How to Communicate Equity Value to Your Employees
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It’s hard for startups to attract and retain high quality talent. While large public companies can offer generous cash and public stock, private startups must instead compete by offering candidates equity that has the small probability of being worth a life-changing sum of money one day.
In order to persuasively sell candidates, you must be able to explain to them that it’s worth taking a cash pay-cut to join your company. To do this, you should understand the fundamentals of startup equity such that you can be intentional with your compensation decisions. This essay covers the key choices you’ll need to make around equity and tips for communicating the implications to your team.
Reminder: as a founder, it’s not your job to be your employees’ personal tax advisor. In fact, your legal counsel would almost certainly say you should not be giving your team financial, tax, or legal advice.
That being said—most startups are really bad at explaining compensation to their teams. Many founders default to obfuscating details hoping their team won’t realize. This approach is short-sighted. The outcome is that your team doesn’t understand their startup equity. They get stressed thinking about taxes and do not appreciate the real value that you’re offering them.
At Compound, we believe that communicating compensation transparently and fairly is actually the right way to build an efficient, high-output culture.
(We’ve partnered with dozens of companies and communities and can offer educational resources to your employees in the form of a live equity workshop, access to our free software, or educational content in our Manual. If you are interested in a partnership, request access here and mention “partnership”. )
These are the key decisions you need to make around how you give equity compensation:
- Overall compensation philosophy
- Type of equity in your employee stock option plan
- Vesting schedules and cliffs
- Early exercise
- Post-termination exercise window
Of course, this is not an exhaustive list and there is no absolute right or wrong way to issue equity. There are tradeoffs with each of these decisions and you should think thoughtfully about them and include appropriate legal counsel. This article is not financial or legal advice.
How much equity should I offer my employees?
The decision of how much equity to give each employee is a bit of science and a bit of art.
To start, consider what kind of talent you want to attract. Your compensation philosophy will impact the people you can hire: while not a perfect correlation, you can expect to attract higher quality candidates if your compensation is at the 75th percentile vs the 50th percentile.
There are several tools available that will help you with benchmarking, some of which are dedicated compensation benchmarking tools (Pave, Salary) others of which are built into HR software (Lattice, Workday) or cap table management software (Carta, Pulley).
Compensation benchmarking is best used as a “guard rail” as you enter negotiations for employees. The reality is that each employee will have a unique compensation package and negotiation – especially for early-stage companies. There’s no formula for the amount of compensation that will work for employee #10, #11, #12, etc. Instead, there are a bunch of factors that go into each hire:
- Revenue / user growth
- Public perception
- Capital intensity
- Market timing
- Opportunity cost for the employees
Make an offer that is fair and you think the employee would accept and negotiate based on the situation.
What type of equity should I offer my employees?
The simple mental model is that founders and the first few employees will get restricted stock awards (RSAs). After the first few employees, you’ll offer stock options: either incentive stock options (ISOs) or non-qualified stock options (NSOs). The main difference between ISOs and NSOs is in their tax treatment – exercising ISOs does not immediately trigger ordinary capital gains taxes, but the gain does count for alternative minimum tax (AMT) purposes. The capital gain realized between the strike or exercise price and the value of the stock when exercising NSOs is taxed immediately as ordinary capital gains upon exercise. (There’s a lot of nuance with taxes and options, you can read more here.)
Note that there are restrictions on the quantity of ISOs that you can issue. The number of options that will have ISO tax treatment will depend on their value at exercise and their exercise strategy. By law, any employee can only exercise $100,000 of ISOs per year – any other ISOs exercised that year will be taxed as NSOs.
What should the vesting schedule be?
The most common vesting schedule is a 4-year vesting schedule with a 1-year cliff. This is the most common option in the US. After all, you are innovating with products and services and any more risk that you add by innovating on equity isn’t worth the risk. It does create some interesting challenges and potential legal exposure around the 1-year cliff if people are underperforming and you need to make a change at month 9-12.
