Startup Compensation: Salary vs Common Stock vs Preferred Stock vs Options

Entrepreneurship has grown in popularity amongst recent college graduates. My startup recently joined a office space incubator in Chicago and I spent the last week discussing various topics with fellow entrepreneurs and investors. One of the topics that drew the most confusion amongst my peers and their employees revolved around compensation.

In a series of four posts, I want to go through compensation strategy. This post focuses on the securities and methods commonly used to compensate startup employees. The intention for entrepreneurs to understand their capital options and employees to determine how much they’ll be paid.

Whether you are deciding compensation or considering accepting it, use this equation: Compensation = Salary + Stock + Terms (negative value). After understanding all three factors, research the comparable salary in a public company to determine if the offer is fair.

Salary
Cash has the least risk because you know it’s worth and it is liquid. Since startups are risky, the only guaranteed money you have is the money already paid out. Since startups don’t have a lot of cash and are still growing revenues by reinvesting gains, companies may offer royalties to developers or commission amounts to salesmen with a cap. While these should be counted as salary, I would discount them by at least 50% because in each of the cases your success is dependent on several other people in sales or development performing their job in a timely manner.

Here is the formula I would use to calculate the minimum salary required: Rent + Food + Living Expenses + Taxes = Minimum Salary Required = Cash + 0.5 (Commission or Royalties). Note, the 50% is generous discount rate (can be larger) and dependent on your situation. If you aren’t getting a reasonably predicable salary, pick a different job or lower your standard of living.

Common Stock, Preferred Stock, and Stock Options
Equity is one of the attractive features of startup culture; however, it is also what makes compensation risky. Few ventures exit; and without a liquidity event (e.g., IPO or acquisition), equity is worthless.

Normally, common stock is awarded to workers and preferred stock is given to investors. In the case of a liquidity event, preferred shareholders will get paid first. Hence, common stockholders in startup which have raised significant amounts of capital must be wary of the preferred shares capitalization and the estimated exit value to understand the amount they will receive: Exit Value - Debt - Total Preference = Residual Common Stock Value. The more money the company raises, the higher they will need to exit.

Capitalization = Shares Outstanding x Price Per Share. This equation is relevant when understanding your common stock portion as well: Your Current Ownership % = # of Shares Granted to You / Total Capitalization. You will be offered a number of shares or a percentage of equity at the appropriate valuation. If a startup is hesitant to provide you with any of this information, don’t work there.

Preferred stock will have different different series (A to Z) depending on the round of capital raised. Typically, before or during Series A, employees will receive restricted stock because their equity percentages tend to be bigger. Ask to see the founder’s agreement and ask for the early execution clause to receive shares at a lower cost basis. Finally, file a section 83b Election within 30 days with the IRS. Additionally, long-term capital gains tax on stock in the USA is 15%.

Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs)
Another type of equity is options. Most companies will have an options pool used to grant equity incentives. These can be thought of as call options which are exercised at a particular strike price and particular date. These are the securities that minted several hundred millionaires in Google and Facebook IPOs.

At the same time, options can bankrupt a person. For example, a company is worth $10M when options are granted to an employee with 0.75% options equity at an $1 strike price. Options Exercise Price = %/100 * Strike Price * Company Value or $75,000 in our example. That amount has to be paid by the employee when translating to common stock. Because the company is worth $50M or 5x the strike price at the exercise date, the option holder is bullish on the company’s prospects, he/she has the money and is wants start the long-term capital gain clock, the decision to pay is made.

There are two types of options: ISO and NSO. ISOs can only be granted to employees at fair market value and are taxed at exit. Moreover, they can be treated as long-term capital gains (look into AMT IRS rules). NSOs are more flexible and is a term for any option that doesn’t qualify as an ISO. These securities can be issued to anyone, even at a lower strike price and earlier exercise date. It’s a pain for startups to issue ISOs, but employees must analyze tax advantages.

Vesting and Dilution Terms
Equity is subject to vesting or the time you receive shares and dilution or the percentage your equity is worth. Vesting is created to ensure that employees earn their equity and are incentivized to stay with the venture. Normally, there is an 1 year cliff with no vesting. From there, straight line vesting may occur monthly.

Every time a company raises money or options are exercised, equity holders are diluted. Additionally, the board can issue more shares diluting everyone. (Options Authorized + Future Investor Shares) / (Total Capitalization + Future Options Authorized + Future Investor Shares) = Dilution Factor. Know that the percent you have will decrease to make sure you get the largest share early.

At exit, (Current % Ownership + Future Vested % Ownership)/100 * Dilution Factor * Company Exit Price - Total Exercise Price = Capital Gains. Typically, options holders bet that the company will grow 5x its value in 3 years and 10x in 5 years. Negotiate for the shortest vesting and the most equity to minimize your risk.

Conclusion
Startups are called risky for several reasons. A lot of your compensation is left to chance and the key calculation you have to make is the risk factor. Hence, financially, Salary + Stock + Terms should be greater than a comparable roles compensation. If you don’t have an appetite for risk or aren’t motivated by the culture of equity, don’t accept the offer.

Lastly, I made many assumptions and am inexperienced so consult a tax account or attorney before making a decision.

Sources and Excellent Reads:

  1. Startup Equity for Employees
  2. David Naffziger’s Blog - ISO and NSO options
  3. yCombinator Term Sheet
  4. Founder Institute Adviser Contract 
  5. Venture Deals (Book on Amazon)
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Opinion: Wall Street Regulation and Compensation - AFTER Watching Inside Job

I finally got around to posting after watching Inside Job (2010). In my previous post, I discussed the debate surrounding Wall Street’s compensation and regulation. After watching the film, I’m more familiar with its main points, which accurately explain the causes of the financial crisis and identify a few of the people responsible. I recommend the film to everyone seeking to learn the basics of the 2008 financial crisis.

