Most startups have a reputation for being cash-strapped. They want to reinvest the majority of cash inflow back into improved services and broaden their base.
Thus, the compensation at a startup is structured differently compared to a matured organization.
Startups usually offer low salaries & employee benefits along with a higher proportion of the equity in their growth stage.
This article will highlight the common differences between the compensation types offered at a startup and help you decide which offering is better for you.
Equity Compensation vs Salary Compensation
Decide whether salary or equity is better for you in the short term and in the long term. You can do whatever you want with your salary, which makes it the simplest to manage.
Determining equity is a lot more difficult; It’s like betting on the future success of the company when you own stock in it. As an employee, you can think of yourself as a VC that accepts equity as payment for the services you provide to the company.
A (partial) salary replacement for employees is stock ownership in the company. These are the two main kinds of compensation that an employee can be offered when joining a startup: equity compensation and salary compensation.
What is Equity Compensation in a Startup?
This is a non-cash compensation that gives you a part of the company’s ownership. This allows various private and public companies to safeguard their cash flows and put them to use towards the company’s growth.
Various startups also use this as a means to reward the employees who perform well. This also keeps their motivation levels in check and ensures their loyalty towards the company.
These equity percentages depend significantly on the financial outlook and net worth of your startup. Each kind of equity compensation comes bearing a unique benefit and challenges alongside.
Types of Equity Compensation
While getting equity compensation does confer a percentage of ownership towards company stock, it is further bifurcated into various types. It is offered as per the policies set up by the company.
- Employee stock options: This is the most common type of equity option out there, which lets the employee purchase a certain amount of the company share at a predetermined price, often referred to as the strike or exercise price. One needs to wait for a pre-decided waiting period known as the vesting period to carry out the purchase. In most cases, this period lasts between three to five years. Stock options provide a good range of leverage and have some extent of risk added to them. Make sure you carry out a 409A valuation to analyze the exercise price correctly.
- Restricted stock: This stock is also called letter stock or fixed securities. As the name suggests, this type of stock cannot be transferred completely unless and until you meet some restrictions which the company sets. For instance, these restrictions can be related to a particular work timing or performance.
More or less, you can consider this kind of stock as an additional bonus reward instead of cash. This option is especially favorable to company executives due to its benefits in the domain of income tax treatment and accounting rules. This stock type is further bifurcated into restricted stock units and restricted stock awards.
- Employee stock purchase plans: This purchase plan lets employees buy a company’s share at discounted rates. Furthermore, these stock options are capped to a specific limit per employee annually ($25,000 in most cases). An employee can buy these units by utilizing their payroll deductions. Employers often use the funds that they have saved to purchase stock for their subordinate employees.
Pros and Cons of Equity Compensation
Getting an equity stake in a company might sound exciting, but everything has specific terms and conditions when it comes to stock redemption. It is worth noting that no employee ever gets the equity but only gets access to employee stock options, allowing them to purchase equity at a heavily discounted price.
This also means that if the company does well in the future, there’s a high probability that these stock options may return in the form of a big payday at the end, which won’t happen in the case of a regular salary.
With all the pros aside, let us also discuss the pitfalls of this kind of offering. First and foremost, the buyers are left vulnerable to the market’s and company’s performance. There isn’t any guarantee of performance which further increases the risk. You might end up suffering from a substantial stock crash if your company doesn’t perform well.
Equity compensation also comes with a vesting schedule, which means that you cannot leave the company unless you are also willing to let go of those stocks. In some cases, these benefits are also forfeited if an employee is fired, which you need to be aware of.
Lastly, even though it may seem like cashing out these stock options may yield a considerable payout, people often forget the tax deductions, which take up a sizable chunk of the payout.
Example of Equity Compensation
Let’s say that you get a new job in a newly formed startup. They may offer you equity compensation based on your role and the performance that you put on the table. Employers often promise a significant payout to newcomers if the company does well and may also use these stakes as a reward for good performance.
Keep in mind that each form of compensation will have different tax consequences, and the kind of equity compensation you get is based on how your employer has structured it.
