The complete guide to equity compensation for startups

Many startups choose to offer equity compensation to employees as part of the total compensation package for their role, alongside base salary.

But they don’t all offer equity compensation in the same way.

How much equity in the company should be reserved for employees? Should all roles be eligible for equity compensation or just senior team members? Should you opt for RSUs or stock options? Should equity be granted as a one-off for new hires, or should refresh and promotion grants be considered as a way to reward performance? Will your equity compensation strategy change as the company grows?

These are just some of the myriad questions that startup founders must ask themselves when it comes to deciding on how to structure equity compensation.

In this guide to equity compensation for startups we’ll cover everything you need to know to structure your company’s equity compensation – including the answers to the questions above!

With equity compensation employees are granted an ownership stake in a company as a form of payment for their work. If the startup does well and increases its value over time, then the equity the employee owns will also increase in financial value.

There are many different ways that equity compensation can be implemented, which we’ll dive deeper into in Part 2 of this guide.

Should your startup give equity compensation to employees? The pros and cons

Equity compensation comes with pros and cons for both the employer and the employee – let’s take a look at both sides of the coin.

The pros of offering equity compensation to startup employees

Equity compensation gives employees an ownership stake in the startup they work for, meaning that if the company is successful and continues to grow and increase its valuation, the equity granted to the employee can become very valuable over time. Therefore, equity compensation can be a very financially attractive proposition for potential employees, so is a great way to increase the competitiveness of a compensation offer to a new hire.

Equity compensation can also be a highly effective long-term mechanism for employee motivation and retention, reducing employee turnover and aligning incentives between the company and its employees. It creates a direct link between the success of the startup and financial reward for the employee, with the value of the equity increasing over time if the company as a whole increases in value. And, through equity refresh grants, it can also be used as a way to recognise and reward performance – so it's an employee loyalty and retention mechanism that can continue to grow over time. 

Finally, long-term financial gains derived from equity compensation are often taxed at lower rates than salary income (especially in countries with tax-advantaged employee equity schemes like Enterprise Management Incentives (EMIs) in the UK, bons de souscriptions de parts de créateurs (BSPCE) in France or the stock options scheme in Spain, under the 2022 emerging companies law – ley de fomento del ecosistema de las empresas emergentes.

In summary, the main pros of offering equity compensation to your startup employees are:

• Motivate employees to contribute to the long-term success of the business by aligning their financial reward with the company value
• Attract talent by increasing the competitiveness of the compensation package
• Incentivise employees to stay with the company long-term, as their equity stake is unlocked over a prolonged period of time
• Manage payroll costs by balancing lower salary offers with equity compensation
• Ability to give back and share the financial success of the business with the employees who helped to build it.

The cons of offering equity compensation to startup employees

Equity compensation does come with risks.

For the employee, the major risk is that the company could fail and so the equity they have will never result in a cash payout for them – especially risky if they are accepting a lower salary offer in the hope of longer-term financial gain from their equity.

And if the equity does become valuable, it can have limited liquidity. The exact terms of this depend on how you structure your equity compensation program, but typically the equity an employee holds can only be exercised and converted into cash at the time of certain liquidity events taking place, such as an IPO or a merger/acquisition.

Because of this complexity, some job candidates will always favour cash compensation over equity, so if you’re trying to balance a lower salary offer with equity compensation, you may lose some candidates along the way.

And there are a few downsides to offering equity compensation for founders too:

• Granting equity to employees dilutes founder control of the company. Offering equity compensation to employees means giving away a slice of the ownership and control that the founders have in the company. This is known as dilution, and is a major consideration for many founders.
• Legal and tax implications. Setting up and managing an equity compensation plan means understanding and complying with any local laws, reporting requirements, and company taxation policies regarding equity compensation. Laws and tax policies relating to equity compensation vary significantly across countries, with many countries having tax-favourable schemes available e.g. EMIs in the UK. As you can see, it can get pretty complex – especially for companies with employees across multiple jurisdictions – which means time, effort, and legal and financial counsel will be needed.
• There are lots of ways to structure an equity compensation offering, and it’s difficult to decide which is right for your company. As a founder, when you’re considering whether to offer equity compensation to employees and how to do it, you’ll come across lots of conflicting advice and examples or how other startups approach equity – without much evidence or objectivity. It’s very difficult to cut through that noise and decide what the right framework is for your equity compensation offering, which can be off putting. If that’s you, keep reading: the next section will be helpful!

