How to think about equity compensation

Reading time: 10 minutes

Many tech jobs pay a portion of employee compensation in the form of equity. This is a great deal for companies:

  • They get to defer paying you
  • They get to pay you without burning cash
  • If you quit before you vest, they don’t have to pay you
  • If you have a lot of unvested equity, you’re less likely to leave

How good a deal is this for employees, really? πŸ”—︎

Imagine that your employer only paid cash and said they wanted to pay part of your salary – still in cash! –Β in pieces over the next several years. You’d only want that deal if they were going to pay you more in the future than they would otherwise pay today to make up for the risk that you might never see the money.

The longer the vesting period, the more risk you take and the bigger the deferred amount should be relative to getting the cash earlier. Similarly, a risky startup should be giving you more than a well-established company that’s sure to be around.

Now consider getting that deferred salary in equity instead of cash.

By promising equity instead of cash, the company is playing a trick on you. πŸ”—︎

They want you to value the deferred equity you’re promised with an expectation of growth – the stock price going up or the company having a big IPO. They want you to think of it as worth more than the cash value of the initial award.

How sensible is that?

If the company is well-established and growing consistently, it’s probably true that the equity will be worth more than the cash. But that does come with uncertainty – in a down market, even if the company does well, equity in the future might be worth less than cash in the future. Their trick is making you think more about the glorious upside than the risky downside.

I go back to a single question whenever I think about equity comp.

If I was given the equivalent amount in cash, how much equity would I buy? πŸ”—︎

Imagine my company gives me a $100,000 bonus in cash, with a bizarre requirement that I have to invest it all somewhere for a period of time – I can’t use it for current spending. Would I invest it all in my company’s equity? Or would I invest in a more diversified portfolio of high-growth stocks? (E.g. buy the FAANG portfolio.)

We can even imagine that I have a very high risk tolerance and would prefer to go all-in on a single company instead of making a diversified bet. How likely is it that – just coincidentally – my employer is the absolute best investment available to me?

I argue that – all else being equal – you’re better off with cash and a choice of investments than being forced into investing in your employer.

In practice, you probably can’t choose all cash. πŸ”—︎

Companies may not give you much choice in your offer between taking cash now or taking deferred equity. Netflix is a rare case where they give you complete freedom of cash or options. On the other hand, Amazon has a hard salary cap and a lot of comp is backloaded equity (vesting more in years 3 and 4). In many places, you might be able to negotiate some between cash and equity, but in a narrow range.

Still, the thought exercise of thinking in terms of cash helps when comparing offers. If one company offers less salary and more equity, how good a deal is that? Effectively, you’re forced to invest the salary difference in company equity – is that a bet you’d voluntarily make if you had the choice?

For public companies, that’s pretty much it. Any cash difference you can invest in the equity of the other company (or a diversified portfolio of high-growth stocks), so the only things you need to think about are the relative growth rates and risk.

For example, you have offers from BigCo (a large, public company) and NewCo (a small company that just IPO’d). BigCo offers you $180k salary and $100k in equity. NewCo offers you $140k in salary and $120k in equity. BigCo is giving you $40k more in salary, which might be $25k after taxes, which you could use to buy NewCo stock, giving you $100k of BigCo equity and $25k of NewCo equity. (And as BigCo stock vests, you can sell it and buy more NewCo!) That’s what you want to compare to the $120k of NewCo equity.

What about non-public companies? πŸ”—︎

Equity comp is the only way for most engineers to get non-public company equity. The trade-off is that it’s illiquid – you have to hold the equity until the company goes public or is bought.

Holding non-public equity in the company you’re working for is a high-risk play. It’s possible to make a lot of money, but more likely leave you with nothing – not even a job. You’ve probably heard stories of people who struck it rich and you may know some. But you don’t hear the stories of the vast majority that didn’t.

We know that VCs expect most bets to fail. They need a few big wins to make up for the rest of the portfolio.

Unlike a VC, you only get to work for one company at a time. πŸ”—︎

If you’re young, maybe you have a high risk tolerance. Or maybe you think that you’ll work for a series of startups and, like a VC, only one bet has to pay off. Or maybe you’re already financially established and the risky equity is a small part of your total assets.

