A Glossary of all the terms you need to understand equity compensation, from the Holloway Guide to Equity Compensation
A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won’t consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising.
The Internal Revenue Code, in Section 83(b), offers taxpayers receiving equity in exchange for work the option to pay taxes on their options before they vest. If qualified, a person can tell the IRS they prefer this alternative in a process called an 83(b) election. Paying taxes early with an 83(b) election can potentially reduce taxes significantly. If the shares go up in value, the taxes owed at vesting might be far greater than the taxes owed at the time of receipt.
The catastrophic scenario where exercising ISOs triggers a large AMT bill, with no ability to sell the stock to pay taxes, is sometimes called the AMT trap. This infamous problem has trapped many employees and bankrupted people during past dot-com busts. Now more people know about it, but it’s still a significant obstacle to plan around.
In some cases, vesting may be triggered by specific events outside of the vesting schedule, according to contractual terms called accelerated vesting (or acceleration). Two kinds of accelerated vesting that are commonly negotiated are if the company is sold or undergoes a merger (single trigger) or if it’s sold and the person is fired (double trigger).
An acquisition is the purchase of more than 50% of the shares of one company (the acquired company) by another company (the purchaser). This is also called a sale of the acquired company. In an acquisition, the acquired company cedes control to the purchaser.
Alternative minimum tax (AMT) is a supplemental income tax that applies to certain individuals in some situations. This type of tax does not come up for many taxpayers, but higher income earners and people in special situations may have to pay large AMT bills. AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid no income tax in 1966. It is not the same as ordinary income tax or employment tax, and is calculated according to its own rules.
Private companies always have what are referred to as authorized but unissued shares, referring to shares that are authorized in legal paperwork but have not actually been issued. Until they are issued, the unissued stock these shares represent doesn’t mean anything to the company or to shareholders: no one owns it.
A corporation has a board of directors, a group of people whose legal obligation is to oversee the company and ensure it serves the best interests of the shareholders. Public companies are legally obligated to have a board of directors, while private companies often elect to have one. The board typically consists of inside directors, such as the CEO, one or two founders, or executives employed by the company, and outside directors, who are not involved in the day-to-day workings of the company. These board members are elected individuals who have legal, corporate governance rights and duties when it comes to voting on key company decisions. A board member is said to have a board seat at the company.
A C corporation (or C corp) is a type of stock corporation in the United States with certain federal tax treatment. It is the most prevalent kind of corporation. Most large, well-known American companies are C corporations. C corporations differ from S corporations and other business entities in several ways, including how income is taxed and who may own stock. C corporations have no limit on the number of shareholders allowed to own part of the company. They also allow other corporations, as well as partnerships, trusts, and other businesses, to own stock.
Income is the money an individual makes. For tax purposes, there are two main types of income, which are taxed differently. Ordinary income includes wages, salary, bonuses and interest made on investments. Capital gains are the profits an individual makes from selling assets, including stock.
A capitalization table (cap table) is a table (often a spreadsheet or other official record) that records the ownership stakes, including number and class of shares, of all shareholders in the company. It is updated as stock is granted to new shareholders.
Investors often ask for rights to be paid back first in exchange for their investment. The way these different rights are handled is by creating different classes of stock. (These are also sometimes called classes of shares, though that term has another meaning in the context of mutual funds.)
Vesting schedules can have a cliff designating a length of time that a person must work before they vest at all.
Two important classes of stock are common stock and preferred stock. In general, preferred stock has “rights, preferences, and privileges” that common stock does not have. Typically, investors get preferred stock, and founders and employees get common stock (or stock options).
A company is a legal entity formed under corporate law for the purpose of conducting trade. In the United States, specific rules and regulations govern several kinds of business entities. Federal and state law have significant implications on liability and taxation for each kind of company. Notable types of companies include sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and C corporations.
Compensation is any remuneration to a person (including employees, contractors, advisors, founders, and board members) for services performed or rendered to a company. Compensation comes in the forms of cash pay (salary and any bonuses) and any non-cash pay, including benefits like health insurance, family-related protections, perks, and retirement plans.
