How do shares work in a startup? In simple terms, equity is owning a share of a company. Shares are typically issued in a series and categorized as either common or preferred.

One of the definitive characteristics of working for a startup is gaining a piece of the company through equity compensation. Not only does it carry monetary value, but it also offers a feeling of ownership to its employees. It's important for employees to understand that participating in an equity plan does have risks associated with it. For example, when Good Technology was sold to BlackBerry for less than half of its valuation, employees of the company lost money on their stock options.

Stock Options

One growing trend is the issuance of restricted stock units (RSUs), which are usually granted directly to the employee without any required purchase. However, they carry distinct tax implications.

Employee stock options have a couple characteristics that are meant to keep talent from leaving the company too early:

  • Shares associated with a startup company are different than those of a public company, which are fully vested. Initially, unvested shares are not owned 100 percent by you, but vest (becomes yours) over time, alongside the company's loss of the right to repurchase shares from you. Equity vestment occurs over time according to a vesting schedule. If you are given 100 shares at four-year vesting, you'll receive 20 shares at the end of each of the four years until it becomes fully vested. A four-year vesting period is most common.
  • In addition to vesting, you'll likely be working with a cliff, which is the probationary time required before vesting officially begins. Usually, a cliff period is between six months and a year. Your shares will not vest before you reach the cliff, but once you do, all of your associated shares will vest. In other words, if you have a one-year cliff, you will not vest equity during the first year of hire, but once you reach the one-year mark, you'll have vested one year's worth of equity. After that, your company shares will continue vesting each month.

Company employees are usually offered common stock, which is different than the preferred stock offered to investors. Employee equity is distributed from an option pool, which is a set amount of equity allowed for employee distribution. Preferred stock usually includes rights such as board seats, voting rights, or liquidation preference.

The IRS recognizes standard stock options as incentive stock options (ISOs). ISOs do not create a legally taxable event until they are sold. No income is reported until you sell it, which then incurs tax as a long-term capital gain. If you're thinking of selling, keep these tax implications in mind.

Equity Valuation

It can be difficult to determine the actual dollar value of your equity. Generally, there is a range of value that depends on the exit options the business is considering. Determining equity valuation is further complicated by human resources and legal concerns that may occur during discussions of equity valuation between company founders and their employees. Legal professionals often advise company founders to be very cautious about having that discussion.

The value of equity may be diluted when the total amount is divided among many people. A company founder begins by owning all shares representing complete ownership of the company. As time passes, other parties obtain pieces of equity as compensation for work (e.g. employee stock options), funding (e.g. seed, angel, and venture investors), or professional services (e.g. directors, attorneys).

As equity is calculated as a total percentage of ownership, it will always total exactly 100 percent. This means that anytime a person gains another piece of equity, by default it dilutes the percentage of all other equity holders. To avoid equity dilution to its current equity holders, a company must not hire additional employees who receive stock options or accept additional money from investors.

The shares that have been given or sold to people within the company (e.g. subsequent investors) are called issued and outstanding shares. Without including stock options, the number of shares issued amounts to 100 percent of the company's equity.

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