So, your boss wants to give you equity...
You’ve landed a great job at a startup, and your boss has agreed to grant you some equity. Well done for getting a slice of the action!
In this article I share some of the basic lingo to do with employee shares, and also some pitfalls to watch out for.
Note: I am not a lawyer - so take all of this with a hefty portion of salt.
1) Get it in writing
Just because you were promised a certain amount of equity doesn’t mean anything unless it’s in writing - usually in some kind of employee share options agreement.
If you don’t have it in writing then you’re not protected when the company is sold or later raises more money. It doesn’t matter if you think your boss is the nicest person in the world, they could be put under immense pressure later on in the business’s life-cycle by people who don’t know you or care about you. Or your boss could get fired by the board and his replacement might not know or care about promises made by their predecessor.
2) Share options
When founders set up a company, the shares are worth almost nothing. If you receive shares later on when the company has accumulated some value, the government will look to tax you on the value of those shares as income.
This is where share options come in. A share option is ‘the option to buy the share later’. You can think of it as a binding promise that in the future a certain number of shares will be granted to you.
Under the UK Government’s Enterprise Management Incentive (EMI) scheme, companies can give share options without the employee being taxed when they receive the option. The options become full blown shares when they are exercised - which is typically after the vesting period and is subject to a bunch of conditions (I talk about vesting period below).
3) Strike prices
The thing employees tend to forget about share options is that they need to be ‘bought’ when you exercise them.
How this works is that your shares need to be given a price based on the current value of the business. This is called the strike price. The lower the strike price the better, because this is how much you will end up paying for your shares.
For example: let’s say you are offered a share option of 1000 shares with a strike price of £3. When the company is sold, the price per share is £300.
Sale price of shares: 1000 x £300 = £300,000
Strike price of shares: 1000 x £3 = £3,000
Your gain: £300,000 - £3,000 = £297,000
4) Paperwork delays can cost you
If the startup you work for is growing (and it should be) then the value of the company should be increasing over time. What this means is that the strike price will continue to rise while your boss sorts out (or procrastinates over) the paperwork. The longer you wait, the more you risk losing out.
Let’s look at an example. In January your company is worth £100,000 and your boss promises you 2%, but doesn’t get around to doing the necessary paperwork.
Then, in July they finally get around to doing it but now the company is worth £500,000.
The strike price in the first instance is £2000 if the boss had got around to doing the paperwork. The strike price in the second instance is £10,000. Given that you get the difference between the final valuation and the strike price when the company exits, this means you will have lost £8,000 because of the delay.
5) Vesting period
You are not entitled to your share options immediately. Every employee share agreement has a condition called the vesting period. This is typically a schedule that calculates when the options will vest i.e. you’ll actually own the options.
The reason for this is to ensure that employees don’t just take the shares and run. By having a vesting period the company have some kind of guarantee that the employee will stick around for a bit.
Vesting typically follows a monthly schedule where a proportion of your shares options vest over a period of time, for example roughly 2.1% per month so that you are fully vested after 4 years.
You’ll also hear about a cliff. This is a period of time where none of your options vest whatsoever. So for example if you have a vesting period of 4 years, with a 1 year cliff - this means that if you quit after 6 months you’ll get nothing. However, after you’ve worked there a year, 25% (or some other sizable amount) of your share options vest in one go.
So you’ve received share options for 2% of the company. Then another round of investment happens, and your company raises a good chunk of change.
Hooray! my 2% is now worth...wait a sec, what do you mean I don’t have 2% anymore..
When you’re given share options, you’re not given a document saying you have options over 2% of the company — instead you’re given options over a number of shares (e.g. 200). The number of shares you own won’t change.
What does change, is that the number of shares in the pot increases.
Let’s say the company has 10,000 shares. And then they decide to find some more investment. To do this they have to give the investors a chunk of the company in return (let’s say 20%). In this example this means adding another 2000 shares to the pot (totalling 12,000 shares). Because you have 200 shares your percentage of the company is now 1.67% — but that’s ok!
The company has raised money, so that usually means your 200 shares are now worth more than they were before! It doesn’t matter that you have a smaller percentage in the company, what matters is that your shares are now worth more.
Getting a slice of the action is great - but if the terms aren’t right you may find that you’re not getting what you’re think you’re getting.
If you want to find out more about employee share options, one book I recommend is Venture Deals by Brad Feld and Jason Mendelson (affiliate link - I want to read more books!). The book is pretty much focused on the entrepreneur, but you can get some great insight into how employee share options are structured.
If you want a better understanding of how dilution works, check out this calculator on founders workbench: http://www.foundersworkbench.com/capital-calculator/
If you want to encourage your boss to start looking for a lawyer to draw up an employee share option agreement, point them in the direction of our site: https://www.lexoo.co.uk.