Once you’ve decided you’re going to offer equity to your employees, how do you actually go about building your equity compensation offering?

There are many considerations and steps to go through in the process.

And it’s made trickier because there are also lots of conflicting opinions out there on the topic and many companies hold their cards close to their chest regarding equity – so it’s difficult to understand what a typical equity offer actually looks like.

To help make this a little easier, in this part of the guide we’ll run through the key considerations:

• How to decide how much equity to allocate to employees
• How to decide which employees receive equity compensation
• How to decide what type of equity grant to offer e.g. RSUs vs stock options
• How to decide the vesting period
• How to calculate the individual equity offer for a new hire
• How to communicate about equity compensation to employees

And along the way we’ll share data and insights from Ravio’s extensive compensation dataset to help you build a competitive equity compensation offering based on actual market data.

How to decide how much equity to allocate to employees

Most founders first take a top down approach to determine what overall percentage of equity can be allocated and set aside for employees in an employee stock option pool.

Essentially, you want a balance between not giving away too much of the company, but ensuring that the equity compensation offered to employees does represent a meaningful stake in the company.

It’s typical for founders to allocate between 5-15% of equity to employees at the early stages (seed to Series A).

In fact, UK startup investment platform SeedLegals found that in 2022 the overwhelming majority of startups allocated 10% of their equity to their employee stock option pool, as can be seen in the graph below.

So this gives us an equity breakdown that looks something like this at the seed stage:

The best practice approach to determining your employee equity pool is to build a bottom-up hiring plan that models out how many employees you plan to hire in the foreseeable future by role and seniority.

You can then design a simple framework to determine equity grants (both new hire and equity refresh grants if applicable) by job function and seniority level (e.g. tech vs. non-tech or junior vs mid-level vs senior) and use that to calculate how much equity you need to set aside in total for your employee equity pool. This exercise is typically repeated ahead of each new funding round, and/or whenever your company goes through a significant strategic shift.

How to decide which employees receive equity compensation

Once you’ve decided the percentage of equity to allocate to your employee stock option pool, you then need to decide which employees receive equity compensation.

Should all employees receive equity compensation? If so, should all employees get the same amount of equity or should this vary depending on job role and job level? Or, should equity compensation actually be entirely reserved for senior team members? Will this change as the company grows – will early hires receive more equity than later hires? Is equity granted only to new hires, or should it be used as a performance tool too via equity refresh or performance grants?

These are all decisions that need to be made.

As we saw earlier in this article, equity compensation can be a great way to attract and retain top talent for your startup – which might make you lean towards offering equity to all employees.

But, at the same time, the more employees have equity, the more diluted ownership of the company becomes, which can be a downside for founders.

There’s no right or wrong answer here – ultimately your company’s objectives, values, and compensation philosophy will guide you towards what feels fair for your employees and what will maximise business performance.

One popular approach is to offer all employees equity compensation, but with the value of that equity compensation varying depending on the role and seniority.

