The Holloway Guide to Equity Compensation

Stock options, RSUs, job offers, and taxes—a detailed reference, including hundreds of resources, explained from the ground up, for both employees and managers.
80 pages and 362 links — last update a month ago

editione2.1.0

Credits
Original Authors
Joshua Levy (Holloway)
Joe Wallin (Carney Bradley Spellman)
Contributions and Review
José Ancer (Egan Nelson LLP)
Michael Brown (Fenwick & West)
George Grellas (Grellas Shah LLP)
Zach Holman
Chris McCann (Greylock Partners)
Leo Polovets (Susa Ventures)
Eric Tyson
Production
Rachel JepsenEditor
Andy SparksEditor
Hope HackettResearch
Dmitriy Kharchenko & Leigh TaylorGraphics
With the help of many other contributors

Introduction9 minutes, 5 links

Equity compensation is the practice of granting partial ownership in a company in exchange for work. In its ideal form, equity compensation aligns the interests of individual employees with the goals of the company they work for, which can yield dramatic results in team building, innovation, and longevity of employment. Each of these contributes to the creation of value—for a company, for its users and customers, and for the individuals who work to make it a success.

The ways equity can be granted as compensation—including restricted stock, stock options, and restricted stock units—are notoriously complex. Equity compensation involves confounding terminology, legal obscurities, and many high-stakes decisions for those who give and receive it.

If you talk to enough employees and hiring managers, you’ll hear stories of how they or their colleagues met with the painful consequences of not learning enough up front. Though many people learn the basic ideas from personal experience or from colleagues or helpful friends who have been through it before, the intricacies of equity compensation are best understood by tax attorneys, corporate lawyers, and other professionals.

Understanding the technicalities of equity compensation does not guarantee that fortune will smile upon you as warmly as it did the early hires of Facebook. But a thorough overview can help you be informed when discussing with professionals for further assistance, make better decisions for your personal situation, and avoid some common and costly mistakes.

Why This Guide?

The first edition of this work, written by the same lead authors as the one you’re reading now, received significant feedback and discussion on Hacker News, on GitHub, and from individual experts. Now, Holloway is pleased to publish this new edition of the Guide. We’ve expanded sections, added resources and visuals, and filled in gaps.

There is a lot of information about equity compensation spread across blogs and articles that focus on specific components of the topic, such as vesting, types of stock options, or equity levels. We believe there is a need for a consolidated and shared resource, written by and for people on different sides of compensation decisions, including employees, hiring managers, founders, and students. Anyone can feel overwhelmed by the complex details and high-stakes personal choices that this topic involves. This reference exists to answer the needs of beginners and the more experienced.

Holloway and our contributors are motivated by a single purpose: To help readers understand important details and their contexts well enough to make better decisions themselves. The Guide aims to be practical (with concrete suggestions and pitfalls to avoid), thoughtful (with context and multiple expert perspectives, including divergent opinion on controversial topics), and concise (it is dense but contains only notable details—still, it’s at least a three-hour read, with links to three hundred sources!).

The Guide does not purport to be either perfect or complete. A reference like this is always in process. That’s why we’re currently testing features to enable the Holloway community to suggest improvements, contribute new sections, and call out anything that needs revision. We welcome (and will gladly credit) your help.

We especially wish to recognize the dozens of people who have helped write, review, edit, and improve it so far—and in the future—and hope you’ll check back often as it improves.

Scope

This Guide currently covers:

Topics not yet covered:

  • Equity compensation programs, such as ESPPs in public companies. (We’d like to see this improve in the future.)

  • Full details on executive equity compensation.

  • Compensation outside the United States.

  • Compensation in companies other than C corporations, including LLCs and S corporations, where equity compensation is approached and practiced in very different ways.

For these situations, see other resources and get professional advice.

Who May Find This Useful

Our aim is to be as helpful to the beginner as to those with more experience. Having talked with employees, CEOs, investors, and lawyers, we can assure you that no matter how much you know about equity compensation, you will likely run into confusion at some point.

If you’re an employee or a candidate for a job, some of these may apply to you:

  • You’ve heard phrases like stock, stock options, strike price, ISOs, RSUs, 83(b) election, 409A valuation, AMT, or early exercise and know they are probably important but are mystified by what some of them really mean or whether they apply to your situation.

  • You’re considering a job offer but don’t know how to navigate or negotiate the equity component of the offer.

