Startup Equity 101: Company Valuation and Vesting Schedules
This is part 1 of my series on startup equity. See here for the intro to the series!
Before diving into the specifics of different types of equity grants, I want to begin by reviewing two key concepts that underlie equity value: company valuation and equity vesting schedules. We’ll start by asking two basic questions: what is equity in a company, and what is a company worth ? From there, we’ll discuss the mechanics of how you receive equity in the company over time.
Equity Primer
Equity is an ownership stake in a company. Companies issue equity in the form of stocks. Stocks are divided into different classes of shares, and as an employee, you’ll most likely be receiving shares in the form of common stock.
If you own stock in a company, you technically own a piece of the company. If the company is profitable, you may receive a percentage of the profits in the form of dividends. If the company is public, you can buy and sell stock in the company on the stock market.
If your company is private however, buying and selling stock is not as straightforward.
Company Valuation
Unlike public markets, there is no clearly defined price for stock in a private company. In fact, privately owned companies commonly have two different valuations assigned to them: their fair market value and their fundraising, or venture capital (VC) valuation.¹ Knowing the fundraising valuation and fair market value of your company gives you a general idea of how to value your equity compensation.
Venture Capital Valuation
We’ll begin by discussing the VC valuation first, since that is what most people are familiar with. This is the number that makes the headlines on TechCrunch highlighting what investors are valuing new startups at. A company’s VC valuation can be described as the dollar value that new investors are buying into the company at. You divide this number by the total number of shares that have been issued to get the stock’s share price.
Stock Price = Company Valuation / # Shares Outstanding
The VC valuation gives a general idea of what investors are willing to buy your company’s stock for, but it can also be misleading.
Preferred Stock vs Common Stock
Unlike founders and employees, investors in a company are issued preferred stock in the company, rather than common stock like the rest of us. Preferred stock offers investors additional benefits that common stock holders don’t receive, and are therefore priced at a premium to the fair market value of common stock.
Since a company’s VC valuation is calculated using the preferred share price, it creates an inflated image of the actual value of the company. The VC valuation assumes that the price of common stock will rise to match the preferred stock price once the company goes public, which may or may not happen.
Square’s IPO is a great example where investors with preferred stock were able to protect themselves from a reduced IPO price, while employees with common stock lost out. In summary, the equity you’re receiving is not the same as what an investor gets, and fundraising valuations are not always accurate indicators of what your stock will eventually sell for.
Fair Market Value
The second way a company is valued is through its fair market value (FMV), also know as the 409A valuation. The 409A valuation is an accounting requirement for any company that issues stock options and is updated annually. The fair market value is derived from the enterprise value of the company and is generally priced lower than the fundraise valuation. Since the 409A valuation affects the strike price of the company’s stock options, companies generally want lower 409A valuations so their employees can purchase their shares at a lower price.
Fair Market Value = 409A valuation, or what the company declares it’s fairly valued at.
VC Valuation = What investors paid for the company’s stock.
To demonstrate these two values in action, let’s use the following example. Say that your company has 1 million shares outstanding and its latest fundraising round valued the company at $10 million. That sets the VC valuation at $10/share. At the same time, your company completes its 409A valuation and its common stock is determined to have a fair market value of $6/share. This suggests that the investors paid a $4 premium over what the company’s assets are worth in order to own stock in the company. If you consider the VC valuation as an optimistic estimate of the company’s value and the 409A as a conservative estimate, then you can imply that the “true value” of your equity lies somewhere in between $6 and $10.
Even with knowledge of your company’s VC valuation and FMV, present valuation can’t be relied on to predict the future value of your company. Company performance, market conditions, and investor hype can drive company valuation in unpredictable directions, and you won’t know the true value of your equity until you’re able to sell it.
Vesting Schedules
Unlike regular salary, equity grants, particularly for startups, usually have a series of gates that need to be met before stock in a company is formally granted to you. Time-based vesting will be the first gate that you’ll need to meet. Regardless of whether you’re issued stock options or RSUs, you will be bound to a vesting schedule for your equity grant.
A vesting schedule is a predetermined schedule at which your equity will be awarded to you (vested). Most grants are vested monthly over a four-year period with an initial one-year cliff.² This means that your grant payout is spread out over four years, with a one year waiting period before you receive your first grant.
For example, let’s say you’re offered 16,000 shares with 4-year vesting period, 1-year cliff, and monthly vesting. We divide 16,000 by 48 (the # of vesting periods in the 4-year period) to get 250 shares/month. At the end of year 1, congrats! You reach the 1-year cliff requirement and get a lump sum grant of 4,000 (250 x 12) shares. Every month after that, you vest each month’s worth of equity (250 shares) until you hit 4 years.
If you leave your job before the 4-year mark, you relinquish any equity that hasn’t already been vested. In the same respect, if you leave before you finish your first year with the company, you leave with no equity whatsoever ☹️.
In the next part of this series, I will go over the two most common forms of equity grants, stock options (ISOs/NSOs) and restricted stock units (RSUs), and how they work.
[1] For more reading on 409A vs. venture capital valuations: https://discover.shareworks.com/a-private-company/409a-valuations-vs-venture-valuations
[2] Vesting schedules will vary from company to company and can vary in terms of total length, initial cliff, or even periodicity (monthly vs quarterly vesting). 4-year vesting with 1-year cliff is fairly common, so I will be basing my examples off of that structure.
