Congratulations on your decision to join the world of startups, where the benefits appear to be endless. Between ping pong tables and arcade cabinets in the break rooms, a fully stocked fridge of food and drinks provided by local restaurants never having to dress up in suits and ties and potentially becoming your own boss, there’s no doubt that they have their perks. Probably the best part of all of this is the fact that you’re about to become a part of a company that could be worth millions, if not billions of dollars.
This is where equity becomes important. Simply put, equity is the value of the shares issued by the company, and is the bread and butter of all startups. If you’ve got equity in a company then that means you’ve invested in it, and you’re helping it to grow. It brings incentive for founders and other investors to increase the company’s overall value. In short, the more the company itself is worth, the more potential profit in your pocket.
Thing is, you can’t get rich quick with equity. Really, there are a lot of risks involved with it, and each investment of yourself is going to be a different experience. You should never invest in any type of company before you do your research. A wrong investment could cost you dearly. Below are some important factors to consider before you make any type of commitment.
Picking the Right Company
No matter what, at the end of the day an investment is a risk. That risk is what places value on the investment, though, meaning that the payoff is entirely dependent on the level of risk. You buy equity with your cash, but your time and effort are what is going to pay off. You’re going to look at the risks and compare them to the possibility of growth.
Anyone that receives equity compensation should take a moment to evaluate the company and the equity offer based on their individual assessments. Look at the company’s capital and how they valuate themselves. What is the long-term debt of the company, and how does that compare to the shareholder equity? What is the company initially valued at, and how does that company plan on increasing that value? Few companies will simply share some of this information to the public, but you can look at trends to figure some of it out.
Honestly, most startups end up failing. They can start off with really good models, but a lot of the time they either can’t handle a fast rate of growth or they grow too slowly and therefore run themselves into the ground, failing before they even cross the starting line. You may want to invest in a startup, but you have to be aware of these major risks. You should walk in under the assumption that they’re going to fail. It doesn’t sound pleasant, but it’s the truth of the matter.
Now that isn’t to say you should avoid startups, especially considering that every major company you know and love (or hate) today were once one of these startups. Look at companies like Facebook, Apple, Microsoft, etc.. Almost all of them can be traced back to a couple of individuals bouncing ideas off of one another over a slice of pizza. All this mentality means is that there’s a bigger picture to keep in mind. The potential profit from equity shouldn’t be the only reason that you invest. Investing means risk taking, but the damage those risks could do can be minimized if you keep in mind the factors below.
Why Should You care About Exit Strategies
If the money ship is sinking then you’re going to want an exit strategy to escape your failed investment. Don’t sign any agreement until you’ve spoken with the founders and asked about their long term exit strategies. Are they planning to sell at any point? Will they be going public anytime soon? A high valuation exit means a high equity pay. You might not receive any profit though if it isn’t good. Some exit strategies may be:
- Merger & Acquisition: Companies often times form unions with similar, even rival companies. The equities can gain some great value since two companies are joining together, combining their resources. It’s a fast way for companies to grow, and risk is often minimized this way.
- Initial Public Offering: This was the preferred path for a while, however in 2000 the internet bubble has caused this to drop to about 15%. There’s good reason for the shareholders to become unsure over this. It’s not the best thing for startup companies.
- Liquidation and Closure: There will always come a day where a company must make a difficult financial choice. Sometimes variables outside the realm of control, like natural catastrophes or changes in the market can force the company to liquidate. You should know ahead of time what the rules are so you don’t waste your investment.
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Percentage of Ownership
It’s not enough to simply put money into equity and expect to get all of the profit. Others have done the same thing, so you’ll want to know what your percentage of ownership is. What are the total shares outstanding with the options being offered? While you’ll probably never own a majority share, there’s definitely a chance you’ll support a company with enough shares on offer for you to have a direct influence on them and the direction they go in.
Along with that, that percentage of ownership can change depending on certain factors. An employee that works part time will have much lower ownership percentage than a full time one. You might decide at a later date that you don’t want to be investing quite so much, and your percentage of ownership will lower with your investment change, and the same will happen on the opposite end. You should keep all of this in mind when you’re making any sort of exchange.
Are Stock Options Available?
Time to find out what type of equity you’ll be receiving, and these come in the forms of stock options and restricted stocks.
The most common type of employee equity will be stock options. This allows you the rights to buy stocks at a predetermined price known as the strike price. Your price will be based on the fair market value at the time the options are given. The idea with these is to avoid being “in the money”.
Being “in the money” means the strike price and the fair market value are the same. This value will increase or decrease over time, depending on how well the company itself is doing. Let’s say you buy stock today at $1 a share, and then sell it back, you’ve made $0 because you didn’t allow it to grow in price. On the other hand, if you wait for a year the value could rise to $11 and you’ll end up with a $10 profit. Pretty straightforward, right? Thing is, who says that stock won’t get instead? If you bought that stock for $1 and over time that stock’s fair market value drops to $0.87, then you’re losing money on that stock. It’s a game of give and take, and it’s constantly changing.
You may also be offered restricted stock. These stocks, given often as a part of employee pay, will be only partially under the employee’s control unless they meet certain conditions. This isn’t always a bad thing, but they generally are limited in their value, even if the conditions are met.
The Importance of Watching the Taxes
You should expect the IRS to treat your equity like the rest of your income and yank their percent (10%-40%) of it out of it. However there are unique rules and regulations regarding taxing equity, so be sure that you know them. The company you invest in should be able to answer some of your questions, however a tax professional will be a better choice, as their job centers around them knowing and understanding all of the current laws and regulations.
Often employees will be given Incentive Stock Options (ISOs), and these can confer tax benefits, assuming you meet the holding requirements. These are great when you later use your options and sell them at a profit.
Understanding the Vesting Schedule
Every company has their own vesting schedule, so it’s important to get the finer details of that schedule beforehand. This helps you determine exactly how much of the company you own. Vesting means that you’ll gain more and more equity grants over time. Chances are the shares a company grants you won’t be able to be cashed in instantly. You have to continue to work with the company to earn full equity. If the company grows then those stocks will grow in value, and by the time you’re able to sell they should make for a great profit.
On average, most vesting schedules are about five years, with a four year vesting period and a one-year cliff. This cliff is the period where you don’t vest during the first year of your employment with the company. This means that if you walk away during that year then you sacrifice your shares. This is to prevent any dangerous or negative employees from holding onto pieces of the company once they’ve left, or been forced to leave.
You’ll have a better idea of the risk your investment means if you know the vesting period of the company. Companies that have a longer cliff period are ones you should avoid, as that is a major red flag.
What is Share Selling?
You have two options after you’ve met all of the vesting requirements. You can hold onto the stock until an exit event, or you can sell it in a private transaction, either to outside investors, or back to the company itself. You should have those options while remaining within federal law and company policies. This is your profit in your hands, so you’ll want to be aware of all of the rules and regulations a company has when it comes to that vested share. If you put in your time and effort doing everything else, only to realize you can’t sell those shares and make some money, then all of it was thrown away.
Business Valuation Vanzant Missouri 