How to Evaluate an Equity Offer From a Company

An equity offer, often a significant part of compensation from startups and private companies, represents an ownership stake in the business. Evaluating this component is more intricate than simply assessing a cash salary, as its true value is not immediately liquid or guaranteed. Understanding equity’s structure, potential value, and associated risks is important for financial planning and future wealth potential.

Common Forms of Equity Compensation

Stock options grant an individual the right, but not the obligation, to purchase a company’s shares at a predetermined price, known as the strike price, within a specific timeframe. Incentive Stock Options (ISOs) offer potential tax advantages upon sale. Non-Qualified Stock Options (NSOs) are more flexible in terms of who can receive them and their exercise period.

Restricted Stock Units (RSUs) represent a promise from the company to deliver shares of its stock once certain conditions are met, most commonly a vesting schedule. Until these conditions are satisfied, the recipient does not own the underlying shares.

Restricted Stock Awards (RSAs) involve the immediate grant of actual company shares to an individual, subject to a vesting schedule. The recipient owns the shares from the grant date, even if not yet fully vested. This immediate ownership contrasts with RSUs, where shares are delivered only upon vesting.

Phantom stock is a compensation arrangement that provides cash bonuses to an employee based on the value of the company’s stock, without granting actual equity ownership. The value of the phantom stock units mirrors the actual stock’s performance, with payout occurring at a future date or upon a specific event. This arrangement allows employees to benefit from stock appreciation without the complexities of actual share ownership.

Essential Equity Terminology

A vesting schedule outlines the timeline and conditions under which an individual gains full ownership rights over their equity compensation. Common structures include “cliff vesting,” where a percentage of equity vests entirely after a specific period, often one year, followed by monthly or quarterly vesting thereafter. “Graded vesting” allows equity to vest incrementally over several years, such as 25% per year for four years.

The strike price, also known as the exercise price, is the fixed cost per share at which an individual can purchase shares when exercising stock options. This price is typically set at the fair market value of the company’s common stock on the grant date.

Fair Market Value (FMV) for private companies is often determined through a 409A valuation, an independent appraisal that establishes the value of common stock. This valuation is necessary to ensure compliance with Internal Revenue Code Section 409A, which governs deferred compensation. The 409A valuation provides an objective basis for setting the strike price of options and for calculating taxable income when equity events occur.

Dilution occurs when a company issues new shares, which increases the total number of outstanding shares and reduces the ownership percentage of existing shareholders. For example, if a company has 10 million shares outstanding and issues another 2 million, an individual’s 1% ownership stake would decrease proportionally unless they acquire more shares.

Liquidation preference is a provision that determines the order and amount of payout to shareholders in the event of a company’s sale or liquidation. Preferred shareholders receive their initial investment back before common shareholders receive any proceeds.

Total shares outstanding refers to the total number of a company’s shares currently held by all shareholders. This figure is used to calculate an individual’s actual ownership percentage in the company by dividing the number of shares an individual holds by the total shares outstanding.

The exercise period is the timeframe during which an individual can convert their vested stock options into actual shares by paying the strike price. Understanding this timeframe is important, as options typically expire if not exercised within this window.

Strategies for Valuing Your Equity

To estimate the current paper value of an equity offer, one can multiply the number of shares or options granted by the most recent 409A valuation per share. For example, if you receive 10,000 shares and the 409A valuation is $5.00 per share, your current paper value is $50,000. This calculation provides a snapshot of the equity’s worth at a specific point in time, based on an independent appraisal. However, this value is theoretical until a liquidity event occurs.

Assessing the future potential valuation of equity involves considering various factors that could influence the company’s growth and market position. These factors include the company’s revenue trajectory, its competitive landscape, the overall market trends in its industry, and the potential for future funding rounds. Understanding these elements helps in projecting a possible future fair market value, which is crucial for estimating potential gains.

The vesting schedule directly impacts the realizable value of your equity over time. For instance, if you have a four-year vesting schedule with a one-year cliff, you would only have rights to 25% of your total equity after the first year. The remaining equity vests gradually, typically monthly or quarterly, over the subsequent three years.

Calculating the potential gains from stock options involves subtracting the strike price from the projected future fair market value per share and then multiplying that difference by the number of shares. For Restricted Stock Units (RSUs) or Restricted Stock Awards (RSAs), the realizable value at vesting is the fair market value of the shares on the vesting date. For example, if RSUs vest when the share price is $10, and you have 1,000 vested units, the value is $10,000.

Dilution directly impacts the percentage ownership represented by your equity, even if the total number of shares you hold remains constant. If a company issues more shares in subsequent funding rounds, your percentage ownership of the company will decrease, even if the per-share value increases.

The ability to convert equity into cash often depends on specific events. For private companies, common liquidity events include an Initial Public Offering (IPO), where shares become publicly tradable, or an acquisition by another company. Understanding the company’s path to liquidity and its timeline is crucial for assessing the practical value of your offer.

Comparing equity to cash compensation requires weighing the certainty of a fixed salary against the potential upside and inherent risks of equity. A higher cash salary provides immediate financial stability, while a substantial equity component offers the potential for significant wealth creation if the company performs well. This comparison involves assessing your personal risk tolerance and financial goals, as equity’s value can fluctuate and may not always materialize as expected.

Tax Considerations for Equity

The tax implications of stock options vary significantly between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). For ISOs, there is generally no regular income tax due at the time of exercise. However, the difference between the fair market value and the exercise price at the time of exercise may be subject to the Alternative Minimum Tax (AMT). When the shares acquired through ISOs are later sold, any gain is typically taxed as a long-term capital gain, provided certain holding period requirements are met.

Non-Qualified Stock Options (NSOs) are taxed differently. Upon exercise, the difference between the fair market value of the shares and the exercise price is taxed as ordinary income. This amount is subject to federal income tax, Social Security, and Medicare taxes. When the shares acquired through NSOs are subsequently sold, any additional gain or loss beyond the value taxed at exercise is treated as a capital gain or loss.

Restricted Stock Units (RSUs) are generally taxed as ordinary income upon vesting. The fair market value of the shares on the vesting date is considered taxable income. This income is subject to federal income tax, Social Security, and Medicare taxes.

Restricted Stock Awards (RSAs) are also generally taxed as ordinary income, but the timing can differ based on a Section 83(b) election. Without an 83(b) election, the fair market value of the shares at the time they vest is taxed as ordinary income. With a Section 83(b) election, an individual can choose to be taxed on the fair market value of the shares at the grant date, even though they are not yet vested.

The distinction between capital gains and ordinary income is important for equity compensation. Ordinary income, such as salary or income from NSO exercise, is taxed at your regular income tax rates, which are generally higher than capital gains rates. Capital gains, which arise from the sale of assets held for investment, are taxed at different rates. Long-term capital gains, for assets held over one year, typically have lower tax rates than ordinary income.

Taxable events for equity can occur at various stages depending on the type of equity. For stock options, a taxable event can happen at exercise (for NSOs and potentially for ISOs under AMT) and at sale (for both ISOs and NSOs). For RSUs, the taxable event occurs at vesting. For RSAs, the taxable event is typically at vesting unless a Section 83(b) election is made, in which case it occurs at the grant date. Understanding these timings is important for tax planning and avoiding unexpected tax liabilities.