Employee equity has always been a nebulous topic for me. Every time I thought I understood how it worked, I would read or hear something that made me question my understanding. Thank goodness people like Fred Wilson exist. He is a venture capitalist, blogger, and a budding professor. The video I embedded below is Fred Wilson explaining Employee Equity to a classroom full of future entrepreneurs. The video is 70 minutes long and is very thorough so if you want an expert in the field to walk you through how Employee Equity works (and some of the tax implications), I urge you to watch the entire video.
If you're short on time and you're an employee with options, the first 30 minutes will suffice for a basic understanding. If you're an entrepreneur, you'll still want to watch the last 40 minutes of the talk since it's more about strategy of how to structure your company's employee equity.
The reason I didn't simply tweet out the link to this video is because I wanted to list some of the topics that he provided clarity to for me. Below is a brief recap of what I learned.
Restricted Stock vs. Options
Founder stock vs. restricted stock vs. option grants were a point of confusion for me in the past. Mr. Wilson does a terrific job differentiating the three as well as providing great examples for when a company would give out each of the three. I'll try to give my best summary of what he said:
- Founder stock - when the company is formed, it's most likely worth nothing so it's most economical to divvy up the shares at the beginning (which is actual ownership) and pay the taxes up front for a nominal amount.
- Restricted stock - typically this stock is only given to early employees. Just like Founder stock, this stock is comprised of actual shares of the company and is immediately taxable. Restricted stock differs from Founder stock as it usually has the same vesting provisions as Options (i.e. 4 years, 1-year 25% cliff).
- Options - what most non-founder, non-early employees receive in terms of equity. As mentioned above, Options come with vesting provisions. The biggest difference, however, is that Options aren't actual shares of the company - Options are a right issued to you to buy a certain allotment of actual shares at a set price (also known as 'strike price').
I'll play out an example of how Options work:
If a company had a valuation when it was just formed, each share would be worth next to nothing. If the company then received an Angel or Series A round, the investors would value the company to determine how much of the company they own based on the valuation divided by their investment. As a result each share would now have a value. For the sake of this example, let's say each share is worth $.50 now. If you were to join the company at that moment and were issued options (let's say 10,000 options), your strike price would be $.50 per share. If you stuck around for four years and vested all your options and your company was bought at a much higher valuation, say $5.00 a share, you could exercise your grant of 10,000 options and pay $5,000 to own those shares (10k options x $.50 strike price), which you could turn around and sell for $50k at a $45k net profit. Savvy? It's important to note that striking on your options is a taxable event, which is why most people wait until the options are valuable (i.e. your company goes public) before they exercise their right and deal with the tax implications.
One last thing about Options. The quantity allotted to you in your Options grant is entirely relative. 10k options at one company could be worth less than 1k options at another. Outside of vesting, there are three variables in the Options value equation: quantity (# of options), number of outstanding shares in the company, and company valuation. If you're company is worth $50mm and there are 10 million outstanding shares in the company, each share is worth $5. When you exercise your options, the options in the employee equity pool become shares with real values. So if someone offers you Options at a company, it's very important to take into consideration the current value of each share (if the company is willing to disclose that information).
When you start a company, you own 100% of the company. As soon as you start hiring people, you're going to need to give away equity and, as a result, your ownership of the company dilutes. If you hire a co-founder as your company is forming, your 100% would likely become 50%. After hiring your founding team, you could be down to 40%. If you receive a round of fundraising, it will dilute more and so on. Generally speaking, dilution appears as something you would try to avoid. However, that's not always the case.
The biggest takeaway I had from this video about dilution is that your ownership diluting is not a bad thing if the event that caused the dilution adds more value to your company. Quick example of breaking even with dilution: let's say you own 40% of your company and it's valued at $2.25mm before funding. Your investors put in $250k for 10% of your company at a $2.5mm post-money valuation. Your shares dilute 10%, which brings you from 40% to 36%. Before the round, your 40% is worth $900k. After the round, your 36% is worth $900k (2.5mm x .36). Same money for you, more operating money for the company. Dilution - not so bad after all.
For supplemental reading, check out Fred Wilson's Employee Equity blog post. Also, I should disclose that I'm not a lawyer or accountant so please consult a professional about anything tax-related.