Guest Post: Matt Howland is the GM of Private Markets at Carta. Matt is proud to be serving the 500 Startups network as a mentor. Founders can find Matt on Union for training and consultations.
Understanding and managing equity can be confusing, but as a founder, it’s essential to take the time to learn equity basics. Getting equity right ensures:
- Your employees are motivated to do their best work and stick around
- You get the best possible investors and term sheets
- You as a founder retain a meaningful portion of what you’re building
- You avoid legal trouble
Here are some answers to the most commonly-asked questions about equity that we receive at Carta:
What is a cap table?
A capitalization table (or “cap table”) provides a record of who owns which pieces of a company. It tracks stakeholders’ percentage ownership, equity dilution, and the preferred or common stock in each round of investment.
As companies scale, their cap tables grow and become more complex. As soon as founders are ready to distribute stock among co-founders, early investors, and employees, it’s important to make sure the cap table is accurate and up-to-date. A clean cap table will help you set your company on the right track, avoid a broken cap table, and reduce legal fees.
All equity—including employee option grants, investor’s stock, and founder’s skates—is tracked in the cap table.
What are the types of startup equity?
There are two types of startup equity—preferred stock and common stock.
Preferred stock is mainly issued to investors, who pay a higher price per share of ownership. In return, these shareholders have a greater claim to a company’s assets and are paid out first in a liquidity event.
Common stock is the most basic form of stock, and is mainly issued to founders and employees. Equity compensation for startup employees is usually issued from a pool of Common Stock.
The fair market value of common stock is typically determined through a 409A valuation.
What’s a 409A valuation?
A 409A valuation is the process that answers the question “how much is this company worth?” It sets the fair market value (FMV) of a company’s stock and this price is used as the strike price for option grants.
Section 409A was added to the Internal Revenue Code partly in response to the Enron scandal. At Enron, executives sped up payments associated with equity before the company went under to maximize their payouts. 409A created a regulatory framework to level the playing field and help avoid future Enrons.
Now, companies need a 409A every year or every time they have a material event that could impact the value of the company, like raising a round of financing. Companies need a 409A before issuing option grants.
What are option grants?
Stock options give employees the right to purchase shares in the company after they meet certain milestones. Most often these milestones are time based with shares vesting after a certain period of time. More on vesting in a minute. When employees exercise their options, they become stockholders.
Every stock option has an exercise price—or strike price—at which a share can be purchased.
What is strike price?
The strike price for options is generally equal to the fair market value of common stock the day the option was granted. IRS code 409A requires the exercise price to be FMV or higher. Startup equity for first employees typically has a very low strike price.
Options can be valuable because they allow employees to purchase shares at a fixed price during the term of their option. If a company grants an employee a stock option at $1/share and the company’s stock price increases to $2/share, the employee has the right to purchase however many options they were granted at $1/share.
On the other hand, if the company grants an employee a stock option at $1/share and the stock price drops to $0.50/share before the employee exercises their option, they do not lose any money.
Are there different kinds of stock options?
There are two types of employee stock options in the US:
Incentive Stock Options (ISOs) are the most common type of security issued to startup employees. ISO holders do not have to pay taxes when the option is issued or exercised (except for the Alternative Minimum Tax, if applicable). Vested ISOs are typically exercisable as long as the employee still works for the company or within three months of leaving.
Non-qualified Stock Options (NSOs) are simply defined as “not an ISO” in the US and therefore don’t have ISO’s tax benefits. These option grants are typically issued to outside contractors, consultants, and international employees, or to employees in US states that do not recognize the tax benefits of ISOs (hello, Pennsylvania!)
What are other popular equity awards?
A stock option gives an employee the right to buy a set number of shares at a fixed price but they don’t own the shares until they exercise the option. A Restricted Stock Award (RSA) grants the shares outright with some restrictions.
The stock is restricted because employees still need to earn them. Like options, the most common RSA restriction is time-based with a vesting schedule.
RSAs are typically issued to early employees before the first round of equity financing, when the FMV of the Common stock is very low. Founders will often issue RSAs early on when they have little cash to pay employees. RSAs provide an individual the right to purchase shares at FMV, at a discount, or at no cost depending on the type of work or services they’ve already done for the company on the grant date. Generally we see no-cost RSAs in our client cap tables.
Restricted Stock Units (RSUs) are different. Unlike RSAs, where employees own shares on the grant date with some restrictions, an employee does not own RSU shares on the grant date. This means the RSU holder does not have voting rights nor do they typically receive dividends or any other benefits of share ownership.
An RSU, like a stock option, typically vests over time. When shares vest, the holder of the RSU receives shares at the then-current FMV and owns the stock outright. The holder does not pay any purchase price to buy the shares.
Vesting over time is the most common RSU restriction, but the date an employee receives their shares could also be linked to another restriction, like a liquidation event, performance conditions, or a specific milestone.
What does a typical vesting period look like?
A vesting period is a length of time or a milestone that must be met before employees can gain ownership of their options.
A typical option lifecycle and vesting period looks like this:
- Grant – the date when a company awards an option grant to an employee
- Cliff – typically shares don’t begin to vest for a certain amount of time after the employee joins, usually one year. After the employee hits their cliff, their shares will begin to vest monthly or quarterly
- Fully Vested – all options granted are earned and exercisable
- Exercise – an employee exercises all or part of their options
- Sale – an employee sells all or part of their equity stake
If options are not exercised, the options are forfeited and added back to the option pool.
What is an option pool? How big should an option pool be?
An option pool is the amount of a company’s common stock that is reserved for future grants. Employee equity plans distribute options from the option pool. Investors and the board will renegotiate the size of a company’s option pool with each round of capital. The average option pool is 10-20% of total equity.
The size of each company’s option pool should depend on their hiring plan until the next round of funding. A company planning to hire several C-level executives soon after closing a round will need significantly more options than a company not hiring any executives. The option pool is important because it guarantees a company can easily issue new equity grants as they scale and hire more people.
We hope you have a better understanding of equity basics. We’re always here to help at Carta, whether you need to clean up your cap table, prepare to issue employee equity with a 409A valuation, or want equity management advice.
Carta is thrilled to be working in partnership with 500 Startups. Together we look forward to helping founders map ownership and manage equity as they scale. Learn more at Carta.com
Interested in learning more about partnerships with 500 Startups? Contact Kelley@500startups.com or visit our our partnership page for details.
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