Startup Equity: What Should You Ask For?
If you’re already in the startup world, there’s a strong likelihood that you Founder equity (we’d be surprised if you didn’t!), but if you’re new to the industry, understanding how much to ask for in any given opportunity might be somewhat of a mystery to you. We are here with the help of fellow entrepreneurs in our community to share insights, guidelines, and other resources for anyone in the position to ask for (and receive) equity compensation from a company.
What is Equity Compensation?
Equity is the value of a company's stock, which you earn as a percentage of the company’s profits (or losses). Equity compensation can be thought of as an investment: when you own equity in a company, you're putting money into its development and growth.
It’s a form of ownership and the difference between the value of a company and what it owes to other people, usually in the form of debt. Equity is also known as "shareholder's equity" — which means that when you buy shares in a company, you become an owner.
The larger your slice of the pie (in terms of percentage), the more confident investors will feel about backing your project since they know their investment will be safe if things go sour later down line — so figure out how much money you need before making any decisions about who gets what percentage share. Equity, above all else, is power.
Equity vs Salary
It's paramount to keep in mind that salary and equity compensation are two very different things. Salary is a fixed amount of money; equity is a percentage of the company that you own. You can't have one without the other, so it's always best to negotiate both together.
This is worth breaking down in further detail. Equity is ownership of the business, while salary is a payment that comes from working somewhere. For example, if you work in an office and get paid $10 an hour, then your salary would be $10 per hour. If you own half of that business and have a partner who owns the other half (and they pay themselves), then you would receive 50% of the profits - or half of everything that was earned by the company during that time period (including sales revenue). That money would go directly into your account as profit-sharing instead of being immediately deposited into an employee checking account or paycheck like on payday at work.
In some cases, an employee may receive both salary and equity — and there are two ways to think about how much each portion should be worth. First, there are many different types of companies; some are more likely to succeed than others. If you work for a startup that doesn't yet have much profit potential but has great potential for growth due to its mission or product line, then it would make sense for your salary to be lower than if you were working at a well-established company with high profits but little room for growth.
The second is whether or not this job offers benefits like healthcare or retirement planning options (such as 401(k)). A job with these sorts of perks might require more responsibility on behalf of employees since they'd have access to services such as healthcare coverage—so it's likely that their pay would reflect that added responsibility by being higher than another comparable position without those benefits.
Calculating Equity
When calculating equity, or "equity value," it's important to know what the total value will be before you decide how much you're willing to offer up or ask for. The general formula is:
Total Company Value = Total Investment + Net Profit - Debt + Equity
Offering Equity:
For example, if you’re making $1 million in net profit every year and your investment is worth $2 million, then the total value of the company would be $3 million ($1m sales + $2m investment -$500k debt + 1/3rd ownership). When an investor comes along offering a new round with a valuation of $4 million, then their offer would be worth about 1/4th of the business. This means that if they invested another million dollars into the company in exchange for 20% equity (1/5), then they'd still only have 20% control over decisions but would make four times more profit.
Asking for Equity (from a company)
Figuring out just how much equity you should ask a company for might feel awkward to some that haven’t been here before. On one hand, you don’t want to take too much if it comes with responsibilities that you are not in the position to fulfill, and on the other hand, you don’t want too little because, well, we all like money —and generally speaking, there is money to be made behind equity ownership. Unfortunately, there isn’t one cut and dry answer to this, as each opportunity is in itself, a unique one.
Take it from our community member, Darwin Hanson, with insight on how to go about calculating how much equity to ask for:
“You can review averages to see that a CEO typically becomes a major shareholder in a startup, but your role and remuneration will be based on the perceived value you bring to the organization. You value someone's contribution through equity when you think that they will be able to add long-term benefits, you would prefer that they don't move company part way through the process, and to keep them from being enticed by a better salary (a reason for equity tied to a vesting arrangement). Another reason is when the company doesn't have salary money available but the potential is very strong. In this situation, you should be especially diligent in your analysis because you will realize that even the best-laid plans sometimes fall completely short. So to get the best mix, you have to be very real about the company's long-term growth potential, your role in achieving it, and the current liquidity necessary to run the operations. It should also be realized that equity needs to be distributed. You cannot distribute 110% and having your cap table recalculated such that your 5% turns into 1% in order to make room for the newly hired head of technology is rather demotivating for the team. Equity should be used to entice a valuable person to join, stay, and contribute. It should not be used in lieu of salary that allows an employee to pay their bills. So, like a lot of questions, the answer is really, it depends. Analyzing the true picture of your long-term potential will allow you to more easily determine the correct mix.”
