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How Much Equity Should You Ask For At A Startup?
If you're exploring the wild frontier of the startup world, one of the first things you'll come across when receiving an offer letter is a conversation around equity compensation. The thought of getting shares in a potentially groundbreaking company is alluring, and it could be the pathway to generational wealth. But the real question is: How much equity should you ask for when joining a startup?
The amount of equity an early-stage startup offers varies significantly, and so does the type of equity. As a general rule, it's important to know that equity compensation can take the form of stock options or equity shares. Understanding this difference and how it impacts your financial future is vital to making informed decisions.
Related: Equity Based Compensation Explained
Diving into the startup equity pool, let's look at a typical scenario. You're a senior software engineer in San Francisco. An exciting new startup is headhunting you to be a key employee. The offer is competitive - a base salary that meets market rate plus an equity offer. But what does that equity offer mean? Is it a good deal?
Understanding Equity
It's crucial to understand what percentage of the company’s shares the offer represents. If you’re presented with a number of shares, make sure to ask for the total number of shares outstanding. This gives you a clear view of your potential ownership stake. As an example, if you're offered 10,000 shares, and the total shares outstanding are 1,000,000, you're effectively being offered a 1% stake in the company.
As an early-stage employee, the equity stake could range anywhere from under 1% for new hires to about 20% for the first employee or two, or even more for a founding team member (though the founder really needs to reel in their cap table if they're throwing 20% at people). The key questions here are the company's stage and valuation. An early-stage startup might offer more equity because it can't afford high salaries. On the other hand, a company just closing its Series B round may offer less equity but a larger salary.
Moreover, employee equity pools typically come in the form of stock options. These give you the right to buy a share of the company at a predetermined price, known as the strike price, usually equivalent to the fair market value at the time the options are granted. The hope is that, as the company’s value grows over the vesting period, so does the value of the shares you can buy. The difference between the exercise price and the value of the shares at a future exit event or liquidity event can be substantial real money.
However, let’s not forget about the one-year cliff. The typical vesting schedule includes this one-year cliff, meaning that if you leave the company before your first anniversary, you get nothing. This is a tool to ensure new employees are committed to the hard work required in startup worlds.
Angel Investors and Early Stage Founders
Angel investors play a unique role in the startup ecosystem and have their own considerations when it comes to equity.
Typically, angel investors get involved in the company’s earliest stages, often even before venture capitalists. These investors take a substantial risk as they invest in the company when it might only be an idea or in its very early phases, often pre-revenue.
So, how much equity does an angel investor get in a startup? The numbers vary greatly depending on factors like the company's valuation, the amount of money invested, and the investor's individual negotiation. However, a general guideline is that early-stage investments often translate to somewhere between 10-25% equity. Want a clear example? Check out this video making the rounds on Twitter, where a man being interviewed took a huge risk as an angel investor, only for it to pay off with life-changing money:
When determining how much equity to give to an angel investor, there are several key questions that need to be answered. First, what is the pre-money valuation of the company? This figure will be used as a benchmark to determine the value of the angel investor's equity stake.
Next, how much money is the angel investor contributing? As a general rule, the more money an investor contributes, the larger their equity stake will be. It's crucial to remember that with each new funding round, including angel investment, dilution occurs as new shares are issued, so the percentage of equity held by founders and early employees decreases.
It's important to understand that angel investors are not just buying a piece of a company; they're also bringing their experience, networks, and often serve as mentors. The benefits they bring to the table can significantly impact the success of the company, beyond the financial contribution.
Moreover, it's worth mentioning that angel investors usually receive preferred stock rather than common stock. Preferred stock often comes with certain special privileges not enjoyed by common stockholders, including a higher claim on assets and earnings. For instance, they may have a liquidation preference, which means they'll get their money back before other stakeholders if the company is sold or liquidated.
Employee Tax on Equity
As an employee, you also have to consider the tax burden. If you're granted stock options, you typically don't owe taxes until you exercise the options, but then you're taxed at your ordinary income rate. Some savvy startup employees may use a strategy called early exercise, combined with filing an 83(b) election, to potentially reduce their tax liability. However, be aware: such a move involves risks and needs to be discussed with a tax advisor.
It's also essential to think about how future funding rounds will dilute your equity. Let's say you've negotiated for 1% of the company. As the startup goes through funding stages, like seed stage and series B, new shares will be issued. This increases the total number of shares and decreases the percentage that your shares represent.
Looking at the landscape, data from Index Ventures suggests that senior engineers at a Series A company might expect between 0.2% and 0.33% of equity, while a C-level executive might expect between 1% and 2%. A chief marketing officer at a new startup could expect anywhere between 1-3% equity. However, these are not hard rules; much depends on the company's growth, success of the company, and the employee's ability to negotiate their equity grant.
Getting startup equity as part of your compensation package is a thrilling opportunity, but there are many aspects to consider. Founders and business owners are often protective of their equity, and legal teams meticulously manage the cap table, so it’s crucial to navigate these waters with care.
Conclusion
In the end, the best advice for startup employees is to negotiate your equity offer with your eyes wide open. Ask about the vesting schedule, strike price, the company's valuation, and any tax implications. Don't be afraid to negotiate both the amount of money and the equity you're being offered. You're putting your sweat equity into the business, after all.
By the way, it's always recommended to consult with a lawyer or financial advisor when considering such complex matters. Equity is a key part of the compensation for employees at startups, and understanding the ins and outs of equity compensation can help you turn that hard work into a significant payday if the company takes off.
Navigating the startup equity path can be daunting, but if you ask the right questions and do your homework, you'll be well-prepared to make the right decisions for your financial future. It's all about balancing risk and reward - and making sure you're getting what you're worth.
