New CS grads are often showered with salary, perks, and equity. When I was graduating, I had no idea how any of this worked. How does tax work? How much will my shares be worth? I joined Uber after college, a company few people doubt will IPO and do so successfully, but still there were still many surprises. I'm going to walk through how equity grants work, so that the new grads among you can make better informed decisions.
In almost all cases (including founders!), equity has a vesting schedule, the most typical is over 4 years with a 1 year cliff. Your first year of employment, you receive 0 equity. At your 1 year mark, you receive 25%. You receive 1/48 of your original equity grant each month over the following 3 years.
Especially when you join an early stage company, you are granted ISOs - Incentive Stock Options. An option is the right to purchase a stock at some point in the future at a particular price.
Let's say your strike price is $10, which means your options give you the right to purchase your alloted shares at $10/share. Startups must periodically undergo a government valuation process called a 409a, and this process is also what re-adjusts the strike price.
Employers, employees, and investors have an interest in keeping this price down for both tax and pure capital reasons. Everyone's interest is pretty much aligned here in this regard.
Let's say the preferred price is $20, which means that investors have paid $20 for those same shares. When people say that a company is worth $X million or $Y billion, it roughly means this preferred price * outstanding shares = valuation.
It's important to note that the $20 has had some risk removed. number: investors often have something called a 'ratchet clause', which means they are guaranteed a certain minimal return (2x), and they will receive additional shares to ensure them that return if necessary.1
Moreover, investors often have liquidation preferences, meaning they will be first to receive their money in case of bankruptcy.
That said, the preferred price is arguably the most accurate indicator of the company's current value, as it is the price that some members of the public paid to own part of the company.
After you've been at the company a year2 and vested your first year, you decide to exercise your options. Let's say you were granted 20,000 shares. You vested a quarter, so 5,000 shares. You need to cut two checks. With a $10 strike, you owe the company $50,000. Additionally, you have income of (20-10) * 5,000 = $50,000, and are taxed on that amount. You'll pay about 1/4 in income tax, so another $12,500 you have to pay to the federal government.
The plus side is additional gains are only subject to capital gains tax
(18%), assuming you hold for a year. If the stock rises to $40, you only
.18 * 5,000 * (40-20) = $18,000. In total you paid $30,500 in tax.
If you wait to exercise until it has already reached 40, you'd pay
.25 * 5,000 * (40-10) = $37,500 in taxes. With exercising early, you
saved $7,000 in tax. Doing the same operation with the rest of your shares will
save you even more money.
Note there is a tradeoff here: you have less liquidity (cash on hand) when you exercise, as opposed to holding your options. All of this calculus means that you should run the numbers on a few hypothetical situations before you accept your job offer so you can best decide what tradeoff to make for your situation.
Even if you've vested your options, most companies don't allow you to keep options more than 90 days after terminating employment. Unless you have the money in your bank account to exercise your options (to purchase AND to pay the tax), your options will go up in smoke.3 Once you own the stock, you keep it regardless of employment status.
This is the real meaning of golden handcuffs. It's not being afraid of leaving a company because of the perks and high compensation. It's being unable to take the equity that you have already earned because you don't have the capital. Every person accepting equity should understand the math behind their equity and the tax implications.
An investor invests \(1mm and receives 100k shares (\)10 preferred price). The investor has a 3x ratchet clause. The stock IPOs for $20. Because this is only a 2x return, the investor automatically receives an additional 50k shares. 150k shares * $20/share = $3mm, giving the investor 3x on their investment. ↩
Some companies will allow employees to early exercise their options, meaning to exercise their options before they have vested them. In case you exercise options that you never vest, the exercise money (but NOT any tax you owe!) is returned to you. ↩