Welcome to the wonderful world of startup companies, where you’ll find a nearly endless stream of benefits awaiting you. Becoming your own boss, having arcade games and a full fridge in the breakroom, and being able to wear just about any clothes that you want are all big selling points. The greatest perk though is the fact that you’re going to be part of a multi-million dollar company.
That’s where equity comes into play. Simply put, equity is the value of the shares issued by the company, and is the bread and butter of all startups. If you’ve got equity in a company then that means you’ve invested in it, and you’re helping it to grow. It brings incentive for founders and other investors to increase the company’s overall value. In short, the more the company itself is worth, the more potential profit in your pocket.
Thing is, you can’t get rich quick with equity. In fact, equity comes with a fair amount of risks, and no package is the same as another. You need to do quite a bit of research before you invest in any company, especially if you’re looking at a startup company. A wrong investment could cost you dearly. Here are some things to consider before making those major financial decisions and fully evaluate your offers before committing fully to a startup.
Finding the Right Company
You will be taking a risk by making an investment, there’s no way to get around that. The amount of money you make is completely dependent on how much of a risk you’re willing to take. You may be buying the equity with cash, but your return is based on your effort and time. You’re going to look at the risks and compare them to the possibility of growth.
Anyone that receives equity compensation should take a moment to evaluate the company and the equity offer based on their individual assessments. Consider the company’s capitalization and valuation. What is the long-term debt of the company, and how does that compare to the shareholder equity? What is the company initially valued at, and how does that company plan on increasing that value? Few companies will simply share some of this information to the public, but you can look at trends to figure some of it out.
The truth of startup companies is that a vast majority of them fail. They can start off with really good models, but a lot of the time they either can’t handle a fast rate of growth or they grow too slowly and therefore run themselves into the ground, failing before they even cross the starting line. You have to consider all of this before you put all of that work into investing in a startup company. You have to go in believing they’re probably going to fail. It doesn’t sound pleasant, but it’s the truth of the matter.
Every single company began like these small startups, so you shouldn’t take the warnings as a “steer clear” sort of statement. Look at companies like Facebook, Apple, Microsoft, etc.. Most of them, at the start, were just a couple of people talking and throwing ideas at each other while munching on some pizza. It’s just important that the bigger picture is kept in mind. You shouldn’t base your investment choices purely on how lucrative the equity might be. Every investment has risk, but damage can always be minimized by considering all of the factors involved.
Why Should You care About Exit Strategies
If the money ship is sinking then you’re going to want an exit strategy to escape your failed investment. Don’t sign any agreement until you’ve spoken with the founders and asked about their long term exit strategies. Do they plan to sell at all? Will they be going public anytime soon? If the exit has great valuation, then that equity will really pay off. You might not receive any profit though if it isn’t good. A few exit strategies are:
- Merger & Acquisition: Companies forming a union with other companies is fairly normal. This is a solid strategy the can bring real value into those equities as you’re taking two companies and combining all of their resources together. It’s a fast way for companies to grow, and risk is often minimized this way.
- Initial Public Offering: This was the preferred path for a while, however in 2000 the internet bubble has caused this to drop to about 15%. There’s good reason for the shareholders to become unsure over this. It’s not the best thing for startup companies.
- Liquidation and Closure: Companies, one day, will have to make a difficult choice in their finances. In some cases an outside force, like a natural disaster, could make them have to liquidate. Be aware of the rules before you invest, so that you don’t waste your time and money.
What does Ownership Percentage mean?
You can’t just put some money into an equity and expect all of the profits. You’re not the only person investing into the company, so it’s extremely important to figure out exactly what your percentage of ownership will be with your investment. What are the total number of shares available right now? Rarely will you have a majority percentage of ownership, but some companies will offer enough for you to directly influence where a company grows to.
The percentage of ownership may also end up changing. An employee that works part time will have much lower ownership percentage than a full time one. If you decide later on to invest more into the company, naturally your percentage will grow, and vice versa. Anytime you make or change a deal you should think about these things.
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What are the Stock Options?
You should know what type of equity you’re buying into, which could be restricted stocks or stock options.
Stock options are the most common form of employee equity compensations. This allows you the rights to buy stocks at a predetermined price known as the strike price. This is set by the fair market value of the company when the options are granted to you. This one is when you don’t want to be “in the money” per se.
“In the money” is when the strike price of the stock is equal to the fair market value. The value of this will change over time, and is dependent on how well the company is doing. As an example, if you buy a stock set at the fair market price of $1, and then decide to sell that stock the same day, you would have a net gain of $0 because it wasn’t given the time to grow in value. On the other hand, if you wait for a year the value could rise to $11 and you’ll end up with a $10 profit. This sounds simple, right? This is the risk where investors are constantly exposing themselves to, because it can easily go either way. If you bought that stock for $1 and over time that stock’s fair market value drops to $0.87, then you’re losing money on that stock. It’s a game of give and take, and it’s constantly changing.
Restricted Stock, on the other hand, can be offered as well. These stocks, given often as a part of employee pay, will be only partially under the employee’s control unless they meet certain conditions. This isn’t necessarily a bad thing, however these stocks often have limited value, even if the conditions have been met.
Always keep an Eye on Taxes
The IRS will look at your equity and cash equally as compensation, and as such it can be taxed. However there are unique rules and regulations regarding taxing equity, so be sure that you know them. You can always ask the company you’re investing into about the tax rates, but it’s also a good idea to consult with a tax professional, as they are always caught up with current laws and regulations of equity compensation.
The most common thing for employees to receive would be Incentive Stock Options (ISOs) which, so long as holding requirements have been met, are able to confer tax benefits. These are great when you later use your options and sell them at a profit.
What is the Vesting Schedule?
You should learn the company’s unique vesting schedule ahead of buying in. This helps you determine exactly how much of the company you own. Over time vesting will give you more and more equity grants. Just because a company grants you a certain number of shares doesn’t mean you can instantly cash those in. You’ll need to stick with the company for awhile in order to get the full equity. If the company grows then those stocks will grow in value, and by the time you’re able to sell they should make for a great profit.
On average, most vesting schedules are about five years, with a four year vesting period and a one-year cliff. This cliff is the period where you don’t vest during the first year of your employment with the company. What this means is that you won’t receive any of those shares or their benefits if you walk away within that cliff. This is to prevent any dangerous or negative employees from holding onto pieces of the company once they’ve left, or been forced to leave.
You’ll have a better idea of the risk your investment means if you know the vesting period of the company. Companies that have a longer cliff period are ones you should avoid, as that is a major red flag.
Should You sell Your Shares?
You have two options after you’ve met all of the vesting requirements. You can either hold onto your stock until there is an exit event, or you can sell the stock in private transactions to outside investors or just back into the company. Now, based on company policies and federal law there may be certain restrictions, but those two options should still be mostly open. This is when you turn profit, so it’s important to know all of the regulations and rules that each company exercises when it comes to finally selling your vested shares. If you go through all of that work of vesting, understanding tax rates, researching the company exit strategies and earning ownerships but can’t cash out in the end, then it was all for nothing.
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