesting schedules for all contributors in >95% of cases.