  • You’re joining a startup for the first time and are overwhelmed by all the paperwork.

  • You’re quitting, taking a leave of absence, or are being laid off or fired from a company where you have stock or options and are thinking through the decisions and consequences.

  • A company you work for is going through an acquisition, IPO, or shutdown.

  • You have stock in a private company and need cash.

Founders or hiring managers who need to talk about equity compensation with employees or potential hires will also find this Guide useful. As many entrepreneurs and hiring managers will tell you, this topic isn’t easy on that side of the table, either! Negotiating with candidates and fielding questions from candidates and employees requires understanding the same complex technicalities of equity compensation well.

That said, this topic is not simple and we ask that readers be willing to invest time to get through a lot of confusing detail. If you’re in a hurry, or you don’t care to learn the details, this Guide may not be for you. Seek advice.

A Note on Fairness

Much of what you read about equity compensation was written by a single person, from a single vantage point. The authors and editors of this Guide have navigated the territory of equity compensation from the perspective of employees, hiring managers, founders, and lawyers. We do believe that the knowledge here, combined with professional advice, can make a significant difference for both employees and hiring managers.

One of the difficulties for candidates negotiating equity compensation is that they may have less information about what they are worth than the person hiring them. Companies talk to many candidates and often have access to or pay for expensive market-rate compensation data. While some data on typical equity levels have been published online, much of it fails to represent the value of a candidate with their own specific experience in a specific role. However, even without exact data, candidates and hiring managers can develop better mental frameworks to think about offers and negotiations.

On the other hand, challenges are not limited to those of employees. Founders and hiring managers also often struggle with talking through the web of technicalities with potential hires, and can make equally poor decisions when making offers. Either over-compensating or under-compensating employees can have unfortunate consequences.

This is a preview. Purchase for full, lifetime access plus PDF download.

Roadmap6 minutes, 2 links

The Holloway Reader

The Holloway Reader you’re using now is designed to help you find and navigate the material you need. Use the search box. It will reveal definitions, section-by-section results, and content contained in the hundreds of resources we’ve linked to throughout the Guide. Think of it as a mini library of the best content on equity compensation. We also provide mouseover (or short tap on mobile) for definitions of terms, related section suggestions, and external links while you read.

How This Guide Is Organized

This Guide contains a lot of material. And it’s dense. Some readers may wish to read front to back, but you can also search or navigate directly to parts that are of interest to you, referring back to foundational topics as needed.

Equity compensation lies at the intersection of corporate law, taxation, and employee compensation, and so requires some basic understanding of all three. You might think compensation and taxation are separate topics, but they are so intertwined it would be misleading to explain one without the other. We cover material in logical order, so that if you do read the earlier sections first, later sections on the interactions of tax and compensation will be clearer.

We start with Equity Compensation Basics: What compensation and equity are, and why equity is used as compensation.

This is a preview. Purchase for full, lifetime access plus PDF download.

When to Turn Elsewhere

CEOs, CFOs, COOs, or anyone who runs a company or team of significant size should be sure to talk to an equity compensation consultant or a specialist at a law firm to learn about equity compensation plans.

Founders looking for an introduction to the legalities of running a company may wish to check out Legal Concepts for Founders, from Clerky, in addition to talking to a lawyer. Founders should also lean on their investors for advice, as they may have additional experience.

Executive compensation at large or public companies is an even more nuanced topic, on both sides of the table. Hire an experienced lawyer or compensation consultant. There are extensive legal resources available on executive compensation.

Seeking Professional Advice

This Guide does not replace professional advice.

Please read the full disclaimer and seek professional advice from a lawyer, tax professional, or other compensation expert before making significant decisions.

Does that make reading through these details a waste of time? Not at all. Important decisions rarely should or can be blindly delegated. This Guide complements but does not replace the advice you get from professionals. Working with the support of a professional can help you make better decisions when you have an understanding of the topic yourself and know what questions to ask.