That said, you could get creative here. Some companies have longer vesting schedules to incentivize staying with the company longer. Other companies have shorter vesting schedules to appear more attractive to candidates.
Should I offer early exercise?
Early exercising is when employees have the right to exercise their options before they are vested. Early exercise is not a standard practice in Silicon Valley and most startups don’t offer it to employees. But it’s really valuable for employees.
See, when employees exercise their options, if the strike price and the 409A price are the same, they won’t owe any taxes. So to pay the least taxes, employees would want to exercise their options when they are the same price. If they aren’t allowed to exercise options until they vest, they might never have that opportunity if the 409A valuation is increasing (which is what you want as a startup!).
The burden of early exercising can fall to the company – if an employee early exercises their options and then leaves before they are all vested, it’s common for the company to repurchase the unvested options back (as the employee didn’t earn them). This scenario is common, so it’s worth talking with your general counsel and personal attorney or CPA about it.
 Of course, there are many other factors that employees consider when exercising their options (amount of cash/liquidity, confidence in the company, opportunity cost, among others).
How long should the post-termination exercise window be?
The post-termination exercise window is the amount of time that employees have to exercise any vested options after they leave the company (voluntarily or involuntarily). The standard in Silicon Valley is a 90-day post-termination exercise window. That standard was established long before there were unicorn valuations and their commensurate tax implications.
Employees often don’t know about this rule and even if they do, a few months after they leave isn’t usually enough time to plan and execute an equity strategy that’s in their best interest. Extending this window gives your employees more flexibility, will make you much more attractive to recruits (see this GitHub list of companies with extended strike windows), and doesn’t cost your company any cash. The consequence is that vested shares that departing employees earned but did not exercise do not revert to your option pool and you may need to refresh your option pool for new employees, which is a dilutive event.
Once you’ve made these equity decisions, you can go above the baseline to communicate more about the company equity to your employees.
It’s helpful to put yourself in the shoes of the employee: if you were trying to maximize the value of your equity, what would you want to know?
The first two things would be number of shares and share price. These are table stakes to include in the job offer.
During the job offer, walk employees through the equity option grant and its current value. Discuss how the growth of the company’s value can lead to growth in the value of that equity - the value they create and can capture. Talk about the company’s growth trajectory so that the employee can make their own assumptions about what the equity could be worth. Suggest they explore a free tool like Compound’s equity modeling tool to assess the potential value of their equity compensation.
As an aside, you can also help retain employees by communicating equity to them on an on-going basis. Once an employees knows your number of shares and share price, they would want to know how quickly the share price is increasing. Part of this calculus is the dilution in each round. To account for these things, you could share the 409A and fully-dilluted shares outstanding with employees every time there’s a new valuation. Keep in mind this isn’t standard practice, nor a requirement, but a helpful favor for your employees.
The 409A is also useful for employees in another key consideration: taxes. Employees may have to pay taxes upon exercising their equity and upon selling it and their bargain element (the spread between their strike price and 409A price) is how these taxes are calculated.
And while this information isn’t rocket science, it also takes time to learn. Consider providing plenty of resources to employees as they get their job offers and along their journey helping to build your company. As an example, we wrote the Compound Manual (a series of articles about equity, financial planning and investing specifically for tech employees) precisely for situations like this. It’s easy to include as a link on a Notion page or in a job offer, and leverages your time by letting employees learn about their equity on their own.
It can also be helpful to host live equity chats every quarter or so. It gives employees the chance to ask questions. (Reminder that Compound can help!)
Of course, there’s a downside to all of this (which is why not everyone does it). Discussing equity might lead to a lot of questions. But here’s the thing – your employees will have these questions regardless of if you bring them up yourself. Wouldn’t it be best to frame the discussion in a transparent way that allows you to build credibility and commitment from your team?
Ultimately it’s your call on how much you want to communicate equity to your employees, but we’ve seen that it can be valuable in recruiting to explain the basics to your candidates.