Fast-growing private companies can compensate their employees in many ways. Learn how to compare options and RSUs to standard cash-salaries.
There are two useful frameworks for how to think about the different types of compensation:
Compensation awarded for just staying employed with the company is less risky - it might look smaller on paper, but you’re guaranteed to get it. Compensation tied to performance is "at risk" - it might look bigger on paper, but the value is offset by the risk that you may not earn it.
There are four common forms of compensation - salary, bonus, equity, and benefits.
All in, a total compensation package for a new employee could look like the following:
What ultimately matters is how much cash you take home. States and local tax codes and the choices you make can have a big impact.
Taxes will form the bulk of the difference between your headline salary number and how much you take home in cash. Taxes can happen at the federal, state, and local levels in the US depending on where you live and vary significantly. Just looking at the state-level income taxes - a handful of states have no income tax, some have a flat income tax for all residents, and most have a graduated-rate income tax that increases the more you make. Even the top graduated rates range by as much as 10% between states.
After taxes, your pre-tax deductions will make up most of the remaining difference between your salary amount and take-home pay. By spending pre-tax, you reduce the amount of taxes you ultimately pay. How much you spend pre-tax is in your control. Typical examples include health insurance premiums, health-related savings accounts, life insurance, disability insurance, and a 401(k) retirement account.
If you want to calculate the net take-home pay for yourself, check out SmartAsset's nifty Paycheck Calculator where you can plug in all of your own numbers including salary, where you live, and deductions.
Salary is ultimately a tradeoff. Total compensation that includes a larger bonus and/or equity component tends to have smaller salaries and appear more valuable on paper. You have to determine for yourself whether that compensation is still as valuable when it's risk-weighted - the bonus might look large, but if you think there's only a 75% chance of getting it, a compensation package that has a larger salary and smaller bonus may be more valuable.
Bonuses are compensation that's not guaranteed, it's at risk. While bonuses can be paid in cash, equity, or even company paid-for amenities like sporting events tickets, it's generally understood to be cash unless it's specified otherwise.
The two critical considerations for bonuses are timing and terms. Timing is both when it gets awarded and when you'll be paid. Terms can vary significantly. If you're unsure, talk with a lawyer.
Also, keep in mind that bonuses are taxed differently than your salary. You'll see the bonus tax referred to by its more formal name, the supplemental tax rate. Some states and localities like New York City may make you pay additional taxes on supplemental income in addition to the federal taxes.
Equity typically has the biggest potential upside. If the company does well and becomes more valuable over time, your partial ownership will become more valuable too - it's great! It can quite literally be life-changing. But equity is also riskier. Most startups fail and the equity becomes worthless. Keep both in mind as you think about your total compensation.
The value of equity is a more complex question than it first appears. There can be many different share classes at companies. This is especially common for startups.
You'll often hear the classes referred to as common and preferred. Common is almost always the share class with the least rights, it's what employees receive. Investors typically receive preferred shares that have additional rights. There can be many classes of preferred.
The price for preferred shares is typically determined when a company raises a round - it's whatever the investors were willing to pay. When you see an announcement for a funding round (e.g. Seed, Series A, Series B …), that's typically a sale of preferred shares.
The price for common equity is typically determined through a process called a 409A valuation, a value appraisal conducted by a third party that the IRS accepts as a "fair basis" for value. The price for common equity is almost always less than the preferred price because the common equity has fewer rights.
There are many ways to structure equity. Depending on the stage of the company you're joining, you're more likely to see some structures than others. The most common structures are restricted stock awards (RSAs), incentive stock options (ISOs), non-qualified stock options (NSOs), and restricted stock units (RSUs). It's an alphabet soup of structures! RSAs are typically only usable during the creation of a company. Options tend to be used throughout a company’s pre-IPO lifecycle, but many companies start to replace options with RSUs as they mature and valuation growth slows.
Most equity is subject to vesting - earning ownership rights. Vesting is most commonly time-based but can also be tied to performance or other metrics. A typical time-based structure is 4-years monthly vesting with a 1-year cliff. That means you take ownership of 25% of the award at the end of year 1, then take ownership of an additional 1/48th of the total award for the remaining three years.