Equity Compensation Basics7 minutes, 25 links

History and Significance

Companies ranging from two-person startups to the Fortune 500 have found that granting partial ownership in a company is among the best methods to attract and retain exceptional talent. In the United States, partial ownership through stock options has been a key part of pay for executives and other employees since the 1950s.* As recently as 2014, 7.2% of all private sector employees (8.5 million people) and 13.1% of all employees of companies with stock held stock options, according to the National Center for Employee Ownership.* Many believe employee ownership has paidfostered innovations in technology, especially in Silicon Valley, from the early days of Hewlett-Packard to recent examples like Facebook. Stock options helped the first 3,000 employees of Facebook enjoy roughly $23 billion at the time the company went public.*

controversy Some controversy surrounds the use of equity compensation for high-paid executives. Public companies offer executives equity compensation in no small part because of a tax loophole. In 1993, President Bill Clinton attempted to limit executive pay with a new section* of the Internal Revenue Code. Unfortunately, the legislation backfired; a loophole made performance-based pay—including stock options—fully tax deductible, thereby creating a dramatic incentive to pay executives through stock options.* From 1970–79, the average compensation for a CEO of one of the 50 largest firms in the United States was $1.2M, of which 11.2% was from stock options. By 2000–05, the same numbers had risen to $9.2M and 37%, respectively.*

Growth and Risk

Generally, equity compensation is closely linked to the growth of a company. Cash-poor startups persuade early employees to take pay cuts and join their team by offering meaningful ownerships stakes, catering to hopes that the company will one day grow large enough to go public or be sold for an ample sum. More mature but still fast-growing companies find offering compensation linked to ownership is more attractive than high cash compensation to many candidates.

With the hope for growth, however, also comes risk. Large, fast-growing companies often hit hard times. And startups routinely fail or yield no returns for investors or workers. According to a report by Cambridge Associates and Fortune Magazine, between 1990 and 2010, about 60% of venture capital-backed companies returned less than the original investment, leaving employees with the painful realization that their startup was not, in fact, the next Google. Of the remaining 40%, just a select few go on to make a many of their employees wealthy, as has been the case with iconic high-growth companies, like Starbucks,* UPS,* Amazon,* Google,* or Facebook.*

Compensation and Equity

Definition 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.

Company strategies for compensation are far from simple. Beth Scheer, head of talent at the venture fund Homebrew, offers a thoughtful overview of compensation in startups.

Another term you may encounter is total rewards, which refers to a model of attracting and retaining employees using a combination of salary and incentive compensation (like equity), benefits, recognition for contribution or commitment (like awards and bonuses), training programs, and initiatives to improve the work environment.

This is a preview. Purchase for full, lifetime access plus PDF download.

The Goals of Equity Compensation

The purpose of equity compensation is threefold:

  • Attract and retain talent. When a company already has or can be predicted to have significant financial success, talented people are incentivized to work for the company by the prospect of their equity being worth a lot of money in the future. The actual probability of life-changing lucre may be low (or at least, lower than you may think if your entire knowledge of startups is watching “The Social Network”). But even a small chance at winning big can be worth the risk to many people, and to some the risk itself can be exciting.

  • Align incentives. Even companies that can afford to pay lots of cash may prefer to give employees equity, so that employees work to increase the future value of the company. In this way, equity aligns individuals’ incentives with the interests of the company. At its best, this philosophy fosters an environment of teamwork and a “rising tides lift all boats” mentality. It also encourages everyone involved to think long-term, which is key for company success. As we’ll discuss later, the amount of equity you’re offered usually reflects both your contribution to the company and your commitment to the company in the future.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Fundamentals of Stock Corporations13 minutes, 35 links

In this section, we describe the basics of how stock and shares are used.

Those familiar with stock, stock corporations, public companies, and private companies can jump ahead to how those companies grant equity.

Kinds of Companies

Definition A corporation is a company that is legally recognized as an entity separate from its owners. 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.)

In practice, people often use the word company to mean corporation.

This is a preview. Purchase for full, lifetime access plus PDF download.

Stock and Shares

Definition Stock ownership is often formalized on stock certificates, which are fancy pieces of paper that prove who owns the stock.

Sometimes you have stock but don’t have the physical certificate, as it may be held for you at a law office.

This is a preview. Purchase for full, lifetime access plus PDF download.

Public and Private Companies

Definition 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.

Definition 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.

···

Governance

Definition 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.

Boards of directors range from 3 to 31 members, with an average size of 9; for private companies the typical board size is typically between 3 and 7 directors.* Boards are almost always an odd number in order to avoid tie votes. It’s worth noting that the state of California requires public companies to have at least one woman on their boards.*

Key decisions of the board are made formally in board meetings or in writing (called written consent).* Equity grants have to be by the board of directors.*

This is a preview. Purchase for full, lifetime access plus PDF download.

IPOs

Definition 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.