Common distinctions include:

• First hires. Some companies choose to give the very first hires in the company (after the founders) a set percentage of equity. It can often be quite arbitrary e.g. 1% to the first three hires, which is a bad idea. Instead equity at this early stage should reflect the level of risk the employee is taking on by joining a company in the very early days. For example, a first-time founder with very little external funding and unproven business model and no customers will most likely have to give up much more equity to early hires than a successful serial entrepreneur who has secured a high amount of external funding from reputable investors and is already seeing traction.
• Top leaders. Similarly to first hires, some companies give their leadership team a set percentage of equity – it’s common for equity compensation to be a major point of compensation negotiation for top leaders joining startups. As with those first hires, it’s important to determine the amount of equity given to top leaders by reflecting the risk for them to join your startup, particularly using the following factors as a framework: how much traction does the company have? what is the potential upside value of the equity for them? what salary are you able to offer? what is the candidate giving up by leaving their current role (including any equity left on the table due to vesting)?
• Variance across job functions and/or job levels. As with salaries, there is variance across roles and levels of seniority in what makes a competitive equity compensation offer. For instance, it’s typical for a level multiplier to apply, with employees at higher levels offered proportionally more equity compensation. And it’s also typical for product and engineering roles to receive higher equity compensation than commercial roles. For this reason, it’s vital to use reliable equity benchmarks like Ravio’s when building your equity compensation package.

More detail and expert advice on this topic can be found in our article: Should you grant equity compensation to all employees?

Do startups typically offer all employees equity compensation?

It depends! There is significant variance across Europe in terms of how startups approach equity compensation for their employees.

In France, it’s very common for all startup employees to receive equity, with 67% of companies offering equity compensation to all employees – and only 6% of companies offer equity compensation only to leadership employees or founders.

In comparison, only 26% of startups in the Netherlands offer equity compensation to all employees, whilst 17% of companies offer equity compensation only to leadership or founders.

And, alongside location, how companies approach equity compensation also varies depending on their funding stage, headcount size, industry, and more factors.

Therefore, to ensure your equity offering is truly competitive it’s important to understand what the standard approach to equity compensation is in the location(s) your company operates and hires within. To access more equity benchmarking data like this, head to Ravio to get started.

How to decide what type of equity grant to offer e.g. RSUs vs stock options

There are many, many different vehicles for granting equity to employees as part of their compensation package – all with different pros and cons to weigh up against your company’s priorities.

The most commonly used options are:

• Stock options (ISOs and NSOs)
• VSOPs
• RSUs.

Let’s take a look at an overview of the differences between these types.

How do stock options work as a type of equity compensation?

Stock options are a type of equity compensation which do not give employees actual shares in the company, but instead give an employee the right to buy shares at a fixed price, known as the strike price (or sometimes the exercise or grant price).

If the company is successful its stock will increase in value over time and the employee can therefore make money by buying shares at that fixed strike price, and selling for the actual market price of the shares – pocketing the difference as cash.

In their standard form, these stock options are known as non-qualified stock options (NSOs) and come with taxation requirements, which differ across countries depending on local laws and tax policies.

In the UK, for instance, the following taxation applies to NSOs:

• Employer pays national insurance tax when the employee exercises i.e. buys the shares
• Employee pays income tax when they exercise the shares, on the difference between the strike price and the actual market value
• Employee pays capital gains tax when they sell the shares, on the difference between the market value at exercise and the market value at sale.

However, many countries also have very tax favourable stock options schemes – which tend to be the most popular way to offer equity for employers.

For instance, in the UK, the government’s Enterprise Management Incentive (EMI) scheme is tax favourable both for employers and employees:

• The employer is not taxed at all, and may even eligible for corporation tax deductions by using the scheme
• The employee is not taxed at exercise. Capital gains tax still applies at the point of sale, but the employee may qualify for reduced rates under Business Asset Disposal Relief (BADR).

However, EMIs do have restrictions, for instance only UK companies with under 250 employees are eligible for the scheme, so they are not accessible for all companies.

Other examples in the European market include Bon de Souscription de Parts de Créateur d'Entreprise (BSPCE) in France, the Key Employee Engagement Programme (KEEP) in Ireland, Qualified Employee Stock Options (QESO) in Sweden.

How do VSOPs work as a type of equity compensation?