Nevertheless, the film does possess its own biases. Recent events demonstrate that that the economy still hasn’t stabilized and many of the issues haven’t been resolved. The European Union debt crisis, Dodd-Franks’ Bill debate, big bank balance sheets, and the Occupy Wall Street protests are all connected to the regulation and compensation debate.

In this post, I express my opinion after watching Inside Job and how its main points of regulation and compensation are tied to recent events. In an effort to follow the film’s chronology, I will start by talking about banking regulation. More specifically, I want to compare the Icelandic crisis to the current Greek crisis. From there I will discuss how the topic of compensation is portrayed in the movie and connect it to a book I recently read. Finally, I’ll give my own point to view while talking about the Occupy Wall Street protests.

Banking Regulation – Icelandic and Greek Crises

Banking regulation is a complex process. Since the financial markets are directly tied to economic output, the difficult balance between regulation and efficiency have to be reached. Inside Job started with an explanation of the banking crisis that resulted when the government deregulated Icelandic banks. The film blames the banking system for taking on systemic amounts of risk that caused the nations deforestation, credit illiquidity, and the failure of many of the country’s businesses. The effect was the Icelandic citizens took matters into their own hands, refused to pay the $17,000 in personal debt incurred per citizen, and elected politicians who conducted the necessary reform.

In Iceland, the bankers destroyed the state; in Greece, the state destroyed the bankers. Italy, Spain, Portugal, and Greece left austerity to the wind by decided to spend more money than sustainable. The value of their currency fell drastically, and banks and other countries are helping to bailout the European Union. The result is slower growth around the world, pension and wage cuts, and decreased buying power for individuals.

In both of the cases, the citizens, government, and corporations all sustained losses. As with any big financial crisis, everyone suffers when a “bubble” is bursts. Historically, the loss is short-term (less than a decade) as long as there is a way to move forward through stimulus (e.g., The Great Depression 1929), regulation (e.g., The Asian Crisis 1998), and/or time (e.g., Tech. Bubble 2001).

In the case of the financial crisis in the United States, stimulus was already used, and the banks bailed out have provided a significant return on investment. Time will play a role in pricing the mortgage securities to market, and regulation has so for been weak.

The Dodd-Franks’ Bill attempts to address the problem of “too big to fail” through the Volcker Rule and other consumer protection clauses. However, many of the sections have still not been enacted and may be more adversarial to the financial industry than beneficial.

Compensation – “Damn It Feels Good To Be A Banker”

As the film continues, the director shifts his focus to the United States and Wall Street. The focus was on describing the events in layman terms while identifying the people responsible for the chain of events. For the readers not yet familiar with how the 2008 financial crisis unfolded, check this short video out. The emphasis on executives and government officials who failed to react to the numerous warning signs results in a series of interviews with bankers who weren’t sympathetic and politicians demanding retribution. There are two themes in the section: the lack of regulation following the crisis and the levels of compensation still received by top bankers.

This idea of excessive compensation is exaggerated for satirical purposes in “Damn It Feels Good To Be A Banker”. Bankers are known for receiving big bonuses. In my previous post, I explained that at the junior levels, this isn’t very generous on an hourly basis, but it is still undeniably one of the highest paying jobs an undergraduate, like myself, can get right out of school. However, Inside Job repeatedly criticizes the compensation received by the bankers following the crisis. Recently, bonus levels have been at one of their lowest levels. At the same time, banks are laying off several workers.

Moreover, the culture of greed depicted in movie and demonstrated in the book have been controversial. While this is a subjective topic, I like to think of bankers extravagant spending as beneficial to the public as economist Hayek theorized. As for the culture, that is why government regulatory agencies were created. Here is a really awesome video on greed: YouTube video.

Occupy Wall Street

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As the South Park video comically illustrates, the Occupy Wall Street movement gets quite a bit of criticism because of its name, some of the protesters actions (i.e. defacing police cars), and the lack of a unified set of goals. Nevertheless, as you can see from the banner in the top right, I support the Occupy Wall Street movement. To me the protests are a sign that Americans aren’t ignorantly complacent while regulation is added that doesn’t benefit the majority of people.

The idea of people expressing their liberties and organizing to create change is the foundation of freedom. In the sections above mainly list problems. To end this post, I wanted to provide a solution. I am no politician, but here are a couple of changes I think would benefit the American government, businesses, and people:

1. Legislation to help people who work hard to build wealth.

  •  Student loan relief – education may not stop racism, but is does improve our output as a nation. Students shouldn’t be penalized with high debt for attending college.
  •  Universal healthcare – everyone should be eligible for free basic healthcare. This would be a huge relief on the middle class and poor. There are numerous reasons to support this legislation, but if you need more look at this graphic.

2. A president who promises new advisers. Bringing in people not affiliated with Wall Street should be the ones in charge of regulating it. Inside job talked about conflicts of interest, I believe this is one of the biggest ones preventing any significant new legislation. Here are a few of the items they should address.

  •  FANNIE and FREDDIE – the government should address the systematic risks inherent in its for-profit governmental mortgage lending groups
  • Price to market – for the balance sheets of the banks to stabilize, the derivatives must be valued at their market prices. Until then, risk and volatility will remain high.
  • Stabilize the housing market – a one-time refinancing should be easier for all Americans, since many were mislead by the commercial bankers who wrote the loans.
  • Grow the jobs market – continue growing the job market through entrepreneurship and stabilized credit markets.

3. Place debt controls on our government. “I could end the deficit in 5 minutes,” Buffet explained. “You just pass a law that says that anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.” Most importantly at the municipal level of government.