Companies take years to IPO after being formed. The median time between a company’s founding and its IPO has been increasing. According to a Harvard report, companies that went public in 2016 took 7.7 years to do so, compared to 3.1 years for companies that went public in 1996.*

···

Sales and Liquidity

danger With private companies, it can be very hard to know the value of equity. Because the value of private company stock is not determined by regular trades on public markets, shareholders can only make educated guesses about the likely future value, at a time when they will be able to sell stock.

After all, private company stock is simply a legal agreement that entitles you to something of highly uncertain value, and could well be worthless in the future, or highly valuable, depending on the fate of the company.

confusion We’ll discuss the notion of a company officially assigning a fair market value later, but even if a company gives you a value for your stock for tax and accounting purposes, it doesn’t mean you can expect to sell it for that value!

This is a preview. Purchase for full, lifetime access plus PDF download.

Startups and Growth16 minutes, 43 links

If you’re considering working for a startup, what we cover next on how these early-stage companies raise money and grow is helpful in understanding what your equity may be worth.

If you’re only concerned with large and established companies, you can skip ahead to how equity is granted.

Startups

Definition 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.

confusion Unlike the terminology around corporations, which has legal significance, the term startup is informal, and not everyone uses it consistently.

Startups are not the same as small businesses. 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. Distinguished startup investor Paul Graham has emphasized that it’s best to think of a startup as any early stage company intending to grow quickly.

This is a preview. Purchase for full, lifetime access plus PDF download.

Fundraising, Growth, and Dilution

Many large and successful companies began as startups. In general, startups rely on investors to help fund rapid growth.

Definition 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.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Dilution Illustrations

These visualizations illustrate how ownership of a venture-backed company evolves as funding is raised. One scenario imagines changes to ownership in a well-performing startup, and the other is loosely based on a careful analysis of Zipcar,* a ride-sharing company that experienced substantial dilution before eventually going public and being acquired. These diagrams simplify complexities such as the ones discussed in that analysis, but they give a sense of how ownership can be diluted.

Loading chart…

Stages of a Startup

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:

  • Bootstrapped (little funding or self-funded): Founders are figuring out what to build, or they’re starting to build with their own time and resources.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

The Option Pool

Definition 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.

Once the pool is established, the company’s board of directors grants stock from the pool to employees as they join the company.

technical Well-advised companies will reserve in the option pool only what they expect to use over the next 12 months or so; otherwise, given how equity grants are usually promised, they may be over-granting equity. 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. It’s worth employees (and founders) understanding that a small pool can be a good thing in that it reflects the company preserving ownership in negotiations with investors. The size of the pool may be increased later.

Counting Shares

There are some key subtleties you’re likely to come across in the way outstanding shares are counted:

Definition 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.

confusion For example, a corporation might have 100 million authorized shares, but will only have issued 10 million shares. 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Classes of Stock

Definition 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.)

Definition 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).

The exact number of classes of stock and the differences between them can vary company to company, and, in a startup, these can vary at each round of funding.

This is a preview. Purchase for full, lifetime access plus PDF download.

How Equity Is Granted23 minutes, 35 links

In this section we’ll lay out how equity is granted in practice, including the differences, benefits, and drawbacks of common types of equity compensation, including restricted stock awards, stock options, and restricted stock units (RSUs). We’ll go over a few less common types as well. While the intent of each kind of equity grant is similar, they differ in many ways, particularly around how they are taxed.

Except in rare cases where it may be negotiable, the type of equity you get is up to the company you work for. In general, larger companies grant RSUs, and startups grant stock options, and occasionally executives and very early employees get restricted stock awards.

···

Restricted Stock Awards

At face value, the most direct approach to equity compensation would be for the company to award stock to an employee in exchange for work. In practice, it turns out a company will only want to do this with restrictions on how and when the stock is fully owned.

Even so, this is actually one of the least common ways to get equity. We mention it first because it is the simplest form of equity compensation, useful for comparison as things get more complex.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Stock Options

Definition 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.

Definition 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.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Vesting and Cliffs

Definition 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.

Definition 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.

Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.

This is a preview. Purchase for full, lifetime access plus PDF download.

How Options Expire

Definition 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.

danger Expiration after termination. Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point. As we’ll get into later, you need to understand the costs, taxes, and tax liabilities of exercise and to plan ahead. In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter.

important Longer exercise windows. Recently (since around 2015) a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Companies with extended exercise windows include Amplitude,* Clef,* Coinbase,* Pinterest,* and Quora.* However, the 90-day exercise window remains the norm.

