#15 - A guide to receiving startup equity

How to evaluate your offer.

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TL;DR

  • startups can have a hard time providing above-average salaries, but they usually make up for that by providing appealing employee participation schemes;

  • the unfeasibly high costs associated with buying actual shares are the main driver for share options (or equivalents of) being a popular instrument;

  • holding startup equity has some great advantages: your early commitment, belief and hard work in the company could be rewarded in the event of an IPO or sale;

  • the three questions to ask yourself to value your options: when was the strike price set, at what valuation and what's in the fine print?


A guide to receiving startup equity

In the world of startups and scale-ups, a common challenge we face as employees is the fact that startups have a hard time providing above-average salaries.

The fault lies in the nature of the startup-phase, which often implies the company is either still unprofitable or trying to reinvest the majority of it's potential profit back into the business to grow faster. In either of those situations, cash is a scarce commodity.

By contrast, large and established companies are much better positioned to offer high salaries and paid secondary benefits, because their maturity in the market tends to mean they already generate a lot of free cash flow. Once the need to grow aggressively disappears, it opens up funds that can be redirected to employee compensation.

Thankfully there's a great instrument that allows startups to match those higher salaries with a form that doesn't involve cash, called employee participation.

Employee participation is really an umbrella-term for the many legal structures that allow an employee to benefit from the success of the startup they are helping to build with their blood, sweat and tears. However, the most commonly found constructs at startups are instruments that behave like shares or share options.

My goal for this article is to help you understand what this component of your compensation means in terms of value and potential.

employee participation = umbrella term for various legal structures that let employees share in the overall success of the company;

startup equity = one sub-category of employee participation that refers specifically to instruments that behave like company shares or share options;

shares and share options = (an option to buy) a small slice of ownership in the underlying business you're helping to build;

How suited am I to advise you on financial matters?

I have absolutely no qualifications to be providing you financial advice, but what I can provide is my experience of being on the receiving end of startup equity grants.

I have also interviewed several qualified investors and asked them to poke holes in this article before I share it with you, so in conclusion, I feel reasonably comfortable that what I have to share will help you make your own decisions when the time comes.

Understanding the basics of startup equity plans

Employee participation can be structured in multiple different ways, each with its own advantages and drawbacks relating to ease-of-use, fiscal treatment and/or the associated rights and obligations it provides the person participating.

Before we dive into the various instruments for startup equity participation, it's important to understand in the most general sense which advantages could be unlocked by holding shares or share options of a company:

  1. the shares/options can increase in value if the company flourishes;

  2. there's a possibility of receiving future dividends/profits;

  3. there's a possibility of receiving the right to be informed and/or vote on important company decisions that require shareholder approval;

In the startup world you'll find that most startup equity schemes are centered around point number one — the other two usually won't be relevant or applicable to your particular agreement or the situation that the startup is in.

So far I've been referring to shares as well as share options, and it's vital to understand the difference between them and why you are much more likely to encounter a startup equity plan that works like an option.

As an early employee, you probably won't have the funds available to buy actual shares of the company even if you were offered the chance. Purchasing a 1% stake in a startup that is valued between €1-€10 million means you'd need to pay up to €100.000 to receive your equity stake. That's the kind of money most of us don't have lying around.

Even if the company were to gift you those shares, it would trigger an instant taxable-event that requires you to pay up to 49,5% (box 1 Dutch taxes) of the received value in taxes. That's still a lot of money that you would be paying for shares that carry some inherent risk of being completely worthless if the startup fails to succeed.

Share options, or instruments that work similar to share options, try their best to mitigate that problem for us by removing the necessity to put down money up front while still keeping the advantage of profiting from long-term company growth.

Hence why, the most commonly found employee participation vehicles found at startups are either share options or instruments that work like share options.

To put it all in perspective, here's an overview of the most commonly found startup equity instruments and where they fit into the share or option-type model:

Instruments that work like shares:

  • Shares — which are issued by a notary and (unless specifically stated otherwise) include voting rights, dividend rights and can increase/decrease in value;

  • Certificates of shares, issued by a STAK, that don't include voting rights but do include economic rights like dividends and value growth;

Instruments that work like options:

  • Options on actual shares — which give you the employee the right, but not the obligation, to purchase company shares in the future at a discounted rate.

  • Options on certificates of shares — which give you the right, but not obligation, to purchase certificates of shares without voting rights in the future;

  • Share Appreciation Rights* — also known as Shadow Stock, which aren't real options or shares, but act as a bonus agreement that mirrors the same value growth you could get from having shares (dependent also on the agreement);

  • Purchasing shares on loan — purchasing actual company shares through a favorable loan offered to you by the company that needs to be repaid.

