- Equity for Software Engineers at Big Tech and Startups
- Equity Stock options explained for startup employees | Carta
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- Types of startup stock options
Small businesses, like a coffee shop or plumbing business, typically intend to grow slowly and organically, while relying much less on investment capital and equity compensation. LLCs tend to be better suited for slower-growth companies that intend to distribute profits instead of re-investing them for growth.
Because of this, and for complex reasons related to how their capital is raised, venture capitalists significantly prefer to invest in C corporations. Many large and successful companies began as startups. In general, startups rely on investors to help fund rapid growth. Selling shares in a business to investors is one form of fundraising, as are loans and initial coin offerings. Financing refers both to fundraising from outside sources and to bringing in revenue from selling a product or service.
These investors are called venture capitalists or VCs. Venture capitalists invest in companies they perceive to be capable of growing quickly and commanding significant market share. A startup goes through several stages of growth as it raises capital based on the hope and expectation that the company will grow and make more money in the future. As the number of outstanding shares goes up, the percentage ownership of each shareholder goes down. This is called dilution.
As a company issues stock and raises money, the smaller percentage of the company you do have could be worth more. The size of your slice gets relatively smaller, but, if the company is growing, the size of the cake gets bigger. That is, the price for an investor to buy one share of the company would be increasing. It can happen that a company fails entirely and all ownership stakes become worthless, or that the valuation is lower than expected and certain kinds of shares become worthless while other kinds have some value.
When investors and leadership in a company expect the company to do better than it actually does, it can have a lot of disappointing consequences for shareholders. These visualizations illustrate how ownership of a venture-backed company evolves as funding is raised. These diagrams simplify complexities such as the ones discussed in that analysis, but they give a sense of how ownership can be diluted.
Equity for Software Engineers at Big Tech and Startups
Understanding the value of stock and equity in a startup requires a grasp of the stages of growth a startup goes through. These stages are largely reflected in how much funding has been raised—how much ownership, in the form of shares, has been sold for capital. Very roughly, typical stages are:. The low end of this spectrum is now often called pre-seed.
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Series B tens of millions : Scaling the business. Series C, D, E, and beyond tens to hundreds of millions : Continued scaling of the business. Keep in mind that these numbers are more typical for startups located in California. The amount raised at various stages is typically smaller for companies located outside of Silicon Valley, where what would be called a seed round may be called a Series A in, say, Houston, Denver, or Columbus, where there are fewer companies competing for investment from fewer venture firms, and costs associated with growth including providing livable salaries are lower.
For this reason, the amount of equity team members get is higher in the earlier stages starting with founders and increasingly lower as a company matures. See the picture above. The option pool is part of a legal structure called an equity incentive plan. The whole pool may never be fully used, but companies should still try not to reserve more than they plan to use. The size of the pool is determined by complex factors between founders and investors. The size of the pool may be increased later.
In this example, the corporation would have 90 million authorized but unissued shares. When you are trying to determine what percentage a number of shares represents, you do not make reference to the authorized but unissued shares. Typically, people count shares in two ways: issued and outstanding and fully diluted. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them. Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it costs you to buy the shares.
Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest.
Equity Stock options explained for startup employees | Carta
You can find this in your contract. When and how you should exercise your stock options will depend on a number of factors. You would be better off buying on the market. But if the price is on the rise, you may want to wait on exercising your options.
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Once you exercise them, your money is sunk in those shares. So why not wait until the market price is where you would sell? That said, if all indicators point to a climbing stock price and you can afford to hold your shares for at least a year, you may want to exercise your options now. Also, if your time period to exercise is about to expire, you may want to exercise your options to lock in your discounted price.
You will usually need to pay taxes when you exercise or sell stock options.
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What you pay will depend on what kind of options you have and how long you wait between exercising and selling. With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W The amount of income reported will depend on the bargain element also called the compensation element.
Types of startup stock options
When you decide to sell your shares, you will have to pay taxes based on how long you held them. If you exercise options and then sell the shares within one year of the exercise date, you will report the transaction as a short-term capital gain. This type of capital gain is subject to the regular federal income tax rates. If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year.
ISOs operate a bit differently.
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You do not pay taxes when you exercise ISOs, though the amount of the bargain element may trigger the alternative minimum tax AMT , which phases out income exemptions targeted for low- and middle-income taxpayers. When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain element is treated as regular income.
Stock options are becoming a more common way for companies to attract and keep employees. Option terms are set by the individual company through a contract you must sign. You should familiarize yourself with the terms in that contract. It will tell you how many options the company is granting and the length of the vesting period. The contract will also have the grant price, which is what you will pay when you exercise those options.