A corporation is a company that is legally recognized as a single entity. The corporation itself, and not its owners, is obligated to repay debts and accountable under contracts and legal actions (that is, is a “legal person”). Most commonly, the term corporation is used to refer to a stock corporation (or joint-stock company)), which is a corporation where ownership is managed using stock. Non-stock corporations that do not issue stock exist as well, the most common being nonprofit organizations. (A few less common for-profit non-stock corporations also exist.)
A dividend is a distribution of a company’s profit to shareholders, authorized by the board of directors. Established public companies and some private companies pay dividends, but this is rare among startups and companies focused on rapid growth, since they often wish to re-invest their profits into expanding the business, rather than paying that money back to shareholders. Amazon, for example, has never paid dividends.
Sometimes, to help reduce the tax burden on stock options, a company will make it possible for option holders to early exercise (or forward exercise) their options, which means they can exercise even before they vest. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications.
Employment taxes are an additional kind of federal tax beyond ordinary income tax, and consist of Social Security and Medicare taxes that are withheld from a person’s paycheck. Employment taxes are also referred to as payroll taxes as they often show up on employee pay stubs. The Social Security wage withholding rate in 2018 is 6.2% up to the FICA wage base. The Medicare component is 1.45%, and it does not phase out above the FICA wage base.
In the context of compensation and investment, equity broadly refers to any kind of ownership in a company that can be held by individuals (like employees or board members) and by other businesses (like venture capital firms). One common kind of equity is stock, but equity can take other forms, such as stock options or warrants, that give ownership rights. Commonly, equity also comes with certain conditions, such as vesting or repurchase rights. Note the term equity also has several other technical meanings in accounting and real estate.
Equity compensation is the practice of granting equity in exchange for work.
A person who has received a stock option grant is not a shareholder until they exercise their option, which means purchasing some or all of their shares at the strike price. Prior to exercising, an option holder does not have voting rights.
The exercise window (or exercise period) is the period during which a person can buy shares at the strike price. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open.
The ability to buy and sell stock is called liquidity. In startups and many private companies, it is often hard to sell stock until the company is sold or goes public, so there is little or no liquidity for shareholders until those events occur. Thus, sales and IPOs are called both exits and liquidity events. Sales, dissolutions, and bankruptcy are all called liquidations.
The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a company’s stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a company’s stock is determined by the company’s most recent 409A valuation.
Fundraising is the process of seeking capital to build or scale a business. 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.
Fully diluted refers to all of the shares that a company has issued, all of the shares that have been set aside in a stock incentive plan, and all of the shares that could be issued if all convertible securities (such as outstanding warrants) were exercised.
A private company becomes a public company in a process called an initial public offering (IPO). Historically, only private companies with a strong track record of years of growth have considered themselves ready to take this significant step. The IPO has pros and cons that include exchanging a host of high regulatory costs for the benefits of significant capital. After a company “IPOs” or “goes public," investors and the general public can buy stock, and existing shareholders can sell their stock far more easily than when the company was private.
Compensatory stock options come in two flavors, incentive stock options (ISOs) and non-qualifying stock options (NQOs, or NQSOs). Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options (or NSOs), respectively.
Income tax is the money paid by individuals to federal, state, and, in some cases, local governments, and includes taxation of ordinary income and capital gains. Generally, U.S. citizens, residents, and some foreigners must file and pay federal income tax.
Incorporation is the legal process of forming (or incorporating) a new corporation, such as a business or nonprofit. Corporations can be created in any country. In the United States, incorporation is handled by state law, and involves filing articles of incorporation and a variety of other required information with the Secretary of State. (Note that the formation of companies that are not corporations, such as partnerships or LLCs, is not the same as incorporation.)
Issued and outstanding refers to the number of shares actually issued by a company to shareholders, and does not include shares that others may have an option to purchase.
A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). If investors have put millions of dollars into a company and it’s sold, employees’ equity won’t be worth anything if the company is in liquidation overhang and the sale doesn’t exceed that amount.
Preferred stock usually has a liquidation preference (or preference), meaning the preferred stock owners will be paid before the common stock owners when a liquidity event occurs, such as if the company is sold or goes public.