This is a preview. Purchase for full, lifetime access plus PDF download.

Kinds of Stock Options

Definition 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.

In this Guide, we refer to ISOs and NSOs.

TypeAlso called
StatutoryIncentive stock option, ISO
Non-statutoryNon-qualifying stock option, NQO, NQSO, NSO
This is a preview. Purchase for full, lifetime access plus PDF download.

Early Exercise

Definition 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.

caution However, the company has the right to repurchase the unvested shares, at the price paid or at the fair market value of the shares (whichever is lower), if a person quits working for the company. The company will typically repurchase the unvested shares should the person leave the company before the stock they’ve purchased vests.

Restricted Stock Units

While stock options are the most common form of equity compensation in smaller private companies, RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.

Definition 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.)

This is a preview. Purchase for full, lifetime access plus PDF download.

Less Common Types of Equity

While most employee equity compensation takes the form of stock, stock options, or RSUs, a complete tour of equity compensation must mention a few less common forms.

Definition 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.

Two examples of phantom equity are phantom stock and stock appreciation rights:

This is a preview. Purchase for full, lifetime access plus PDF download.

Tax Basics11 minutes, 46 links

The awarding of equity compensation can give rise to multiple types of taxes for the recipient, including federal and state income taxes and employment taxes. Skip ahead to understand how taxes on equity work, but if you have time, this section gives a technical summary of tax fundamentals, just in case you (like most people!) never really figured out all the numbers on your pay stub.

Given the complexity, most taxpayers aren’t aware of how their tax is calculated. It does take up thousands of pages* of the federal tax code and involves the intricate diversity of state tax law as well.*

You don’t need to know every detail, and can rely on software and professionals to determine the tax you owe, but we do suggest understanding the different kinds of taxes, how large they can be, and how each is “triggered” by different events.

This is a preview. Purchase for full, lifetime access plus PDF download.

Kinds of Income

Definition 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.

One key difference between ordinary income and capital gains is that when capital gains taxes are calculated, consideration is given not just to the sale price of the asset but to the total gain or loss the investment incurred, each outcome having significantly different tax consequences.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Federal Taxes

Definition 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.

important In general, federal tax applies to many kinds of income. If you’re an employee at a startup, you need to consider four kinds of federal tax, each of which is computed differently.

confusion When it comes to equity compensation, it’s possible that you’ll have to worry about all of these, depending on your situation. That’s why we have a lot to cover here:

This is a preview. Purchase for full, lifetime access plus PDF download.

State Taxes

State tax rates and rules vary significantly. Since federal rates are much higher than state rates, you usually think of federal tax planning first. But you should also know a bit about tax rates in your state.

State long-term capital gains rates range widely. California has the highest, at 13.3%; several states have none.*

important For this reason, some people even consider moving to another state if they are likely to have a windfall gain, like selling a lot of stock after an IPO.

This is a preview. Purchase for full, lifetime access plus PDF download.

Taxes on Equity Compensation19 minutes, 29 links

Equity and taxes interact in complicated ways, and the tax consequences for an employee receiving restricted stock, stock options, or RSUs are dramatically different. This section will cover these messy details and help you make decisions that reduce the tax burden of your equity compensation.

83(b) Elections

This section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.

  • Generally, restricted stock is taxed as ordinary income when it vests.

  • If the stock is in a startup with low value, this may not result in high tax. If it’s been years since the stock was first granted and the company is now worth a lot, the taxes owed could be quite significant.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

409A Valuations

When a person’s stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stock—and thus any tax owed on it—is not obvious.

Definition 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.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Taxes on ISOs and NSOs

Typically, early to mid-stage companies grant stock options, which may be ISOs or NSOs.

  • dangerWhen you get stock options and are considering if and when to exercise, you need to think about the taxes and when you owe them. In principle, you need to think about taxes you may incur at three points in time:

    • at time of grant

    • at time of exercise

    • at time of sale

  • These events trigger ordinary tax (high), long-term capital gains (lower), or AMT (possibly high) taxes in different ways for NSOs and ISOs.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

The AMT Trap

When it comes to taxes and equity compensation, one scenario is so dangerous we give it its own section.

danger If you have received an ISO, exercising it may unexpectedly trigger a big AMT bill—even before you actually make any money on a sale! If there is a large spread between the strike price and the 409A valuation, you are potentially on the hook for an enormous tax bill, even if you can’t sell the stock. This has pushed people into bankruptcy. It also caused Congress to grant a one-time forgiveness, the odds of which happening again are very low.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Stock Awards vs. ISOs vs. NSOs

Because the differences are so nuanced, what follows is a summary of the taxes on restricted stock awards, ISOs, and NSOs, from an employee’s point of view.

