Equity Compensation for Startups
Equity is how startups compete for talent. Here's how to structure it fairly.
Startups can’t compete with big company salaries. But they can offer something big companies can’t: meaningful ownership. Equity compensation is how you attract people who believe in what you’re building and want to share in the success.
Equity Basics
What Is Equity
Equity is ownership in the company:
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Stock or options to buy stock
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Value tied to company success
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Potential upside if things go well
It’s not cash—it’s a bet on the future.
Why It Matters
For employees:
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Potential for significant wealth
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Alignment with company success
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Participation in what they’re building
For companies:
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Compete for talent with limited cash
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Align incentives
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Reduce early burn rate
The Trade-Off
Equity involves trade-offs:
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Less certain than cash
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Value may never materialize
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Requires company success
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Tax implications
Good candidates understand this.
Types of Equity
Stock Options
The right to buy stock at a set price (strike price).
Incentive Stock Options (ISOs):
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Favorable tax treatment
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Must be employee
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$100K annual limit
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AMT considerations
Non-Qualified Stock Options (NSOs):
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Less favorable tax treatment
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Can be used for anyone
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No annual limits
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Taxed as ordinary income at exercise
Restricted Stock
Actual shares with restrictions:
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Vests over time
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Subject to forfeiture if you leave early
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Taxed at grant (can elect 83(b))
More common in very early stages.
Restricted Stock Units (RSUs)
Promise to deliver shares later:
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Vests over time
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Taxed when shares delivered
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No upfront cost
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More common in later stages
The 83(b) Election
When receiving restricted stock:
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Can elect to pay taxes now at current value
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If value is low, this is often smart
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Must file within 30 days
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Can’t undo it
Example: Stock worth $1K now, might be worth $1M later. Pay taxes on $1K, not $1M.
Vesting
Standard Vesting
Most common: 4-year vesting with 1-year cliff.
How it works:
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Year 1: 0% → 25% at cliff
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Years 2-4: Monthly (or quarterly)
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Year 4 end: 100% vested
The cliff: Must stay one year to get any equity. Protects against early departures.
Why Vesting Exists
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Incentivizes retention
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Protects against quick exits
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Aligns long-term interests
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Standard practice everywhere
Vesting Variations
Different schedules:
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3-year vesting (more aggressive)
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5-year vesting (less common)
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Front-loaded vesting (more early)
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Back-loaded vesting (more later)
Accelerated vesting:
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Single trigger: Accelerate on acquisition
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Double trigger: Accelerate on acquisition + termination
How Much to Give
Early Stage Guidelines
At seed/Series A, typical ranges:
First hires (1-5): 1-2%
Early employees (5-20): 0.25-1%
Later early (20-50): 0.1-0.5%
Post-50: 0.01-0.1%
These are rough guides. Varies by role, stage, candidate.
Role Matters
Higher equity roles:
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Executive/C-level
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Key technical hires
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People taking big risk
Lower equity roles:
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More junior positions
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Later-stage hires
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Support functions
Stage Matters
As company grows:
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Risk decreases
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Salary can increase
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Equity percentage decreases
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Total equity value may increase
Later hires get smaller percentages of a potentially bigger pie.
Creating an Equity Framework
Build consistent bands:
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By level (IC1, IC2, Manager, Director, VP)
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By function (Engineering, Sales, Ops)
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By stage (Seed, Series A, B, etc.)
Consistency prevents problems.
Option Pool
What It Is
Shares reserved for employee grants:
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Set aside from cap table
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Dilutes existing shareholders
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Typically 10-20% at funding rounds
Managing the Pool
Track carefully:
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Outstanding grants
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Available pool
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Upcoming hires
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Refresh grants
Running out of pool is a problem.
Refresh Grants
Additional grants for existing employees:
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Reward strong performers
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Replace vested equity
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Retain key people
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Re-up motivation
Common annually or at promotions.
Communication
Educating Employees
Most people don’t understand equity:
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Explain what they’re getting
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Show potential outcomes
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Be honest about probability
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Discuss tax implications
Materials to provide:
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Grant details
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Vesting schedule
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Explanation of value
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Tax considerations (suggest they consult advisor)
Transparency on Value
Help them understand potential:
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Current valuation
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Different exit scenarios
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Percentage ownership
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Dilution expectations
Don’t promise specific outcomes.
Cap Table Visibility
How much to share?
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Their grant details: Always
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Company cap table: Consider it
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Others’ grants: Usually no
More transparency builds trust.
Tax Implications
Options
At grant: Usually no tax
At exercise:
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ISOs: Potential AMT on spread
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NSOs: Ordinary income tax on spread
At sale:
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ISOs (if holding requirements met): Capital gains
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NSOs: Capital gains on appreciation after exercise
The Exercise Decision
Employees face a choice:
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Exercise now (pay tax, become shareholder)
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Wait for liquidity (risk, but no upfront cost)
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Leave and lose unvested
Extended exercise window: Some startups allow 10-year exercise. This is employee-friendly.
Encourage Professional Advice
Tax implications are complex:
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Encourage employees to consult tax advisors
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Provide information, not advice
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Help them understand the questions to ask
Common Mistakes
No Consistent Framework
Ad hoc grants with no structure.
Fix: Create equity bands by level and function.
Overpromising Value
“This could be worth millions!”
Fix: Be realistic about probability and timing.
Not Explaining It
Assuming employees understand.
Fix: Educate on what they’re getting and why it matters.
Cliff Surprises
Employee didn’t understand they’d lose everything before cliff.
Fix: Explain vesting clearly at offer stage.
Short Exercise Windows
Standard 90-day post-termination exercise.
Fix: Consider extended exercise windows.
No Refresh Grants
First grant is the only grant.
Fix: Build refresh pool and process.
Ignoring Tax Implications
Not helping employees understand tax consequences.
Fix: Provide information and encourage professional advice.
Equity vs. Cash
When to Lean Equity
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Early stage (cash is scarce)
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Candidate believes in mission
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Long-term player
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Risk tolerant
When to Lean Cash
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Candidate has financial needs
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Later stage (can afford it)
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More risk averse
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Shorter-term commitment expected
Finding the Right Mix
Ask candidates:
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“How do you think about cash vs. equity?”
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“What would make this package work for you?”
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“What’s your financial situation?”
Customize within your framework.
Key Takeaways
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Equity is how startups compete for talent—meaningful ownership in exchange for risk
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Stock options are most common: right to buy stock at a set price
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Standard vesting: 4 years with 1-year cliff; protects both sides
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Earlier employees get more equity (higher risk, higher reward)
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Create consistent equity bands by level, function, and stage
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Educate employees on what equity means, potential outcomes, and taxes
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Extended exercise windows are employee-friendly and increasingly common
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Refresh grants retain top performers and replace vested equity
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Be honest about probability—don’t overpromise
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Encourage professional tax advice; equity tax is complex
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