Through a Virtual Stock Option Plan (VSOP) an employer can give virtual shares (also known as phantom shares) to an employee along with a nominal strike price – enabling the employee to be financially rewarded if the startup is successful, without granting them actual shares and giving them an ownership stake in the company.

Virtual shares are typically granted under a vesting schedule, as with real shares.

At the point of a liquidity event e.g. IPO (many VSOPs have the condition that virtual shares are only paid out at company exit), the virtual shares are converted into a cash benefit with the employee paid a cash equivalent to the market value of their virtual shares at that point, minus the strike price.

Taxation requirements apply for both employer and employee when the virtual shares are ‘sold’ i.e. converted into a cash benefit. In the UK, for instance, the employer will pay national insurance tax and the employee will pay both income tax and national insurance on the cash benefit.

How do RSUs work as a type of equity compensation?

Restricted Stock Units (RSUs) grant employees actual shares of the company’s stock – unlike stock options which give employees the right to buy shares at a certain price later on. However, they are ‘restricted’ because the stock is not actually owned by the employee until it has vested.

Vesting occurs over a designated period of time (the vesting period), with the stock ‘restricted’ until that vesting period has elapsed. There’s more information on vesting in the next section of this guide.

With RSUs there is no strike price, instead the employee simply makes money by selling the shares they have been granted – especially if the company’s shares increase in value between the time they vest and the time they are sold.

Taxation requirements apply, but at the point that the shares vest and/or are sold – rather than when the shares are exercised, as with stock options.

In the UK, for instance, the following taxation applies to RSUs:

• Employer pays national insurance tax when the employee’s shares vest
• Employee pays income tax on the ‘fair market value’ of the shares when they vest
• Employee pays capital gains tax when they sell the shares, on the difference between the market value at vest and the market value at sale.

Again, some countries have tax favourable schemes available for RSUs.

In the UK, for instance, both Share Incentive Plans (SIPs) and Save As You Earn (SAYE) are schemes which offer tax favourable conditions for both employer and employee – but in both cases may require the employee to put in money upfront to pay for the shares, which can make them a less attractive option.

How to decide the vesting period for your equity compensation offering

In equity compensation, vesting is the legal process of transferring ownership of shares from company to the employee.

Typically, vesting takes place gradually over a pre-determined period of time (the vesting period), incentivising employees to stay with the company until they have gained the full benefit of their equity compensation. Therefore, a longer vesting period can be good for employee retention, but a shorter vesting period can be attractive for the employee.

There’s also typically a set cliff within the vesting period, a period of time which must pass before the shares start to vest, ensuring that the employee is a good fit and contributes to the company before they actually gain equity.

Within the vesting period, shares will vest at regular points (the vesting frequency), typically monthly, quarterly, or annually. For potential employees, a more frequent vesting schedule is more attractive, meaning that they’re less likely to leave equity on the table if they do end up leaving the company before the end of the vesting period.

The vast majority of companies opt for a 4 year vesting schedule with monthly vesting and a 1 year cliff – meaning that the employee has to stay with the company for a year to be eligible to receive their equity compensation, and will own their designated equity in full if they stay for four years.

It has also become a bit of a trend for the big names of the tech world to switch to a much shorter vesting period, so you may come across this too when deciding on your vesting schedule.

Removing the cliff entirely is one option, like Doordash, or switching to a one-year vesting period for new equity grants like Coinbase, Lyft, Stripe.

Both are ways to shorten vesting and therefore increase the competitiveness of the total compensation offering (though there are also downsides to a shorter vesting period for employees to be aware of).

How to decide the exercise window for your equity compensation

For both stock options and VSOPs, you also need to define an exercise window: the time period in which the options can be exercised.

Because stock options and VSOPS represent the right to buy shares in the future, rather than actual company shares, they are typically granted with an expiration date, after which this right can no longer be exercised and so the equity becomes worthless for the employee.

