Understanding Equity Offered in Startups: A Comprehensive Guide

Evaluating equity when negotiating compensation with a startup is a nuanced process that requires a deep understanding of the stage of the company and its future plans. This article aims to provide startup employees with the insights needed to make informed decisions, balancing the potential benefits against the associated risks.

Understanding the Stage of the Company

One of the key factors to consider when evaluating an equity offer is the stage of the startup. Early-stage startups, often characterized by rapid growth and high risk, are very different from established ones. Employees at early-stage startups are frequently offered equity in exchange for a lower salary and benefits package compared to industry standards, as mentioned by a Google employee:

“Never accept startup equity unless you are the co-founder and getting co-founder equity. Early stage employees have a very high risk for a relatively low reward. You get paid less than market, no 401k, etc. and you get a tiny amount of worthless lottery tickets that you pay a premium for both in terms of the original investment and taxes.” - Google Employee

This perspective emphasizes the significant risks and potential drawbacks associated with equity in a startup. However, the potential rewards can be enormous if the startup succeeds, especially for early hires.

Understanding the Nature of Equity

The nature of the equity offered also depends on the role within the company. For co-founders, equity is usually used as a way to share the risk and reward during the company's growth. For regular employees, especially those in the early stages, the stakes are different:

“If you join a startup, you get common shares. The VCs that back it have preferred shares that guarantee minimum cash payouts when the company sells/IPOs regardless of the actual price the company sells for. If the company sells for higher or at its valuation, everyone gets rich. If not, the value of the Common Stock gets lowered so inflate the value of preferred stock so VCs can get their min payout. Note that founders generally do fine either way since they get bonuses for having run the company before the sale.” - Google Employee

This quote illustrates the intricate nature of equity structures in startups, with preferred shares giving VCs and founders a higher claim on the company's assets during liquidation. Common shares, which are often offered to employees, can have significantly lower value, especially if the company does not perform well.

Assessing Likely Outcomes

The likelihood of success or failure can greatly influence the value of equity. An Amazon engineer provides a useful framework for assessing the potential outcomes:

“It's all about what percent of the company you own and what the likely outcomes will be. Let’s say you join as employee 5 and get 2 of the company before Series A. You have to expect your 2 will be diluted down to 1 or less. Investors with preferred shares get their money out first in a sale liquidation preference. So let’s say investors own 50 and invested 50MM. The company now has a 100MM post-money valuation and you’re worth 1MM on paper. Yay! But now let’s say the company actually does ok but not great and sells to an acquirer for 60MM. Now the preferred shareholders get their 50MM back and the other 10MM gets split between the other 50 if investors weren’t guaranteed a premium on their money. You now make 200K. But that assumes you started with 2 of the company. Usually only the first couple engineers might get even that much. Start with anything less as a percentage and these numbers start to look really bad for a Senior Engineer compared to the RSUs you might get from a bigger company unless the startup is compensating you well in cash.” - Amazon Engineer

From this perspective, it becomes clear that the success of the startup and the initial position of the employee within the company play significant roles in the potential value of the equity offer. For early employees, the benefits are often speculative and heavily dependent on the company's future performance.

Conclusion

Evaluating equity offers in startups is a complex process that involves careful consideration of the company stage, equity structures, and potential outcomes. While there are significant risks associated with early-stage equity, the potential rewards can be substantial. Employees should carefully weigh these factors using a cost-benefit analysis to make the most informed decisions possible. Whether you’re a co-founder or an early employee, understanding the nuances of equity compensation is crucial for navigating the startup ecosystem successfully.