Taxes on RSUs

If you are awarded RSUs, each unit represents one share of stock that you will be given when the units vest.

  • Here’s the tax summary for RSUs:

  • caution When you receive your shares, you are taxed on their value at that time.* If you are an employee, this means you may have to write a check to the company to cover your income and employment tax withholding. Often, for U.S. employees, companies will withhold the tax in the form of shares such that no action is required by the employee at vesting time.*

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Tax Comparison Table

Table: Comparing Taxes on Types of Equity Compensation

This table is a summary of the differences in taxation on types of equity compensation.

Restricted stock awardsISOsNSOsRSUs
Tax at grantIf 83(b) election filed, ordinary tax on FMV. None otherwise.No tax if granted at FMV.No tax if granted at FMV.No tax.
Tax at vestingNone if 83(b) election filed. Ordinary tax on FMV of vested portion otherwise.No tax if granted at FMV.No tax if granted at FMV.Ordinary tax on current share value.
Tax at exerciseAMT tax event on the bargain element. No ordinary or capital gains or employment tax.Ordinary tax on the bargain element. Income and employment tax.
Tax at saleLong-term capital gains tax on gain if held for 1 year past when taken into income. Ordinary tax otherwise (including immediate sale).Long-term capital gains if held for 1 year past exercise and 2 years past grant date. Ordinary tax otherwise (including immediate sale).Long-term capital gains if held for 1 year past exercise. Ordinary tax otherwise (including immediate sale).Long-term capital gains tax on gain if held for 1 year past vesting. Ordinary tax otherwise (including immediate sale).

Tax Dangers

Because they are so important, we list some costly errors to watch out for when it comes to taxes on equity compensation:

  • danger If you are going to file an 83(b) election, it must be within 30 days of stock grant or option exercise. Often, law firms will take a while to send you papers, so you might only have a week or two. If you miss this window, it could potentially have giant tax consequences, and is essentially an irrevocable mistake—it’s one deadline the IRS won’t extend. When you file, get documentation from the post office as well as a delivery confirmation, and include a self-addressed, stamped envelope for the IRS to send you a return receipt. (Some people are so concerned about this they even ask a friend to go with them to the post office as a witness!)

  • danger Watch out for the AMT trap we’ve already discussed.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Plans and Scenarios12 minutes, 20 links

Evaluating Equity Compensation

Once you understand the types of equity and their tax implications, you have many of the tools you need to evaluate an offer that includes equity compensation, or to evaluate equity you currently have in a company.

In summary, you have to determine or make educated guesses about several things:

  • Equity value. This can be estimated by the value the company may have in the future, and the number of shares you may own.

    • Percentage ownership. As we’ve mentioned, knowing how many shares of stock or stock options you have is meaningless unless you know the number of outstanding shares. What matters is the percentage ownership of the company the shares represent, including the details of how the total is counted.

    • Risk. It is critical to understand risk in the business and dilution to ascertain the possible future value of equity. This article from Leo Polovets provides some additional thoughts.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

What Is Private Stock Worth?

We now turn to the question of determining the value of private company stock. We’ve seen how stock in private companies often can’t be sold, so its value is difficult to estimate.

The value of equity you cannot yet sell is a reflection of three major concerns:

  1. How well the company is doing now—that is, how profitable it is, or how many customers it is attracting.

  2. This is a preview. Purchase for full, lifetime access plus PDF download.

Can You Sell Private Stock?

Ultimately, the value of your equity depends on whether and when you are able to convert it into stock that you sell for cash. With public companies, the answer is relatively easy to estimate—as long as there are no restrictions on your ability to sell, you know the current market value of the stock you own or might own. What about private companies?

A liquidity event is usually what makes it possible for shareholders in a private company to sell their stock. However, individuals may sometimes be able to gain liquidity while a company is still private.

Definition 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.

This is a preview. Purchase for full, lifetime access plus PDF download.

Stock Option Scenarios

The key decisions around stock options are when to exercise and, if you can, when to sell. Here we lay out some common scenarios that might apply to you. Considering these scenarios and their outcomes can help you evaluate your position and decide what you should do.