The market standard exercise window tends to be 10 years – but there can be variance on this from company to company.

The balancing act to consider here is:

• A short exercise window is seen as unfair for employees as it’s less likely they’ll actually see financial gain from the equity compensation, so could impact your hiring or retention
• A long exercise window comes with risks for the company, especially if the company is subject to any reporting or tax withholding obligations

How to decide the post-termination exercise window for your equity compensation

You should also decide on a post-termination exercise window.

This is essentially the same principle as the normal exercise window i.e. a set period of time that employees are able to exercise their right to buy shares, but specifically for employees who choose to leave the company.

The post-termination exercise window can be driven purely by regulatory requirements for some companies. For instance, if employees are granted EMI share options (a tax-advantaged government scheme) they must exercise within 90 days of leaving employment to avoid losing the tax benefits of the scheme.

On the other hands, some companies set their own, arbitrary post-termination exercise window.

Historically in the tech startup scene it has been common for companies to require employees to exercise their options within 90 days of employment ending, regardless of any regulatory requirements.

This penalises departing employees, who are faced with a choice between:

• Not exercising their options, and leaving the potential cash value of the equity on the table
• Exercising their options, meaning they pay the costs of exercising and the tax on exercising, for stock that is not yet liquid and has no guarantee of ever being – this is known as ‘dry taxation’.

Typically this results in employees not exercising their options, which is unfair.

In more recent years may startup employees have spoken out about being burned by these ‘90 day exercise windows’, and this has started a trend of startups offering more generous post-termination exercise windows.

As one example, entrepreneur Ali Khajeh-Hosseini was burned by the 90 day window at RightScale and missed out on the upside of his equity compensation, and has since implemented a 10 year post-termination exercise window at his latest startup, Infracost.

How to calculate a new hire equity grant

Once you’ve decided on your overarching equity philosophy – how much equity to set aside for employees, which employees will receive equity, for what reasons (new hire vs refresher), in what form, and with what vesting requirements – all that remains is to determine how much equity compensation an employee should actually receive when they join the team.

So how do you do that?

Well, looking at market data for equity compensation, it quickly becomes clear that the typical equity grant varies significantly, with the target percentile, job role, job level, industry, company stage, location being the main determining factors.

Which means that you need a framework for making fair and consistent decisions on equity compensation for each new hire (and for refresh grants too if you offer them).

Let’s first take a look at some examples from Ravio’s equity benchmarking data to see exactly how typical equity compensation can vary across these factors – and then we’ll explain how this can help you build an evidence-based framework for awarding equity to employees.

How does equity compensation vary across roles, levels, and locations?

Using Ravio’s equity benchmarking data for a company valued at £80 million with a share price of £3.00 and a strike price of £0.01 (see note above), a P3 software engineer (an established individual contributor, read about the Ravio level framework for more detail) at a typical growth-stage startup in the UK which targets the 50th percentile offers a new hire equity grant at 8.5% of the base salary of (£66,900 at the 50th percentile), which totals £5,700 in equity per year over a typical 4 year vesting period, or £22,900 total, for this role and level.

For a company with the same profile but which targets the 75th percentile, the typical new hire equity grant is higher: 13% of the base salary (£74,100 at the 75th percentile) totalling £9,600 in equity per year or £38,600 in total over a typical 4 year vesting period.

Of course, it’s also possible that a company would offer 75th percentile equity compensation but 50th percentile salary.

For those same growth-stage UK startups, new hire equity grants for P3 account executives in sales are slightly lower than for software engineering, with the typical grant being 6.5% of base salary (£49,600 at the 50th percentile) totalling £3,200 in equity per year, or £12,900 in total over a typical 4 year vesting period.

It’s worth noting, that whilst the base salary and equity offer for sales roles is typically lower, it is standard for these roles to have variable compensation in the form of commissions or bonuses.

