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 for employees, this FAQ, and founder toolkit below. We’ll help you understand equity basics and how to use startup equity to incentivize and retain employees.
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What is equity?
Equity is any security that represents an ownership interest, including shares of stock in a corporation, a membership unit in a limited liability company (LLC), a partnership unit in a general or limited partnership, and other similarly structured securities.
What are the most common types of startup equity?
Common stock is the most basic form of stock. It’s mainly issued to founders and 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?
Equity is generally issued to employees in the form of employee stock options. With employee stock options, employees must work at the company for a certain period of time or meet certain milestones before they can exercise (purchase) those shares and own equity in the company. This process is called “vesting,” which we’ll cover later.
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, if applicable).
Non-qualified Stock Options (NSOs) – NSO option grants are typically issued to outside contractors, consultants, and international employees. NSO holders generally have to pay taxes both when they exercise and sell their shares.
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 milestone that must be met before employees can own 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. Strike prices should at least be the fair market value (“FMV”) of the stock when the options are granted. 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 usually used as the strike price for option grants.
How do companies keep track of employee equity?
A capitalization table (or “cap table”) is a list of the owners of a company and what percentage of the company they own.
Understanding equity and ownership is something founders need to prioritize when they’re ready to incorporate and distribute stock to co-founders, early investors, and employees. Knowing the basics can help founders start their companies off on the right track, avoid a broken cap table, and reduce their legal fees.
If you’re just getting started, Carta’s Launch plan can help you clean up your cap table. It’s available for free for companies with 25 stakeholders or less that have raised up to $500K. Learn more about Launch or contact your lawyer to get set up.
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