Capital gains are classified as long-term or short-term. Long-term capital gains are the profits an individual makes from selling assets, such as stock, a business, a house, or land, that were held for more than a year. Short-term capital gains are profits from the sale of assets held for less than a year.
Long-term capital gains tax is a tax on the sale of assets held longer than a year. Long-term capital gains tax is often lower than ordinary income tax. Many investors hold assets for longer than a year in order to qualify for the lesser tax burden of long-term capital gains.
When making a job offer, companies will often give a candidate a verbal offer first, to speed things along and facilitate the negotiation, following it with a written offer if it seems like the candidate and the company are close to agreement on the terms of the offer. The written offer takes the form of an 📥documentoffer letter, which is just the summary sent to the candidate, typically with an expiration date and other details and paperwork.
At some point early on, generally before the first employees are hired, a number of shares will be reserved for an employee option pool (or employee pool). The option pool is part of a legal structure called an equity incentive plan. A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes.
Ordinary income tax is the tax on wages or salary income, and short-term investment income. The term short-term capital gains tax may be applied to taxes on assets sold less than a year from purchase, but profits from these sales are taxed as ordinary income. For a lot of people who make most of their money by working, ordinary income tax is the biggest chunk of tax they pay.
Phantom equity is a type of compensation award that references equity, but does not entitle the recipient to actual ownership in a company. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a company’s stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something.
A secondary market (or secondary sale, or private sale) transaction is when private company stock is sold to another private party. This is in contrast to primary market transactions, where companies sell directly to investors. Secondary sales are not routine, but they can sometimes occur, such as when an employee sells to an accredited investor who wants to invest in the company.
Most smaller companies, including all startups, are private companies with owners who control how those companies operate. Unlike a public company, where anyone is able to buy and sell stock, owners of a private company control who is able to buy and sell stock. There may be few or no transactions, or they may not be publicly known.
Public companies are corporations in which any member of the public can own stock. People can buy and sell the stock for cash on public stock exchanges. The value of a company’s shares is the value displayed in the stock market reports, so shareholders know how much their stock is worth.
A restricted stock award is when a company grants someone stock as a form of compensation. The stock awarded has additional conditions on it, including a vesting schedule, so is called restricted stock. Restricted stock awards may also be called simply stock awards or stock grants.
Restricted stock units (RSUs) refer to an agreement by a company to issue an employee shares of stock or the cash value of shares of stock on a future date. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. (They’re called units since they are neither stock nor stock options, but another thing altogether that is contractually linked to the value of stock.)
The date on which an employee receives the shares or cash payment for RSUs is known as the settlement date.
Stock is a legal invention that represents ownership in a company. Shares are portions of stock that allow a company to grant ownership to a variety of people or other companies in flexible ways. Each shareholder (or stockholder), as these owners are called, holds a specific number of shares. Founders, investors, employees, board members, contractors, advisors, and other companies, like law firms, can all be shareholders.
A startup is an emerging company, typically a private company, that aspires to grow quickly in size, revenue, and influence. Once a company is established in the market and successful for a while, it usually stops being called a startup.
Stock ownership is often formalized on stock certificates, which are fancy pieces of paper that prove who owns the stock.
Stock options are contracts that allow individuals to buy a specified number of shares in the company they work for at a fixed price. Stock options are the most common way early-stage companies grant equity.
The strike price (or exercise price) is the fixed price per share at which stock can be purchased, as set in a stock option agreement. The strike price is generally set lower (often much lower) than what people expect will be the future value of the stock, which means selling the stock down the road could be profitable.
The valuation of the company is the present value investors believe the company has. If the company is doing well, growing revenue or showing indications of future revenue (like a growing number of users or traction in a promising market), the company’s valuation will usually be on the rise. That is, the price for an investor to buy one share of the company would be increasing.
Venture capital is a form of financing for early-stage companies that individual investors or investment firms provide in exchange for partial ownership, or equity, in a company. 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. “Venture” refers to the risky nature of investing in early-stage businesses—typically startups—with unproven business models.
Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.
In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.
Warrants are another kind of option to purchase stock, generally used in investment transactions (for example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for vendor financing). They differ from stock options in that they are more abbreviated and stand-alone legal documents, not granted pursuant to a single legal agreement (typically called a “plan”) for all employees.