Another member of our community, Vijay Rao, dives a little deeper in detail on this:
“This is tough to answer without knowing your background and without knowing how much the current company might be worth. As a rule of thumb, a non-founder CEO joining an early-stage startup (that has been running less than a year) would receive 7-10% equity. Other C-level execs would receive 1-5% equity that vests over time (usually 4 years).
I would adjust these numbers somewhat if you have significant experience in the space or a track record of building and monetizing a brand.
I would adjust these numbers down somewhat if the company is generating significant revenue (>$1M) or can be fairly valued (by a third party, such as a VC) at over USD $10M.
I would also adjust the numbers down if the company has received professional investment from a venture capital firm or a strategic partner. Also, remember that salary and equity are both exchangeable and negotiable -- you may be able to get more equity for less salary and vice versa.
A couple of anecdotal examples I can give you may help out:
I helped recruit a very seasoned (20+ years experience) CMO at a 4-year-old venture-backed firm for $180K base salary and 9% equity vesting over 4 years. This person was previously a CMO at a Fortune 500 company.
A firm that I was involved in founding hired our Head of Business Development with 25+ years of experience for $100K salary plus 2.5% equity.
A personal friend of mine with 10+ years in the Sales and Marketing space just got hired (last week) as the Head of Sales & Marketing at a Series A venture-backed Financial Technology firm for $100K salary and 1.5% equity.
Founder, C-level Employees, and Board member salaries
Of all the compensation questions, this is perhaps the most sought out one. Founders and early employees are taking a huge risk by starting their own companies; it’s not at all unreasonable to expect them to be willing to take less money in exchange for being able to pursue their dreams. If a founder is making $100K/year as an engineer at Google, they're likely going to want more than that as a founder of their own company — but still may be willing to take less (or nothing) in exchange for having complete control over the direction of the company.
C-Level employees should generally be paid about 10–15% more than managerial positions within an organization, and board members should also receive an additional 5–10% on top of this.
The Equity Theory
Equity theory explains how people react to their perception of fairness in a situation. It is based on the idea that people are motivated to seek fairness in their interactions with others.
This theory focuses on determining whether the distribution of resources is fair to both relational partners. Equity is measured by comparing the ratio of contributions and benefits for each person. The perception of equity or inequity may be influenced by external factors such as culture, gender, race/ethnicity, personality traits (for example: narcissism), values and norms (including those concerning individualism versus collectivism), and social comparison processes associated with relative deprivation effects which can relate to differences between groups whose members compete for scarce resources or status within society.
Shares Vs. Stock Options
Shares and stock options are both forms of equity. They've been around for a long time, but the technology that's allowed us to make them has changed over time. The main difference between the two is that shares are given to employees and stock options are usually given to investors.
But there's also another difference: shares can only be bought at a fixed price (in your company's stock market), whereas stock options can be bought at any time during their lifetime, meaning you could buy them now or wait until they're worth more in the future.
What Are The Most Common Forms Of Equity?
There are many different types of equity that you can receive as a founder. Here are the most common forms:
Founder’s stock. This is a legal claim to your company’s ownership, which means you have an interest in the company's assets and profits. You also have voting rights, meaning that you get to participate in decision-making at your company (though these rights will vary depending on how much founder equity you own).
Founder's stock options. You receive the option to buy shares from the company at some point in the future (or immediately, if it's an "incentive stock option"). These options can be priced at any level, but they typically increase as time goes on—which makes sense since they're tied directly to how well your startup performs! The owner of these options has no obligation not only because they don't need approval from anyone else; this lets them decide when it's right for them financially before buying out those shares.
ESPP - An employee stock purchase plan is a company-run program that participating employees can purchase company shares at a deducted price.
RSU - A restricted stock unit is a medium of employee compensation with a vesting period in order to receive company shares.
ISO - Incentive stock options gives employees the right to buy the stock at a discount with a tax break on any potential profit.
NSO - A non-qualified stock option is another employee stock that is simpler and more common than ISOs — you pay ordinary income tax on the difference between the price when you exercise the option and the grant price.
How Much Equity Should C-Level Executives Get?
Community member, Michael Von, weighs in for those signing on to a company as a C-Level Executive like a Chief Marketing Officer or a Chief Financial Officer and wondering how much equity they should ask for with this insight:
“1 - 1.5% equity would only be beneficial for a multi-million/billion-dollar company. What is the most you think the [company] will be worth? Let's say it is $4M tops. 15% would give you $600,000. I say shoot for no less than 15%. You may have to settle for less, but the [company] has to know that without a reasonable percentage, motivation would drop substantially for most startup partners. By the way, think of yourself as a partner, not an employee.
How Much Equity Should You Ask For In An Early Stage Startup?