If you’re going to work for a startup, be realistic in your expectations. Studies of the VC industry show that given 1000 startups, only 1-2% percent will become billion-dollar unicorns and maybe another 2-3% will exit with valuations over $500 million. Valuations roughly double with each round of funding, but only about half of startups at any given funding level will go on to raise an additional round.

If you are a super early employee, you might be lucky enough to be given up to 0.5% ownership. If you get diluted by half to 0.25% with additional funding rounds, your share of the hoped-for billion dollar company is $2.5 million – but if there’s only a 2% chance of that happening, your expected payoff is only $50 thousand.

Dan Luu makes a great point that these days seed investing only takes $5k (or less). It’s possible to allocate a portion of your cash compensation to seed investing and wind up with a diversified portfolio of startup equity that way.

Consider a more established startup. πŸ”—︎

A better bet – but still by no means assured – might be to join a late-stage startup already valued at the $500+ million mark. Your equity grant will be a much, much smaller percentage than joining a tiny startup early, but the odds that it reaches an IPO are much higher. In this case, you’re betting not so much on the company reaching the $1 billion valuation mark, but on a successful IPO that doubles or quadruples in value post-IPO. (And plenty of IPOs don’t go that way!) Joining a company closer to a possible IPO means a shorter wait for liquidity.

Again, if you’ve got an offer from a startup, you’re not going to have much wiggle room to dial the equity up or down in exchange for salary. What matter is how you compare your startup compensation offer with an alternative. When comparing to a non-public company, you want to be thinking about comparing odds of survival because that will have more impact on your future financials than the size of the equity grant itself.

If you’re comparing to a public company, odds are that they’re offering a higher salary than the startup – possibly the delta is higher even than the expected value of your startup offer equity. If you want to go to the startup, either you like big, risky bets or you’re going for life experience that you can’t get at a bigger firm (that you think will pay off later in life) and the offer details matter less.

Aren’t startup options better for taxes? πŸ”—︎

Taxes are a hard a subject to cover well briefly for everyone and I am not an accountant. Generally, I think there’s no free lunch – you’ll pay income tax rates on vesting RSUs or exercised options. You only get a tax advantage if you hold the equity after you vest or exercise. If the equity goes up a lot and you hold it over a year, you’ll pay capital gains rates instead of income tax rates. That’s great, if the equity goes up in value, and that’s never guaranteed.

For startup options, it’s even tricker. First, you have invest your own money to exercise, plus maybe pay some income taxes right then, so you’re already starting underwater. Next, you have to wait for an IPO – if that ever happens – before you see any return on your investment. But if you are lucky enough to be in the 2-4% of companies that make it big, yes, you’ll avoid some taxes on your gains.

If you’re confident the company is likely to make it to an IPO, and exercising the options takes only small part of your total assets, maybe that’s a reasonable bet. If you’re emptying your savings or – horrors! – borrowing money to exercise the options, you’re risking everything for a bet on a better tax rate that might leave you broke.

When should you take money off the table? And how? πŸ”—︎

If your startup made it to the IPO or you’re getting RSUs from a public company, then you might find yourself with a large, liquid equity position in your employer’s stock. I think it’s wise to always be converting some of that to more diversified assets. How much depends on your risk tolerance and personal economic situation. If you want to buy a house or put kids through college, then the certainty of getting the money to do that may be worth giving up the potential upside of staying fully invested and letting it ride.

A strategy that I personally like is what I call a ‘50% minimum regret’ strategy. I can’t do anything about the unvested equity, so I let that ride. But of the vested part, I periodically sell half of it. If the equity goes up further, I’m comforted knowing that I still own half. And if the equity goes down, I’m relieved knowing that I sold half at the higher price.

A conclusion and a caveat πŸ”—︎

I started this article talking about deferred cash, and I firmly believe cash is the right mindset for thinking about equity compensation.

If I had $100,000, would I buy the stock of an established company? Would I buy the stock of a new IPO? Would I buy options in a brand new startup?

Even without formal analysis of each opportunity, if I imagine starting from cash, then my gut can guide me.

If I’m more comfortable buying the established company stock, then I value that more than an equivalent amount of equity in another situation.

I encourage you to use this technique when considering your own equity offers.

Caveat: I am not a financial advisor or tax planner. Consider talking to professionals, particularly if the amounts at stake are large.

Special thanks to AbdulFattah, Ankush, Matt, and Pete for feedback on a draft of this article.
I’ve posted a list of reference that helped me write it here.

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