Startups frequently compensate employees through a blend of cash and equity, such as stock options or restricted stock units, which may translate into ownership stakes. For prospective employees, assessing job offers with equity components can prove to be a complicated task. In fact, in a recent research study we found a clear and consistent pattern among participants evaluating offers that included equity compensation: They appeared to perceive that a higher number of shares translated into superior compensation. This led them to be more willing to sacrifice cash compensation when offered a larger quantity of shares, even when the underlying value remained the same. Call it the equity illusion.
When making an offer that includes an equity grant, a startup may propose a specific number of options, but current U.S. regulations don’t require private firms to reveal the total number of shares outstanding. So while potential employees may know the quantity of options offered, they often have no insight into the actual ownership stake those options represent. It’s akin to an employer declaring, “We’ll pay you 100,000,” leaving you to wonder whether that’s in dollars, euros, yen, or yuan. In the same vein, comparing job offers from different startups based solely on the number of securities in their equity packages turns the decision-making process into an exercise in comparing apples with oranges — which can lead you to make an unwise career decision.
To find out how savvy workers are at understanding equity compensation, we ran an experiment with more than 1,000 American workers with STEM degrees, a demographic often drawn to startup opportunities. Indeed, 15% of those surveyed had experience in earning equity compensation in the past.
We presented participants with hypothetical compensation packages from a startup. These packages consisted of varying amounts of cash and equity shares, with the explicit notation that the shares represented a 0.5% stake in the hypothetical company.
Our findings indicated that participants were more inclined to forgo cash in favor of equity, when the equity proposal included a larger quantity of shares despite the consistent value of the shares across different scenarios in our study. For instance, when given the choice of surrendering $10,000 from their cash compensation for 1,000 shares, 74% of respondents chose the shares. When the same equity stake was presented as 50,000 shares for the identical $10,000 concession, the preference for the equity grant increased to 81%. In a similar vein, 60% of the respondents were willing to forgo $30,000 in exchange for 1,000 shares, but this figure rose to 64% when the equity was offered as 50,000 shares.
We followed up this experiment with a survey to gauge the respondents’ comprehension of startup equity compensation offers. We designed a set of questions aimed at assessing their financial literacy in this area, probing their understanding of key aspects such as stock option value, liquidation preferences (which determine the order in which shareholders will be paid upon a company’s exit or liquidation), and the risk levels associated with investment in restricted stock versus stock options — all vital components in the evaluation of equity compensation packages.
The results were illuminating but disconcerting. Nearly 44% of those surveyed were unable to correctly answer a single question related to startup equity compensation; a scant 5% answered all questions correctly. Perhaps more alarming was the overconfidence among participants; though given the option to admit they didn’t know the answer, they selected the incorrect answers. For example, on a question evaluating understanding of how liquidation preferences might affect employee equity value, only 18% answered correctly, a mere 16% conceded they didn’t know, and the rest — nearly 66% — answered erroneously.
Despite this pervasive lack of equity financial literacy, a troubling complacency emerged. Among those who had previously been offered equity, fewer than 25% reported that they had sought professional guidance in evaluating a proposal. This lack of initiative not only reflects a critical knowledge gap but also hints at potential missteps in navigating the intricate landscape of equity compensation, where equity illusions seem to hold sway.
To avoid falling prey to equity illusions, here are five things you can do:
1. Educate yourself.
Before accepting an offer involving equity compensation, you should deepen your knowledge of the core concepts of equity. Understand how exercise prices impact the value of stock options, how liquidation preferences influence employee options, and how stock options and restricted stock units differ. Most importantly, realize that the number of shares offered by a startup doesn’t necessarily correspond to the grant’s economic value.
2. Ask questions.
While current U.S. regulations do not require private firms to fully disclose information from their capitalization tables, you should ask prospective employers questions that can help you evaluate equity compensation offers. Ask about the company’s financing history and capital structure. Understanding how much money has been raised and its implications can help in decision-making. Similarly, inquire about what percentage of ownership the equity grant represents. Look also for relevant benchmarks in the industry. A company refusing to share this information could be a red flag.
3. Think about the costs of equity compensation.
Evaluate the specifics of the investment required. It is essential to multiply the exercise price by the number of options in the grant to determine the amount required to purchase the shares. If options aren’t exercised, they can expire, becoming worthless. Thus, decide if the financial commitment aligns with your personal financial goals. For some, a compensation package with a higher cash salary might be preferable if the financial commitment seems daunting.
4. Consider complications that would arise if the startup stays private longer.
Startups are increasingly staying private for longer periods, which can delay financial benefits from stock options for employees. Those leaving the company typically have only 90 days to decide whether to exercise these options or forfeit them.
Some employees might receive restricted stock units (RSUs) instead of traditional stock options. While RSUs don’t require immediate out-of-pocket costs, they might expire if the company doesn’t go public within seven years.
Moreover, as startups continue to raise money in the private capital market, they undergo multiple funding rounds, each adding layers of complexity to their capital structure. This affects employee equity’s potential value. Joining a maturing startup may also mean facing higher costs for stock options, adding to the financial risk.
5. Consult experts.
Even if you’re confident in your grasp of equity’s broad concepts, seeking expert opinions can provide nuanced insights into specific equity offers, helping you make well-informed decisions.
Becoming well-versed in equity is not merely about understanding finances; it’s pivotal for making informed career and investment decisions in the startup world. By gaining a comprehensive understanding of these intricate financial instruments, you can confidently navigate the startup equity landscape, transforming what might seem like an illusion into actual ownership.