Equity compensation typically increases with job level, in the same way as salary. For instance, the typical equity offered to an M4 software engineer (director level) at that same UK growth-stage startup company profile is 13.4% of base salary – considerably higher than the equity compensation for the P3 software engineer.

And the market standards for equity compensation also differ depending on the company stage. We’ve seen that the market median new hire equity grant for a P3 software engineer at a UK growth-stage startup (series A or B) is 8.5% of base salary. At a UK late-stage startup (series C and beyond) the median new hire equity grant for this role is 15.1% of base salary at the 50th percentile – significantly higher.

For early-stage startups (pre-seed or seed) the market median new hire equity grant is around 4.5% of the base salary for this role (roughly £11,300 in equity per year or £45,200 in total over a 4 year vesting period). It’s also typical for equity compensation to be granted as a percentage of ownership in the company rather than a percentage of base salary at early-stage startups – with the standard for this role being to offer 0.0141% ownership, but this can vary significantly depending on the company’s valuation and approach.

So, as you can tell, there is significant variance in typical equity compensation – which is why it’s important to have reliable equity benchmarks like Ravio’s to hand when you’re deciding how much equity compensation to offer each of your employees.

Using equity benchmarks to decide your framework for awarding equity compensation

As we’ve seen, equity compensation varies across roles, levels, locations, and more. This means that even if you’re opting to grant equity compensation to all of your employees, it’s unlikely that you want to offer them all exactly the same amount of equity.

Equity benchmarking data like that above is therefore invaluable to help you decide on a decision-making framework for awarding equity compensation to employees in a fair, consistent, and market-aligned way for their role.

There are two ends of the scale on how to do this.

Some companies opt for a very granular and detailed framework which breaks down exactly what range of equity compensation is possible for each role, seniority level, and location within the organisation structure (which could be in terms of actual £ grant value, a % of base salary, a % ownership in the company, or actual number of shares) – which ends up looking something like a salary band structure, but for equity.

Others opt for a more simple approach, using a base salary multiplier which varies depending on factors like the job level of the employee or their role (e.g. in a tech startup you might opt to offer engineering employees more equity than commercial).

A rough example of what this might look like is in the table below:

This decision-making framework should be applicable both for new hire grants for new employees and refresh grants for existing employees (if you offer them) – ideally you should be able to easily increase an employee’s equity as their job level increases, to reflect that market data and stay fair and competitive.

As it stands, most companies don’t have a particularly scientific or best practice approach to determining the actual equity compensation offer for an individual employee. Approaches that companies take vary wildly, and in most cases it’s (at least to some extent) a case of a finger-in-the-air ‘this seems fair’ figure that is offered to a new hire

This means that simply by establishing this kind of framework you have an opportunity to truly set your employer brand apart in terms of the rationale behind your equity offers – enhancing the fairness and consistency of compensation as well as making it much easier for employees to understand their equity compensation.

How to communicate about equity compensation to employees

Once you’ve determined the equity compensation offer for a new employee, you need to tell them about it!

There are two key sides to this:

1. Including an equity grant agreement with the employment contract – we’d recommend consulting with your lawyer on what needs to be included.
2. Ensuring employees understand how equity works and the value of their equity compensation.

Let’s take a closer look at the latter.

How to communicate the value of equity compensation to employees

We often hear from founders and people leaders that employees struggle to grasp the value of equity as a form of compensation. With equity a big part of how startups reward their employees’ contributions, it’s important to overcome this.

This isn’t an easy task.

As we’ve said, equity is a complex topic in the first place. At the same time, the value of equity also fluctuates and changes throughout a startup’s journey. Plus, some companies may offer equity refresh grants as part of their performance and progression structure – all adding further complications.

