Equity vs. Salary: Legal Implications for Early Employees

Joining a startup in its early stages can be an exhilarating experience, offering a chance to shape a company's future. A key part of these early-stage job offers is often a mix of salary and equity. While a high salary offers immediate financial security, an equity stake promises a potential future windfall. Understanding the legal landscape surrounding this choice is critical. This decision is not just about a paycheck; it's about your rights, tax obligations, and long-term financial health.

This post will explore the legal implications for early employees when weighing equity against salary. We will cover vesting schedules, tax consequences, the risk of dilution, and how to evaluate a compensation package to protect your interests.

Understanding Equity Compensation

Equity is a form of non-cash payment that gives you a small ownership stake in the company. For startups, offering equity is a way to attract top talent when cash flow is tight. It also aligns your interests with the company's success—if the company grows in value, so does your stake.

There are two primary types of equity you might be offered:

Stock Options: These give you the right to buy a certain number of company shares at a predetermined price, known as the "strike price" or "grant price." You don't own the shares until you "exercise" your options, meaning you purchase them.

Restricted Stock Units (RSUs): An RSU is a promise from the company to give you shares of stock at a future date, once certain conditions (usually vesting) are met. Unlike options, you don't have to purchase the shares.

Both forms of equity come with legal complexities and financial risks that every potential employee should understand.

Key Legal Consideration: The Vesting Schedule

Equity is rarely given to you all at once. Instead, it is earned over time through a vesting schedule. This is a legal mechanism that protects the company by ensuring you stay for a minimum period to earn your full equity grant.

A typical vesting schedule is four years with a one-year "cliff."

The One-Year Cliff: This is the most important initial milestone. If you leave the company—voluntarily or not—before your first anniversary, you typically walk away with zero equity. Once you pass the one-year mark, the first portion of your equity (commonly 25%) vests immediately.

Monthly or Quarterly Vesting: After the cliff, the remaining equity usually vests in smaller increments on a monthly or quarterly basis over the rest of the vesting period (the remaining three years in our example).

It's crucial to review the terms of your vesting schedule in your employment agreement. What happens to your unvested equity if the company is acquired? Some agreements include "acceleration" clauses that cause all or some of your equity to vest immediately upon an acquisition or a change of control. This is a valuable provision to negotiate.

The Tax Man Cometh: Tax Implications of Equity

How and when you are taxed on equity is one of the most complex legal and financial aspects to manage. The tax treatment depends on the type of equity you receive.

Taxes on Stock Options

Incentive Stock Options (ISOs): These have a favorable tax treatment. You are not taxed when the options are granted or when you exercise them. You only pay capital gains tax when you sell the shares. However, exercising ISOs can trigger the Alternative Minimum Tax (AMT), a separate tax system that can result in a significant tax bill even if you haven't sold the shares.

Non-Qualified Stock Options (NSOs): These are more common and simpler from a tax perspective. The difference between the market value of the stock when you exercise your options and your strike price is taxed as ordinary income in the year you exercise. When you later sell the shares, any additional gain is taxed as a capital gain.

Taxes on Restricted Stock Units (RSUs)

With RSUs, you are taxed when the shares vest and are delivered to you. The total market value of the shares at the time of vesting is considered ordinary income. This means you will owe income tax on the value of the shares in that year, even if you don't sell them. Many companies will withhold a portion of the vested shares to cover this tax liability, a process known as a "net settlement."

Dilution: The Shrinking Piece of the Pie

As a startup grows, it often raises more money from investors by issuing new shares. This process is called dilution. When new shares are created, the ownership percentage of existing shareholders—including employees—decreases.

For example, if you own 10,000 shares in a company with 1 million shares outstanding, you own 1% of the company. If the company issues another 1 million shares to a new investor, there are now 2 million shares outstanding. Your 10,000 shares now represent only 0.5% of the company.

While your ownership percentage shrinks, the value of your stake could still increase if the new funding round raises the company's overall valuation. However, significant dilution over multiple funding rounds can substantially reduce the value of your initial equity grant. It's a fundamental risk of accepting equity.

Risks vs. Rewards: Evaluating Your Offer

An equity offer can feel like a lottery ticket. While the potential upside is huge, the statistical reality is that most startups fail. If the company goes out of business, your equity becomes worthless.

Here are practical steps to evaluate an equity offer:

Ask for the Numbers: Don't just accept the number of options or RSUs. Ask for the total number of shares outstanding to calculate your ownership percentage. Inquire about the company's last valuation (the "409A valuation") to estimate the current value of your grant.

Review the Legal Documents: Carefully read your offer letter, stock option agreement, and any related documents. Pay close attention to the vesting schedule, acceleration clauses, and the expiration date for exercising your options after you leave the company (often only 90 days).

Understand the Strike Price: For stock options, a lower strike price is better. It means your cost to purchase the shares is lower, and your potential profit is higher.

Balance with Salary: Consider the trade-off. Is the salary offered a livable wage for you? If you are taking a significant pay cut in exchange for equity, you are effectively "investing" that lost salary into the company. Make sure you are comfortable with that level of risk.

Seek Professional Advice: The legal and tax implications of equity are complicated. It is highly recommended to consult with a lawyer or a financial advisor who specializes in startup compensation before signing an offer. They can help you understand the documents, model potential tax liabilities, and negotiate better terms.

Protecting Your Rights as an Early Employee

Your employment agreement is a legally binding contract. It outlines your compensation, role, and rights. When equity is involved, it's even more important to understand what you're signing. Don't be afraid to ask questions and negotiate terms that protect you.

Key areas for negotiation might include:

Vesting Acceleration: Pushing for single or double-trigger acceleration upon acquisition.

Post-Termination Exercise Period: Negotiating for a longer window than the standard 90 days to exercise your vested options after leaving. This gives you more time to arrange funds if needed.

Information Rights: Requesting the right to receive regular updates on the company's financial health and capitalization structure.

Final Thoughts

Choosing between salary and equity is a defining moment for any early startup employee. A higher salary provides immediate security, while equity offers a chance at life-changing wealth, tied directly to the company's success. However, that equity comes with significant legal complexities and financial risks.

By understanding vesting, preparing for tax implications, and being aware of dilution, you can make a more informed decision. Treat your equity grant with the seriousness it deserves. Review the legal documents, ask the hard questions, and seek professional guidance. This diligence will help you protect your financial future and truly benefit from the risk you are taking by joining a young company on its journey.