  • Exercise and hold. You can write the company a check and pay any taxes on the spread. You are then a stockholder, with a stock certificate that may have value in the future. As discussed, you may exercise:

    • Early, even immediately upon grant.

    • Before vesting (if early exercise is available to you).

    • Sometime after vesting.

    • After leaving the company, as long as the exercise window is open.

      • caution Recall that the window is likely to close soon after you leave a company, often 90 days after termination.
  • Wait until acquisition. If the company is acquired for a large multiple of the exercise price, you may then use your options to buy valuable stock. However, as discussed, your shares could be worth next to nothing unless the sale price exceeds the liquidation overhang.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Summary of Dangers

Because of their importance, we’ll wind up with a recap of some of the key dangers we’ve discussed when thinking about equity compensation:

  • danger When it comes to equity compensation, details matter! You need to understand the type of stock grant or stock option in detail, as well as what it means for your taxes, to know what your equity is worth.

  • danger Because details are so important, professional advice from a tax advisor or lawyer familiar with equity compensation (or both) is often a good idea. Avoid doing everything yourself, but also avoid blindly trusting advisors without having them explain the details to you in a way you understand.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Offers and Negotiations27 minutes, 53 links

When a company offers any form of equity as part of its compensation package, there is a whole new set of factors for a prospective employee to consider. This chapter will help you prepare for negotiating a job offer that includes equity, covering negotiation tips and expectations, and specific reminders on what you can ask and what is negotiable when it comes to equity.

Why Negotiation Matters

Before accepting any job offer, you’ll want to negotiate firmly and fairly. You’re planning to devote a lot of your time and sanity to any full-time role; help yourself make sure that this is paidwhat you want.

confusion It’s perfectly natural to be anxious about negotiations, whether you’re going through this process for the first time or the tenth. There is a lot at stake, and it can be uncomfortable and stressful to ask for things you need or want. Many people think negotiating could get the job offer revoked, so they’ll accept their offer with little or no discussion. But remember that negotiations are the first experience you’ll have of working with your new team. If you’re nervous, it can help to remind yourself why it’s important to have these conversations:

  • Negotiations ask you to focus on what you actually want. What is important to you—personal growth, career growth, impact, recognition, cash, ownership, teamwork? Not being clear with yourself on what your priorities really are is a recipe for dissatisfaction later.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Equal Treatment

important Companies can and should work hard to ensure that all candidates are given equal treatment in the hiring process, but inequalities persist.* Workplace disparities in pay and opportunity span race and gender,* with research focusing on inequality in the U.S. workplace,* executive leadership and its well-documented lack of diversity,** and the technology industry.* Gender bias in negotiation itself is also an issue; many women have been made to feel that they shouldn’t ask for what they deserve.*

More effort is needed to end biases and close the wage gap. All candidates should take the time to understand their worth and the specific value they can add to a company, so that they are fully prepared to negotiate for a better offer.

General Expectations

  • Many companies will give some leeway during negotiations, letting you indicate whether you prefer higher salary or higher equity.

  • Candidates with competing offers almost always have more leverage and get better offers.*

  • Salaries at startups are often a bit below what you’d get at an established company, since early on, cash is at a premium. For very early stage startups, risk is higher, offers can be more highly variable, and variation among companies will be greater, particularly when it comes to equity.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Offers

Definition 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.

Although companies often want you to sign right away to save time and effort, if you’re doing it thoughtfully you’ll also be talking to the company (typically with a hiring manager, your future manager, or a recruiter, or some combination) multiple times before signing. This helps you negotiate details and gives you a chance to get to know the people you could be working with, the company, and the role, so that you can make the best decision for your personal situation.

When you are ready to accept the terms of the offer letter, you can go ahead and sign.

This is a preview. Purchase for full, lifetime access plus PDF download.

Offers From Startups

Because startups are so much smaller than many established companies, and because they may grow quickly, there are additional considerations worth taking into account when negotiating a job offer from a startup:

  • Cash versus equity. If your risk tolerance is reasonably high, you might ask for an offer with more equity and less cash. If a company begins to do well, it’ll likely “level up” lower salaries (bringing them closer to market average) even if you got more equity up front. On the other hand, if you ask for more cash and less equity, it’s unlikely you’ll be able to negotiate to get more equity later on, since equity is increasingly scarce over time (at least in a successful company!). Entrepreneur and venture capitalist Mark Suster stresses the need to level up by scaling pay and spending, focusing appropriately at each funding stage. In the very early days of a startup, it’s not uncommon for employees to have higher salaries than the company’s founders.*

  • ···
    This is a preview. Purchase for full, lifetime access plus PDF download.

