What Startup Founders Must Know About Compensation
Startup Founders should be aware of the various types of compensation they can expect to receive.
Stock Options vs. Restricted Stock Units (RSUs) vs. Performance-Based Stock Units (PSUs) vs. Equity Grants: The Startup Founder compensation landscape is very complicated.
It’s also very different for each stage of a startup’s life cycle and type of company.
Here are some key things that founders should know about the various types of startup equity compensation.
Restricted Stock Units (RSUs) are generally issued to executives who have not yet exercised options. They are generally issued at a discount to the market price and vest over a period of time, usually four years. Restricted Stock Units (RSUs) are generally a form of deferred compensation, and not to be mistaken for a salary or annual bonus.
Performance-Based Stock Units (PSUs) are a type of equity compensation that can vest over time, but can also be forfeited if the company does not meet certain performance goals.
Stock Options are granted to startup executives with no vesting requirements. They are issued at fair market value and have a strike price that the stock may not fall below. Startup Founders need to understand when their stock options can be exercised (when they vest) as well as what happens if they lose their jobs before those options vest or expire.
Equity Grants are the most common type of startup equity compensation. They can be issued at fair market value or discounted, and they can also be issued as Restricted Stock Units (RSUs) with vesting requirements or as Stock Options that have no vesting requirements but have a strike price that prohibits insiders from selling below a certain level.
Stock Compensation is not always tax-deferred and should be accounted for in the event of a liquidity event or termination.
The tax consequences of stock compensation are so complex that many CEOs and CFOs mistakenly believe that they are tax-free.
This can lead to unnecessary taxes being paid by the recipient when exercising options and even more taxes being paid by the company when issuing equity grants to compensate executives.
Compensation Planning vs. Compensation Negotiation: Startup Founders should understand how compensation decisions work at their company, as well as the process they will follow when starting their new role.
They should make sure they understand the metrics they will be measured against for each round of equity grants so they can plan for how much money they may need in the future.
Startup Founders should be aware that they can negotiate their compensation at any time, but doing so can create conflict with the company and may have negative consequences. Startup Founders can save themselves a lot of pain by stating their requests in a friendly manner and only negotiating when necessary.
Startup Founders should expect to face intense pressure to accept whatever compensation package is offered to them.
This is because venture capitalists and investors view startup equity compensation as “Founder Monies” — money that entrepreneurs could invest or otherwise use for personal benefits if they didn’t take equity instead.
This high pressure to accept whatever compensation is offered can lead to founders feeling like they have no choice but to negotiate from a position of weakness, even if their requests are reasonable.
This culture of accepting the first offer without negotiation can lead to founders making decisions they may later regret.
What Startup Founders should know about Liquidity Events and Taxes on Startup Equity Compensation
Startup Founders need to understand the tax requirements associated with receiving stock compensation upon a liquidity event (exit or IPO) so that they plan accordingly for an eventual exit or IPO.
The tax liabilities associated with stock compensation are very complex, especially when stocks are granted at different times over several rounds and then exercised in multiple batches after the IPO or acquisition.
It’s crucial for startup CEOs, CFOs, CPAs, lawyers and investment bankers work together in order to minimize any future tax liabilities associated with equity grants.
This process generally takes months of planning in advance of an exit or IPO so that employees can make informed decisions about what kind of equity compensation makes sense for them given their personal financial situation at the time of the liquidity event.
The key considerations during this process include:
- how much will be paid out in taxes due to income taxes and capital gains taxes;
- how much will be paid out due to tax withholding;
- how much will need be set aside as a liability (deferred income);
- how much will need be set aside as a liability (deferred income) by employees;
- what kind of documents do we need from employees?
- how do we minimize our own tax liability?
- how do we minimize our tax liability for employees?
- What is my marginal tax rate?
- Do I have other sources of capital gains/losses (bonds)?
- How do I account for this exit in my personal financial planning? and
- What do we do with the remaining stock after the tax liabilities are paid?
Investors and founders should also understand that when a company is acquired, all stock compensation agreements are “frozen” while the company is being sold.
This means that employees who have stock options or restricted stock units (RSUs) will not be able to exercise their options or complete a sale of their stocks until after the acquisition has been completed.
This can lead to extreme financial stress as employees will not be able to sell any of their stock until they are allowed to do so by either the investor, founder or employer.
In summary, Startup Founders need to be aware that there is much more to startup equity compensation than simply being granted some shares of stock. Startup Founders need to understand how their compensation will work, the tax implications of receiving stock compensation, and how they can negotiate for more or less equity compensation if they think it’s in their best interest.
About the Author
I am the Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students teach and learn better. I am also a mentor and angel investor in other Startups of my other interests (Proptech, Fintech, HRtech, Ride-hailing, C2C marketplaces and SaaS). You can also find me on Cudy for early-stage Startup Founder mentorship and advice.
You can connect with me on Linkedin (https://www.linkedin.com/in/alexanderlhk) and let me know that you are a reader of my Medium posts in your invitation message.