Here’s a few ideas on how to communicate the value of equity compensation to employees:

• Organise equity 101 education for employees. Support employees with understanding the basics of equity through an upskilling exercise. Depending on your internal comms preferences, this might mean providing written resources and FAQs as part of the onboarding process, or an all-hands presentation that is recorded to refer back to, or something else.
• Include equity in company updates. Don’t think of equity as a ‘one-and-done’ topic of conversation for your team – great communication means ensuring regular touchpoints and opportunities to discuss and ask questions. And given that equity compensation is tied to company success, it can be useful to include an equity update within your company updates on e.g. funding rounds, valuations, future plans for liquidity events – what does this mean for the value of each employee’s equity compensation?
• Include equity in performance review conversations. We’ve seen throughout this guide that market standard equity compensation varies depending on the job role and job level, so many startups include increases in equity compensation (usually known as equity refresh grants) as part of career progression – if that’s true for your company, make sure you’re communicating about the value of increased equity throughout the performance review cycle.

We’ll be exploring strategies for communicating about equity with employees in further detail in future blogs – including advice from expert people leaders on their own experiences offering equity as compensation. Make sure you’re subscribed to our newsletter to be notified if this topic is important to you.

In this final section of our startup equity compensation guide, we cover answers to the most commonly asked questions when it comes to equity compensation – including simple definitions of some of the equity jargon you’ll come across, from dilution to vesting to strike price, and many more.

Many of these we’ve already touched on within the guide, but this section gives you more info and an easy reference point to come back to or to direct your colleagues and employees to when these equity-related questions arise.

1. What is equity compensation? A simple definition
2. What is dilution in equity compensation?
3. What is vesting in equity compensation?
4. What is a cliff in equity compensation?
5. What is a strike price in equity compensation?
6. What is an equity refresh grant?
7. What is a cap table?
8. What does it mean to exercise your shares as an employee?

1. What is equity compensation? A simple definition

In very simple terms, a startup’s equity refers to the ownership of the company.

A common analogy is to imagine equity in a startup as a cake or pie. The pie represents the whole company, with slices cut out of the pie as equity or ownership in the company is given to other people or entities – and those slices can be different sizes too.

If you start a company as a sole founder, you will initially own the business in its entirety and therefore have 100% of the equity.

In this instance, the sole founder has 100% of the pie.

If you’re a group of three co-founders, ownership and equity is initially split between the three of you. It might be an divided evenly with each founder holding 33.3% equity.

Or it might be divided unevenly to acknowledge, for instance, that one founder will contribute more time or work into the company (known as a dynamic equity split) – or simply to give a decision-making mechanism when difficult decisions need to be made and founders are split.

If you decide to raise funds through venture capital, some of the equity in the company is given to the investor(s) in exchange for cash to use to build and grow the business.

The investors are making a calculated bet that the startup is successful and the equity they own will become much more valuable than the cash investment they put in.

When you start hiring additional employees to work on the startup, you might decide to also give those employees equity in the company.

This is equity compensation – employees are granted an ownership stake in a company as a form of payment for their work. If the startup does well and increases its value over time, then the equity the employee owns will also increase in financial value.

2. What is dilution in equity compensation?

Dilution refers to a decrease in equity or ownership for existing company shareholders, occurring when the company issues new shares.

When new shares are created or issued it means there are more shares in existence than previously, and so each of those shares represents a smaller percentage of ownership in the company.

So, in the very early days of a startup the company may be owned entirely by the founders – three founders with a 50/25/25 split, for instance.

If that company then decided to raise a seed round of VC investment and exchange 10% company equity for cash to build the business with, then the percentage ownership of each founder will be ‘diluted’ to allow for this.

And the same is true if the founders decide to offer equity compensation to employees. They might opt to set aside a 10% employee equity pool, which then further dilutes their percentage ownership.

Later investment rounds, and eventually the public sale of shares, will further dilute the proportion of equity for all existing owners.

However, dilution does not typically mean an actual reduction in the value of the equity – because the value of the company should continue to increase at the same time, so each individual share becomes worth more.

3. What is vesting in equity compensation?

Vesting is the process of transferring legal ownership of something from one person or entity to another – so in equity compensation vesting refers to the transfer of shares from the company to the employee.