Why it’s worth participating in a startup equity plan

There is an active debate going on in The Netherlands to make startup equity plans more attractive, in part because of the potential trickle-down effect.

If more employees profit from a successful company exit, the chances are higher some of that money makes it back into the tech ecosystem through early employees starting new companies or re-investing some of their earnings as angel investors.

Aside from the ecosystem benefiting, there's also plenty of other relevant benefits.

Participating in a startup equity plan has some great advantages:

  • it strengthens your alignment with the company — if the entire team does well and executes on its goals, you stand to do well in the future too;

  • it adds an interesting component to your compensation — both early and late employees of Airbnb, Uber, Adyen, Zoom and other tech startup successes made life-changing money when the company IPO'd, the same will soon happen to employees of companies like Mollie and Messagebird;

  • your early commitment, belief and hard work in the company is rewarded in the event of an IPO or company sale;

But there are also risks inherent to startup equity you need to consider:

  • you can't always linearly match company value growth to (your) option/share value growth; founder and/or investor shares will sometimes have a different class of shares that provide preferential treatment in the event of a sale or IPO;

  • in the Netherlands, some option instruments are viewed as a form of salary and profits will be taxed according to the same progressive scale that applies to your regular salary — this could mean forking over 49.5% of your future earnings;

  • share or share option instruments usually come with certain restrictions (listed in the fine print of your option agreement) on whether or not you're allowed to keep them if/when you decide to leave the company before an IPO or sale;

Not all startup equity plans are created equal, and there's merit in making sure you understand what value you are being offered when you are given an opportunity to participate in one of these plans.

The three steps of understanding share options

Since the most commonly found employee participation vehicles found at startups are either share options or instruments that work like share options, it's important to be able to read and fully understand the offer that you are being made.

For the sake of simplicity I'm bringing back the assessment of a highly complicated document to a few main questions I believe are most fundamental to you understanding the value that your options offer represents.

  1. When was the strike price set?

  2. What was the valuation then (‘when the strike price was set’) and now?

  3. What obligations will I find hidden in “the fine print”?

Answering these questions can help you understand and track the value growth of your personal share or share option grant as the company grows.

Before we go through each of these together, let's run through how an option contract works with some dummy numbers so we're clear about how this transaction can translate to future compensation for you.

  • your offer will list a total number of options you're being granted, let's say 2.000 — these options can be exchanged (‘exercised’) for shares in the future;

  • you will receive an exercise (‘strike’) price per option, which usually corresponds to the current price per share of the company or a slight discount — let's say €10;

  • let's say in the next 4 years the company triples in value and the Founders decide to sell the business to Megacorp for €30 per share;

  • you'll exercise the contract by paying the exercise price per share (€10 x 2000 = €20.000) and instantly sell your shares to Megacorp (€30 x 2000 = €60.000).

  • Your profit after this transaction is €40.000 before taxes.

*my beautiful dummy calculation assumes that there are no Founder or Investor class shares that have preferential rights. If there are, which is often the case, it can negatively affect your payout as an employee holding common class shares.

Back to the questions now.

#1 - When was the strike price set?

When Founders make employees an offer to receive share options, they have an accounting obligation to make sure that the exercise (‘strike’) price resembles the current value of company shares as closely as possible.

While Founders may issue share options to employees on any given day of the year, it's unlikely they'll perform a new company valuation each time they do. Valuations are a time-consuming and costly exercise usually reserved for the moments a company raises outside funding so it can establish how much new investors are asked to pay.

So how does this apply to you?

The strike price in your options contract — the discounted price at which you can buy shares in the future — is usually based on the valuation assigned to the company during the most recent investment round.

Depending on how long ago the previous investment round took place, there's a likelihood your strike price will reflect a discrepancy between the share value listed in your offer and the actual value a share holds on the day you receive it.

In other words: if the strike price was set a year ago and the company has continued to grow since then, it's likely the actual company valuation will have grown beyond the valuation being used in the strike price. If this is the case, then lucky you, it means you're essentially receiving a discount hidden inside the strike price of your contract.

Consider asking these questions:

  • When was the strike price set that I'm being offered in my options offer? Does it correspond to a recent investment round?

  • If it does, how much would you say a company share would be worth now based on how much the company has grown since?

#2 - What was the valuation then and now?

Possibly the most challenging question of the three, since answering this involves combining accounting math with ambiguous assumptions about the total addressable market, the quality of the founding team or the future potential of the business.

