Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.
Understanding and managing equity can be daunting and confusing. With this in mind, we developed our Equity 101 series, and this FAQ and our full guide for founders. We’ll help you understand equity basics and how to use startup equity to incentivize and retain employees.
What is equity?
noun | eq·ui·ty | ˈe-kwə-tē A stock or any security that represents an ownership interest.
Equity may refer to shares of stock in a corporation, a membership unit in a limited liability company, a partnership unit in general or limited partnerships, and other similarly structured securities that represent ownership.
What are the most common types of startup equity?
Common stock is the most basic form of stock, and is mainly issued to founders and employees. Common stock is the prevalent form of equity compensation for startup employees.
Preferred stock is mainly issued to investors, who pay a higher price per share for ownership. In return, these shareholders have a greater claim to a company’s assets and are paid out first in a liquidity event.
What kind of equity is issued to employees?
Offering equity to employees is a valuable incentivization tool for founders. Equity is generally issued to employees in the form of an employee stock option. With employee stock options, employees must work at the company for a certain period of time or meet certain milestones before they can purchase those shares and own equity in the company. Most often, this time period is one year, and is called a “one-year cliff.”
There are two main types of employee stock options:
Incentive Stock Options (ISOs) – ISOs are the most common type of security issued to employees. They are more favorable than NSOs because ISO holders do not have to pay taxes upon issuance or at exercise (except for the Alternative Minimum Tax (“AMT”), if applicable).
Non-qualified Stock Options (NSOs) – NSO option grants are typically issued to outside contractors, consultants, and international employees.
Where do stock options come from?
An option pool is an amount of a company’s common stock reserved for future issuance. Employee equity plans distribute options from the option pool.
What is a vesting period?
A vesting period is a length of time or a milestone that must be met before employees can gain ownership of their options.
A vesting period and lifecycle of an option typically look like this:
- Grant – the date when a company awards an option grant to an employee
- Cliff – the first portion of the option grant vests and the employee earns the right to exercise it. The typical cliff date is an employee’s one-year anniversary
- Fully Vested – all options granted are earned and exercisable
- Exercise – an employee exercises all or a portion of options granted
- Sale – an employee sells all or a portion of their equity stake
What is a strike price?
Every stock option has an exercise price — or strike price — which is the price at which a share can be purchased. Tax law limits the exercise price that can be assigned to stock options to at least the fair market value (“FMV”). Startup equity for first employees typically has a very low strike price.
How is FMV determined?
A 409A valuation sets the FMV of a company’s common stock, and this price is used as the strike price for option grants.
How do companies keep track of employee equity?
A capitalization table (or “cap table”) provides a record and analysis of a company’s percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners.
Understanding equity and ownership is something founders need to prioritize as soon as they’re ready to incorporate and distribute stock among co-founders, early investors, employees, and beyond. Knowing the basics will help founders start their companies off on the right track, avoid a broken cap table, and reduce their legal fees.