Welcome to the wonderful world of startup companies, where you’ll find a nearly endless stream of benefits awaiting you. Between ping pong tables and arcade cabinets in the break rooms, a fully stocked fridge of food and drinks provided by local restaurants never having to dress up in suits and ties and potentially becoming your own boss, there’s no doubt that they have their perks. But the biggest perk of all comes from owning a piece of the multi-million (or even billion) dollar company.
This is where equity becomes important. Basically, equity is how much an individual share of a company is worth, and it’s a building block of 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. Basically, if the company is worth a lot then you’ve got a good shot at making a pretty profit.
Equity isn’t a fast money fix though. In fact, equity comes with a fair amount of risks, and no package is the same as another. You should never invest in any type of company before you do your research. A wrong investment could cost you dearly. Before you commit to anything you’ll want to consider the factors that will be discussed below.
Finding the Right Company
No matter what, at the end of the day an investment is a risk. That risk is what places value on the investment, though, meaning that the payoff is entirely dependent on the level of risk. Equity may be purchased with money, but the real earnings come through how much time and effort is placed into the investment. You’ll need to compare and contrast the risks and the possible 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’s their initial value, and how do they plan to increase it? Most shareholders don’t have access to this information, unless you’re at least considered to be the equivalent of a C-level executive, but you can still make an assessment based on current trends one way or another.
Sadly, the majority of startup companies end up failing. Some are unprepared for the rapid growth the experience, however others may be moving so slowly that they don’t even really get started before they fall apart. You have to consider all of this before you put all of that work into investing in a startup company. You need to assume that they’re more than likely going to fail. It isn’t exactly inspiring, but it’s true.
Now that isn’t to say you should avoid startups, especially considering that every major company you know and love (or hate) today were once one of these startups. Think about companies like Google, Microsoft, Apple, 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.
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What are Exit Strategies?
Exit strategies are a good way to escape from a company that’s going down. You’ll want to find out what the exit strategies are before you sign any contracts. Are they planning to sell at any point? Is the company going to go public in the next couple years? If the exit has great valuation, then that equity will really pay off. If it’s not so good though, that same equity may never turn over any profit. A few exit strategies are:
- Merger & Acquisition: It’s fairly common for a company to form a union with others. This strategy combines the resources of multiple companies, which can put a lot of value into the equities. It’s a fast way for companies to grow, and risk is often minimized this way.
- Initial Public Offering: While this method was once considered to be the preferred path, the internet bubble burst in 2000 has caused Initial Public Offering to drop to around 15%. This makes shareholders nervous, and with good reason. 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. Sometimes variables outside the realm of control, like natural catastrophes or changes in the market can force the company to liquidate. You should know ahead of time what the rules are so you don’t waste your investment.
Percentage of Ownership
You aren’t going to be getting all of the profits just cause you’ve bought some equity. Others have done the same thing, so you’ll want to know what your percentage of ownership is. How many shares are currently available? While you’re hardly ever have the chance to own a majority percentage, a few companies will offer enough for you to be able to have a direct influence on the direction of the company.
There’s also the possibility that your ownership percentage could change. An employee that works part time will have much lower ownership percentage than a full time one. You might decide at a later date that you don’t want to be investing quite so much, and your percentage of ownership will lower with your investment change, and the same will happen on the opposite end. You should keep all of this in mind when you’re making any sort of exchange.
Are There Stock Options?
Time to find out what type of equity you’ll be receiving, and these come in the forms of stock options and restricted stocks.
Employees most often receive stock options if they’re receiving equity compensation. You’ll be able to buy stocks at the strike price, meaning at a predetermined price. This is set by the fair market value of the company when the options are granted to you. You’re looking to avoid being “in the money” with this.
“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. Let’s say you buy stock today at $1 a share, and then sell it back, you’ve made $0 because you didn’t allow it to grow in price. 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. Values are constantly fluctuating, so it’s a give and take relationship playing stocks.
You may also be offered restricted stock. Restricted stocks are shares in the company that are generally issued to employees as a part of their pay, but cannot be fully transferred to them until certain conditions are met. 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
Just like getting a paycheck from work, the IRS considers both cash and equity compensation as taxable income and can range anywhere between 10% to almost 40%. You should be aware of the various regulations and rules that surrounded the when, where, and how your equity can be taxed. While you can definitely speak with the company about the current tax rates, your best bet will be to speak with a tax professional, as they’ll be up to date on all of this information.
Often employees will be given Incentive Stock Options (ISOs), and these can confer tax benefits, assuming you meet the holding requirements. Later on you can exercise your options and then sell these at a nice profit.
What Does the Vesting Schedule Look Like?
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. Chances are the shares a company grants you won’t be able to be cashed in instantly. If you want the full equity then you’re probably going to have to work with the company for a bit. If the company is on the rise, then this is a great deal because more than likely those stocks will increase in value, in time for you to be able to turn a major profit.
On average, most vesting schedules are about five years, with a four year vesting period and a one-year cliff. The cliff is the first year of employment where you won’t vest. 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 ensure that employees who haven’t been any help to the company won’t then benefit from it by holding a part of it.
You’ll have a better idea of the risk your investment means if you know the vesting period of the company. If the cliff period is longer than average, that should come off as a red flag, and it might be best to cut ties and move onto another investment.
Understanding Share Selling
You have two options you can make once you have 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. You should have those options while remaining within federal law and company policies. Your vested shares are your money, your profit, so you need to be aware of all the rules and regulations a company may have regarding them. You need to know ahead of time that you aren’t going to be throwing away your time, effort, and money.