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 you need to know about equity. Simply put, equity is the value of the shares issued by the company, and is the bread and butter of all startups. Having equity in a company means that your placing your own stakes into the company, allowing it to build and 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. Really, there are a lot of risks involved with it, and each investment of yourself is going to be a different experience. You should never invest in any type of company before you do your research. Making the right investment can be the difference between success and crippling loss. Before you commit to anything you’ll want to consider the factors that will be discussed below.
Picking the Right Company
You will be taking a risk by making an investment, there’s no way to get around that. That risk is what places value on the investment, though, meaning that the payoff is entirely dependent on the level of risk. 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.
Those who receive an equity compensation should take some time to evaluate the company and equity offer based on their personal 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.
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 may want to invest in a startup, but you have to be aware of these major risks. You need to assume that they’re more than likely going to fail. It’s a disheartening statement, but the numbers never lie.
This isn’t to discourage you from ever investing into a startup, after all, every major company started off as one in the beginning. 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. All this mentality means is that there’s a bigger picture to keep in mind. You shouldn’t base your investment choices purely on how lucrative the equity might be. You will be taking a risk, no matter where you invest, but you can minimize the damage by considering the following factors.
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What are Exit Strategies?
You need to have a solid exit strategy in case things go completely south with the company. Before you sign any agreements, ask the founders of the company what their exit strategies are in the long term. Do they plan to sell at all? Is there a chance of them going public at all over the next few years? 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. Some exit strategies include:
- 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: Despite once being the prefered course of action, this strategy has fallen in favor since 2000’s internet bubble to only around 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: There will always come a day where a company must make a difficult financial choice. They may be forced to liquidate due to outside sources, like major changes in the market. Be sure to know what the rules are, up front, to prevent your investments going completely to waste.
Percentage of Ownership
It’s not enough to simply put money into equity and expect to get all of the profit. Others have done the same thing, so you’ll want to know what your percentage of ownership is. What are the total shares outstanding with the options being offered? 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.
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. If you decide you want to invest more later then your percentage will grow, and if you want less then it’ll shrink. Anytime you make or change a deal you should think about these things.
Are Stock Options Available?
Time to find out what type of equity you’ll be receiving, and these come in the forms of stock options and restricted stocks.
The most common type of employee equity will be stock options. You’re given the right to buy stocks at a set price, called a strike price. This will be based on the fair market value at the time of the options being given. 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. This value is depending on the company and its current situation, so it’ll go up and down throughout the year and into the future. 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 is pretty straightforward, isn’t it? This is the risk where investors are constantly exposing themselves to, because it can easily go either way. Let’s say that you wait a year, but when you go to sell that $1 has dropped down to $0.79, now you’ve lost money. Values are constantly fluctuating, so it’s a give and take relationship playing stocks.
Restricted Stock, on the other hand, can be offered as well. These are often given to employees as a part of their pay, however the employee must meet certain conditions to completely receive them. This isn’t always a bad thing, but they generally are limited in their value, even if the conditions are met.
The Importance of Watching the Taxes
The IRS will look at your equity and cash equally as compensation, and as such it can be taxed. 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.
Most commonly, employees are given Incentive Stock Options (ISOs), a type of stock option that confer tax benefits, provided that holding requirements are met. These are nice to have when you exercise your options later and sell them for profit.
What Does the Vesting Schedule Look Like?
You should learn the company’s unique vesting schedule ahead of buying in. This’ll let you better know what your percentage is. 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. Assuming the company is growing, you’ll be able to sell those stocks after they’ve accumulated extra value.
On average, these vesting schedules will be a year long cliff, and then a four year vesting period. The cliff is the first year of employment where you won’t vest. This means that if you walk away during that year then you sacrifice your shares. 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. 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. You should have those options while remaining within federal law and company policies. 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 put in your time and effort doing everything else, only to realize you can’t sell those shares and make some money, then all of it was thrown away.