Questions Candidates Can Ask

important It’s important to ask questions when you get an offer that includes any kind of equity. In addition to helping you learn the facts about the equity offer, the process of discussing these details can help you get a sense of the company’s transparency and responsiveness. Here are a few questions you should consider asking, especially if you’re evaluating an offer from a startup or another private company:

  • Percentage ownership.

    • What percentage of the company do the shares represent?

    • What set of shares was used to compute that percentage? Is it outstanding shares or fully diluted?

    • What convertible securities are outstanding (convertible notes, SAFEs, or warrants), and how much dilution can I expect from their conversion?

  • Valuation.

    • What did the last round value the company at? (That is, what is the preferred share price times the total outstanding shares?)

    • What is the most recent 409A valuation? When was it done, and will it be done again soon?

    • What exit valuation will need to be achieved before common stock has positive value (that is, what are the liquidation overhangs)?

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Typical Employee Equity Levels

···

Compensation data is highly situational. What an employee receives in equity, cash, and benefits depends on the role they’re filling, the sector they work in, where they and the company are located, and the possible value that specific individual may bring to the company.

Any compensation data out there is hard to come by. Companies often pay for this data from vendors, but it’s usually not available to candidates.

This is a preview. Purchase for full, lifetime access plus PDF download.

Negotiation Tips

···

When negotiating a job offer, companies will always ask you what you want for compensation, and you should always be cautious about answering.

If you name the lowest number you’ll accept, you can be pretty sure the company’s not going to exceed it, at least not by much.

This is a preview. Purchase for full, lifetime access plus PDF download.

Offer and Negotiation Dangers

To wind up our discussion of offers and negotiations, here are some key dangers and mistakes to watch out for:

  • danger Do not accept an offer of stock or shares without also asking for the exact number of total shares (or, equivalently, the exact percentage of the company those shares represent). It’s quite common for some companies to give offers of stock or options and tell you only the number of shares. Without the percentage, the number of shares is meaningless. Not telling you is a deeply unfair practice. A company that refuses to tell you even when you’re ready to sign an offer is likely giving you a very poor deal.

  • caution If you’re looking at an offer, work out whether you can and should early exercise, and what the cost to exercise and tax will be, before accepting the offer.

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Documents and Agreements8 links

This section covers a few kinds of documents you’re likely to see as you negotiate a job offer and sign on to a company. It’s not exhaustive, as titles and details vary.

  • When you are considering your offer, make sure you have all of the documents you need from the company:

    • Your documentoffer letter, which will detail salary, benefits, and equity compensation.

    • An documentEmployee Innovations Agreement, Proprietary Information and Inventions Assignment Agreement, or similar, concerning intellectual property.

  • If you have equity compensation, at some point—possibly weeks or months after you’ve joined—you should get a Summary of Stock Grant, Notice of Stock Option Grant, or similar document, detailing your grant of stock or options, along with all details such as number of shares, type of options, grant date, vesting commencement date, and vesting schedule. It will come with several other documents, which may be exhibits to that agreement:

  • This is a preview. Purchase for full, lifetime access plus PDF download.

Further Reading5 minutes, 49 links

The resources here are a small subset of the full set of resources cited in the Guide to Equity Compensation, selected for their breadth, notability, or depth on specific issues.

General Resources

Considerations for Founders

Considerations for Candidates and Employees

Types of Equity Compensation

Taxes

Vesting and Expiration of Stock Options

Negotiation

Forms and Tools

Disclaimer

This Guide and all associated comments and discussion do not constitute legal or tax advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. The author(s) expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this Guide or associated content.

Credits11 links

Many thanks to all contributors to this Guide and those who have given detailed feedback, including Julia Evans, George Grellas, Chris McCann, Leo Polovets, Srinath Sridhar, Andy Sparks, and David Weekly, and to the many commentators on Hacker News. The original authors are Joshua Levy and Joe Wallin.

Please Help!

This Guide is a living publication, imperfect but improving. If you have an idea or contribution that might improve this Guide, please add suggestions in the margins. We gladly credit all contributors.

License1 links

?L