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Understanding startup equity: a guide to key terms in equity packages

Awarding employees equity is one of the ways startups attract top talent. It’s a powerful lever to attract, retain and incentivise employees in the long run, drawing a direct link between day-to-day activities, the success of the company and the rewards reaped by its people. In fact, there are many reasons why employers provide equity

If you're being offered employee equity for the first time, the complex jargon can be intimidating.  Since there’s no set template to follow, equity packages and agreements look different from business to business. If you’re unsure about understanding startup equity and want to know exactly what you’re signing, seek the advice of a legal specialist. 

For now, to help you better understand startup equity packages, here’s a guide to the key terms you’re likely to encounter.

Share options

Share options are an equity award that grants you the right to purchase a company’s shares for a predetermined price at a future time. Optionholders are most commonly employees, which encourages a sense of ownership within the company and aligns individual financial interests with those of the business. 

Option awards are not the same as shares. Holding options does not mean you currently own a part of the business. Instead, it permits you to do so at a later date.

Vesting schedule

A vesting schedule is a time frame over which you are awarded your options, often staggered over several years. 

The most common timeline companies use is a four-year vesting schedule. All of the options agreed in a compensation package are awarded in equal measures over four years. After one year, 25% of the options will have vested. After two years, 50% will have vested and so on.

If a company were to award all of the options as one lump sum, it would lessen the strength of equity as a retention tool and incentive.

It isn’t a case of one-size-fits-all. Vesting schedules can be adapted and tailored to the needs of the business. For instance, some startups choose a weighted plan. This type of vesting schedule increases the proportion of shares that vest each year. In one example, employees might receive 10% of their options at the end of the first year and 20% over the second, with this percentage increasing incrementally as the third and fourth years pass.

The cliff

Within the terms of the vesting schedule you'll often find a so-called cliff. Once you pass the cliff, your options begin to vest in accordance with the schedule.

If your option agreement features a one-year cliff, no options vest during your first year with the company. When the year is up, all of the options that would have vested during that period (25% if an equal-weighted vesting schedule) are awarded at once.

From that moment onwards, the options vest gradually either monthly or quarterly, depending on your agreement. A four-year vesting schedule with a one-year cliff is one of the most common arrangements.

Strike price

The strike price is the predetermined cost of exercising each of your options and converting them into actual shares. It is included in the option agreement and is usually determined by the business’ share price at the time. The company you work for will obtain a valuation from HMRC to set the strike price based on the fair market value (FMV) – the price that an asset would sell for on the open market. 

It’s not possible to know exactly how much your shares will be worth in the future, but you can calculate the value of your options if you exercised them on the day of the grant. Find the strike price along with the share price from the most recent valuation in your option agreement. The difference between these two numbers – after multiplying each price by the number of options you’ve been granted – is what your shares are worth. In short, the lower the strike price, the more you stand to gain. 

There are tax considerations too. No tax is payable on options at the time of the grant, however, when they are exercised, Income Tax and NICs are payable on the difference between the strike price and the actual share price. In the UK, there are several tax-advantaged schemes. Read more about how share options work in the UK.

Maturity date

All shares have a maturity date, or expiration date, which determines when your options expire and can no longer be exercised. In a lot of cases, this will be ten years from the signing of the option contract. 

Your options may also expire when you leave a company. Whether you have the right to exercise your options after your departure depends on the terms of your leaver clause.

Leaver clauses 

A good leaver:  A 'good leaver’ has the right to purchase any vested options for a set period after leaving the company. This window typically lasts 90 days but will vary from company to company.

A bad leaver: If an employee is dismissed from the business due to gross misconduct, they are a ‘bad leaver’ and will no longer have access to any of their vested options.

Liquidity event

Liquidity events are processes in which a company’s equity – the shares held by founders, employees and other stakeholders – is converted into cash. It allows stakeholders to realise the value of their investment by selling their shares. There are several different types of liquidity events.

Initial Public Offering (IPO)

An IPO is the first time a private company offers its shares to the public to buy. To do so, it offers a new stock issuance and sells directly to investors through a primary market. This is an enormous step for most companies and represents the culmination of the startup journey. After an IPO, the business will be publicly listed on a stock exchange so that shares can be bought and sold in a public market.

Secondary transaction

While primary markets are used to purchase new stock directly from the issuer, secondary markets allow for share trading between buyers and sellers. Secondary markets unlock liquidity before a company goes public. With secondary transactions, you can let founding investors and employees cash in and move on, and use regular liquidity events to motivate your employees. Learn more about secondaries with Capdesk.

Mergers & Acquisitions (M&A)

M&As can happen for a range of reasons. Sometimes, two companies believe it’s in their best interests to combine operations and develop together – a merger. In other instances, a big business feels it’s wiser or cheaper to acquire new skillsets or products by buying a startup than it is to develop those skills or products in-house – an acquisition. Though M&As used to be relatively uncommon in Europe, recent data suggests that they’re becoming an increasingly popular exit option.

To learn more about any of the terms included in this guide, to find more help understanding startup equity in general, take a look at the Capdesk resource centre.

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