When it comes to asking for equity in a startup, the answer is "it depends."
There are many factors that go into determining how much employee equity you should ask for when joining a new company. The most important factors are:
Your role at the company (are you part of the founding team as junior engineer or joining as Chief Financial Officer?)
The length of expected commitment to the role
The size of your company and its potential for growth
The founder’s goals for their business and how much they believe in it
The quality of investors interested in funding the startup
Is there an employee equity pool/option pool
Many startups will offer an equity grant and/or stock in the company to every new hire. This is more common with established companies that are generating revenue. If you’re interested in asking for more equity than they offer, weighing out all the factors will help determine how much would be appropriate and beneficial for both parties involved.
Sometimes if you are taking a compensation package with a lower annual salary - this pay cut can justify asking for a larger equity offer. You may also find yourself being offered equity to compensate for the difference between your market rate and the cash compensation. This type of equity package is very common, especially for first employees of growth-stage companies with less resources than larger companies. Startup equity is often given as equity grants in these cases.
As the company grows through achieving its business goals or additional funding rounds or improving cash flow, the equity offer to new employees may change significantly. As the company looks less and less like a startup, fewer and fewer startup equity grants will be given. Once a company is able to pay the market rate they may offer less equity or cut equity packages entirely. Generally speaking, the more money a company can offer, the less they will choose to offer equity.
Vesting Schedule
A vesting schedule is often included when a company wants to offer employees equity. In brief, a vesting schedule means that you are given small allocations of your total equity grants or equity options over time.
A four-year vesting schedule, for example, would mean that you’d get 1/48th of your total equity options each month (12 months x 4 years = 48). Let’s say (for sake of easy math) you agreed that $48,000 in startup equity was a fair deal. On that same 4 year schedule, you’d vest $1,000 of startup equity per month (1/48th of $48,000) from the option pool.
Vesting Cliff
Unlike a vesting schedule, where you vest a little each month (or year, or quarter, as defined in your equity agreement or stock grant), a vesting cliff works in one of two ways.
The most common - you have none of your equity for a set period of time - say, 2 years, and then you get it all at once.
Alternatively - a vesting cliff and a vesting schedule can be used in conjunction. Let’s say you have a one-year cliff, and a year vesting period. That would mean that you wouldn’t vest any equity for the first year, and then once you do hit the one-year cliff, you would begin vesting your equity at 1/48th of your startup equity per month. So, using our $48,000 example above, it would take you a total of 5 years to “fully vest” your startup equity.
Vesting, shmesting, why don’t we just get it all at once?
Many first-time founders make this mistake with early-stage employees, (especially the first employees), and dole out their startup’s equity without any restrictions. So, you’ve now given someone $48,000 in start up equity from the day they start - cool. Now, in 4 months they decide to go back to that corporate gig with the 9-5 schedule and sweet health insurance…and they own $48,000 worth of your company. Not cool.
Equity Clawbacks
So, as illustrated in the example above, sometimes people leave… and the employee's equity goes with them. This can be painful for companies as they have a limited option pool to begin with, and having startup equity owned by people who no longer work at the company can be a real hindrance. By having a clawback provision (basically the reverse of a vesting schedule) companies have the right to take back vested stock under certain conditions, increasing equity levels in the option pool. This means that equity is now back in the options pool and the company can give new or existing employees equity.
Capital Gains Tax
We’d be remiss not to mention Capital Gains Tax and its relationship to an equity grant of company equity. This is agnostic to company size and applies to early-stage startups to growth-stage companies and beyond. It also applies to everyone from the founding team to an early employee. As the company grows, so does the company valuation and market value of the company equity, and therefore the equity stake of the individual.
This can result in capital gains taxes being due on the employee equity. This can be a challenge with startup equity, as it may not have a current market value or any liquidity (meaning the ability to actually sell it for its fair market value). In the eyes of the law, if the value of the company equity increases, taxes are likely due to the difference between the original company valuation and the current valuation.
Often, the only time individual employees will be able to “cash-out” is during a liquidity event - meaning additional funding rounds, or acquisition of the company.
Summary/Conclusion
It's not just about the money. Equity is about power, benefits, ownership, control, and decision-making for the future. It's important to understand what you're asking for and why. If it's just a matter of cash then maybe you don't need equity at all.
Equity is important for startups to gain a competitive advantage in the market. It can be distributed in the form of stock options or shares. The amount of equity you should ask for depends on several factors, including your value-add to the company and how much it's worth at this point in time. When calculating how much equity you are entitled to receive from your employer, keep salary in mind as well; don't be afraid to ask questions about what would happen if one-factor changes while another stays constant or vice versa.