Restricted stock awards (RSAs) allow you to take ownership of equity now, but the equity comes with restrictions. Founders shares are often structured as RSAs.
Vesting for RSAs typically manifests a buy-back right for the company - if you leave the company before the RSAs vest, the company can repurchase the unvested equity from you. Once the shares vest, they're completely yours even if you leave the company.
Taxes are dependent on how you take ownership of the shares. If you pay the full price for the share, you won’t owe taxes. If you paid anything less, including if they were awarded to you as compensation, you'll likely owe taxes.
RSAs are common when companies are not yet very valuable. As the shares become more valuable, they can be expensive to purchase or result in a large tax bill if they're awarded. The other structures we'll explore help solve those challenges.
Incentive stock options (ISOs) and Non-qualified stock options (NSOs) are the right - but not the obligation - to purchase equity. It's the most common form of startup equity.
There are two main elements to options:
Once the options vest, you own them. That means you own the right to purchase equity at the strike price. You don't get any of the rights that come along with owning equity until you exercise the options.
Owning options versus equity is a critical difference. Companies can write term limits into your options agreement. When the term is up and the options expire, you forfeit the right to purchase equity. Secondly, the company can force you to exercise your options - or forfeit them - when you leave the company. The timeline for exercise when you leave is typically as short as three months.
Exercising options triggers ordinary income taxes on the bargain element at the time the option is exercised. As the company gets more valuable and that bargain element gets bigger, the taxes also get bigger.
If you need cash to exercise the options or pay the tax bill, Prism may be able to help.
ISOs give you a helpful “freebie” on ISOs - the IRS won't tax the first $100K of that bargain element income per year. Above the $100K threshold, any remaining options are automatically taxed as NSOs - you owe ordinary income tax on the bargain element.
There's a lot more that goes into taxes. Exercising ISOs can trigger the Alternative Minimum Tax and you may be able to early exercise your options to reduce your tax bill. You can find out more about options and taxes here.
Options are the most common form of startup equity compensation. As the company becomes more valuable, the cost to exercise options and associated taxes can become prohibitively expensive. Restricted Stock Units can become a more attractive construct.
You can find out more about ISOs and NSOs here.
Restricted stock units (RSUs) are an agreement from the company to issue you shares or the cash value of shares at a future date.
Vesting for RSUs is similar to options - you earn the right to receive shares or the cash value, but you don't actually receive the equity itself. RSUs typically have a trigger event for when the company will issue you your vested equity or the cash equivalent. Like with options, you typically forfeit your rights to the equity if you leave the company before the trigger.
The most common trigger event for RSUs is a liquidation event - when the company is either acquired or becomes a public company through an IPO, direct listing, SPAC, or another method. The reason for the trigger is taxes.
When the trigger event happens and you receive the shares, you're taxed on the full value of those shares at the time you receive them. That value is treated as ordinary income. If the company has been successful, it can mean a very large tax bill.
If the company's been acquired or is now public, you'll either have the cash needed to pay the tax bill or have the ability to sell some of your equity to pay. It's why that trigger is typically tied to a liquidation event - to ensure you can pay your tax bill.
There are nuances involved in RSU taxes that we may explore in a future piece.
RSUs are most common in late-stage, valuable startups and in public companies. For companies intending to go public or be acquired in the near future, RSUs enable employees to take ownership of the equity without paying the option strike price. For companies intending to stay private for many years to come, RSUs avoid the 10-year expiration limit on options.
All of these equity structures - RSAs, ISOs, NSOs, and RSUs - can be issued by both private and public companies.
When you receive equity at a private company - including venture-backed startups - there's no market for that equity. You cannot sell it without company approval. That could be the company offering to buy back your shares to give you some cash or the company going public.
At a public company, there's a market for your equity. That means if you have a large tax bill or need money to exercise options, you can get cash.
Prism is helping bridge that gap for startups, giving equity and option holders access to cash before the company goes public.
It's a lot of moving parts and it can be a bit overwhelming! Here are the key things to keep in mind.
If you have questions about the offer - ask the company! They can help clarify terms, equity valuation, and more. It can be uncomfortable to ask, but the company will want to help. Your total compensation is an agreement between you and the company - they get a super valuable employee and you get compensated for helping them grow. You both need to be comfortable with the agreement.