There is never a definitively correct answer, and when founders raise funding or try to sell their company, a large part of their work is trying to convince their counterpart that the valuation they have in mind for the company is in fact reasonable.

Challenges aside, the three most common valuation frameworks in business are:

  • the EBITDA-multiple; the value of the company is a multiple (eg. 8x) of the earnings before interest, taxes, depreciation and amortization. The multiple will depend on factors such as industry, growth rate, debt and other metrics.

  • the Revenue-multiple; the value of the company is a multiple (eg. 5-7x) of the trailing 12-month annual recurring revenue. This valuation method is common with high growth SAAS-businesses.

  • the Discounted Cash Flow-method; the value of the company is derived from calculating the present value of the future earnings a company expects to make. This method is often used in small businesses, but my advisor for this article Aik Deveneijns views it as an error-prone and generally overestimated valuation model and borderline useless when pricing tech startups.

I'm not telling you this because you need to be able to perform your own due diligence on valuation. I'm telling you because Founders will rarely disclose the latest company valuation, but you can still extract very useful information by learning which valuation method was used and what revenue/earnings the company was hitting at that time.

Say you know that the most recent investment round took place in January 2019, that the company was valued using an EBITDA-multiple and that the company EBITDA of 2018 was €50.000. You still won't know how much the company was valued at in total because you won't know the multiple itself (was it 6, 9, 15 or 20?).

However, if the CFO tells you in a few years time that the EBITDA for 2024 was €500.000, you will be able to make a ballpark assumption that the company — and the value of your options package — will have grown 10x.

I use the term ballpark for a reason, because even if the valuation method stays the same, the multiples can change due to reasons such as high company debt, general market outlook for the segment your company is in or because the acquiring company that wants to make an offer has some strategic/synergetic value to bring to the table.

You'll only ever have a best guess, but at least it will give you some direction.

The questions I would recommend asking are:

  • Can you share the valuation method used during the latest investment round (is it an EBITDA multiple / Revenue multiple)?

  • How much EBITDA / Revenue were we doing at that time? How much EBITDA / Revenue are we doing right now?

  • What percentage ownership do my options represent? (This is a trick question — they probably won't share this information with you, because if they tell you the %, you'll be able to calculate the total company valuation).

#3 - What obligations will I find hidden in the fine print?

We've covered the most important aspect of your options offer, but that's likely only 10% of the documentation that you need to review and sign.

The other 90% are contractual clauses covering crucial elements that warrant just as much scrutiny as the actual offer. Amongst those you'll find:

  • it could contain additional and stricter non-compete terms on top of those already covered in your employment contract;

  • you'll find explanation about what voting rights (usually none) your shares have once you've exercised your options and how shareholder decisions are made;

  • there will be specific guidelines as to whether or not you're allowed to keep your options if you leave, or whether you're obliged to sell them back to the company.

Especially this third component — what happens when you leave — is often documented quite extensively. Founders want to avoid having employees leave a month after they issued them ownership in the company because the entire idea behind sharing ownership is to build long-term commitment with key employees.

To cover their bases, the most important clause Founders will add to your documentation is referred to as a vesting schedule.

A vesting schedule is an instrument that allows Founders to issue you share or share options, while agreeing with you that they only truly become ‘yours’ after a certain amount of years. You'll be granted the options immediately, but depending on the agreements in the vesting schedule, you'll unlock a set percentage of them at predefined intervals throughout a period of (usually) 4 years after the grant.

The vesting schedule can make for a great pair of golden handcuffs, because leaving before all of your options have vested can mean losing out of a lot of money.

A typical vesting schedule at a startup might look something like this:

  • 25% of your options shall vest and become exercisable after one year;

  • 2,083% of your options shall vest and become exercisable on a monthly base during 3 years starting 1 year after the grant date.

The potential implications of a schedule like this for you are best summarised by illustrating examples of what would happen if and when you left the company:

  • if you leave the company 10 months after receiving the options, none of them will have vested and you'll have to give everything back for free;

  • if you leave exactly 2 years after receiving the options, you'll be allowed to keep or sell half of the options back to the company — the other half will still have been unvested and you'll need to hand those back in for free;

Some final advice

Even if the contents can feel overwhelming, there is always room to have an open discussion about the share (option) offer you're being made by your employer.

How much leverage you have to demand alterations to the terms is highly dependent on the phase of the company and the importance of you/your role. Even if the offer is non-negotiable, it doesn't absolve you of your obligation to understand what you sign.

Startup equity plans can be an amazing addition to your compensation, but they can also leave you in a world of regret if you accidentally breach your contractual terms or leave the company before your share or share options have fully vested.