Vesting typically takes place gradually over a set period of time to incentivise employees to remain at a company, with the employee only owning the equity, and therefore the ability to exercise it, once fully vested. This is known as the vesting schedule.

There are three key elements that go into a vesting schedule:

• Vesting period: the overall length of time between an equity agreement being made with an employee and the point at which the designated shares have fully vested and ownership has 100% transferred to the employee.
• Vesting frequency: how often shares vest within the vesting period i.e. how often a percentage of the total designated shares are transferred to the ownership of the employee – typically monthly, quarterly, or annually. For potential employees, a more frequent vesting schedule is more attractive, meaning that they’re less likely to leave equity on the table if they do end up leaving the company before the end of the vesting period.
• Cliff: a period of time which must pass before the shares begin vesting, ensuring that the employee contributes value to the company before they receive their equity compensation and to account for mishires, underperformance etc in the very early days of employment.

The vast majority of startups opt for a 4 year vesting schedule with a 1 year cliff and a monthly vesting frequency.

4. What is a cliff in equity compensation?

Cliff refers to a period of time defined by the employer which must pass before an employee’s equity begins vesting i.e. they gain ownership of the shares.

This is primarily to ensure that the employee contributes value to the company before they receive their equity compensation and to account for mishires, underperformance etc in the very early days of employment.

The most common cliff is one year, which means the employee must stay with the company for one year before their equity starts vesting.

5. What is a strike price in equity compensation?

The strike price is the pre-agreed and fixed price it will cost the employee to buy one share in the company when they exercise their equity, also known as the exercise price.

It’s included as part of the equity grant agreement when equity is granted as stock options – with stock options employees are given the right to buy shares at a fixed price. If the company is successful its stock will increase in value over time and the employee will make money by buying their allotted shares at the fixed strike price and selling them at the market price.

Designated strike prices vary from company to company, but they’re typically determined by the company’s share price at the time an employee joins the company (also known as the fair market value). Companies will typically, therefore, adjust their strike price for new employees as the company grows and its valuation changes.

6. What is an equity refresh grant?

An equity refresh grant is when additional equity compensation is issued to an employee who already has equity in the company, as a way to recognise and reward the employee’s performance – similar to a performance increase of salary.

The initial equity compensation offered to an employee as part of their job offer is typically known as a ‘new hire equity grant’. An equity refresh grant would issue additional equity on top of what was agreed within their new hire equity grant.

7. What is a cap table?

A cap table is a document which breaks down the ownership of a company: who has equity in the company, what percentage ownership they have, and what share class they own – companies can have several different classes of shares with different ownership rights attached to them.

This includes equity granted to employees as equity compensation, so cap tables are an important part of equity management.

8. What does it mean to exercise your shares as an employee?

In simple terms, to exercise your shares means to buy those shares.

When employees are granted equity compensation it’s typical for a vesting period to be in place, which means that the ownership of the equity is gradually transferred from the company to the employee over a set period of time (typically 4 years with a 1 year cliff).

Only equity that has vested can be exercised i.e. converted into actual shares in the company, and once exercised the shares can be sold and converted into cash.

In the case of stock options where the equity agreement gives employees the right to buy shares at a fixed strike price, exercising the options means actually buying those promised shares at the strike price, giving the employee actual shares in the company.

In most cases, employees are restricted by the need for a liquidity event to occur before they are able to exercise their options – IPO, merger or acquisition, and tender offer being the main liquidity events in a startups lifecycle. This restriction is put in place to prevent employees selling shares in the company on to external parties, who would then be on the cap table of the company and have ownership rights.

Most companies also include a post-termination exercise period (PTEP) in their equity grant agreement documentation.

This means that if an employee leaves the company, they have a set window of time e.g. 90 days in which to exercise their options, otherwise they will expire. It’s also typical for the equity to stop vesting immediately when an employee’s contract is terminated.