If you want to cash out the stock later, you must know and study through all the tax implications. For instance, you might even have to pay taxes if your company’s share price goes down once you exercise your options. Thus, we recommend you cash in the shares at the right time so that you can generate a real return.
What is Salary Compensation in a Startup?
Salary Compensation is the sum of an employee’s base salary, bonuses, and other compensation for performing a specific job role. Health insurance, bonuses, retirement contributions, incentives, and short-term disability insurance can all be included in the salary compensation package. This kind of compensation is generally advantageous as it doesn’t fluctuate with the market fluctuations.
Pros & Cons of Salary Compensation
First and foremost, certainty and security. When you know the amount of money you will be getting in hand in a particular time frame, you can plan your finances accordingly without worrying about any fluctuations. Simply put, a steady pay structure lets you plan your future without any worries.
However, with a lower risk come fewer rewards. With these payouts, there isn’t any opportunity for a greater benefit in the future. Even though the employment structure has better posts that offer high employee salary ranges, you cannot benefit from your company’s progress.
Example of Salary Compensation
The base pay you get in a startup without any additional stock or equity benefits is an excellent example of salary compensation. The only way you can move up the ladder is by working hard and getting promotions.
In the case of a well-known private or public organization, compensation might even grow beyond the base paycheck. This is achieved by offering transportation costs, health plans, bonuses, etc.
How to Decide between Salary Compensation and Equity Compensation
Having access to additional salary options when joining a company is always beneficial. But with so many types to choose from, the decision might become a bit confusing for some individuals. Keep these points in mind when evaluating your offering:
Lower or High Salary Offer
Industry analysis suggests that the inclusive equity offers are often lower than the standard pay for a particular role. Even though you get a great learning experience at a new startup, lower salaries are often expected.
In this case, it is only wise if you determine your expenses and then decide the minimum amount of money you need in order to survive. Your expectations can also vary by the city you live in or the industry you are working in.
As mentioned above, all the equity offers will require you to stay at the company for a specific time before you can start purchasing shares or cash them out. In case you plan to relocate or leave the job, then your equity options with a long vesting period will not be of great benefit to you. Thus, keep your future plans in order before agreeing on a settlement.
Beliefs and Trust in the Company
Since the magnitude of your final payout depends largely on the company’s market valuation, you must study the company well and have a strong belief in its prospects.
Carefully think about the working of the company and analyze the service that they are offering. You can also consult a venture capitalist to tell you better about the exit value of your investment.
Alternative with better Financial Sense
If a company has given you two different packages, one with a simple compensation and the other with equity, it is always advised to take a moment and see the difference in the value of both offerings.
How Should Employees Negotiate their Startup Offer?
Before negotiating your compensation at a startup, there are certain pointers that you should keep in mind. They are as follows :
Know Your Market Value
Know your worth before you apply for any job offer. You can leverage online tools like PayScale or Glassdoor to get a glimpse into the average proposition in the post you are interested in. Doing your research beforehand can often save you from undervalued positions.
Provide a Salary Range
Have a range in mind when answering the hiring managers for your expectations with a specific role. Make sure all your expenditures and expenses like 401k (a retirement plan which allows employees to save a certain part of their salary) and travel can be reimbursed within this pay. Giving a range will also demonstrate some flexibility and will give room to specific negotiations during the hiring process.
Consider the Whole Package with Equity
You need to weigh in all the add-ons, not just the base pay offered. For instance, your company might even cover health care, retirement funds, equity compensation, etc. Never hesitate in asking when making such negotiations.
Ensure Your Pay Increase with Funding
Remember to sign a written contract that states that your pay will increase as the company’s market value goes up if you are offered an equity-mixed pay in a newly formed startup. A low salary is often offered in order to compensate for a smaller cash inflow.
Figure Out which One’s for You
A salary in a startup offers a greater degree of security than equity as it lets you have a fixed sum in mind. However, there is a slight risk to this.
In case your company crashes, you will be left with deductions, and even your employment could be terminated in some instances.
If things work out well, having a large equity stake can bring significant benefits for an employee in the long run.
One more key takeaway is that if you join a company early, then your benefit percentage is also significantly higher as you can purchase a high number of stocks at a low price.