Deciding Between Salary and Equity

There was a pretty enlightening trend on Twitter a few days ago, where folks in tech were sharing and comparing their compensation. For me, it cemented the idea that compensation in the tech industry is highly situational. What an employer may offer in base salary, equity, bonuses, and other benefits, largely depend on the role being filled, and where the company and employee are located. There is no one size fits all. To say the least, company strategies for compensation can be far from simple. Considering this, most tech companies offer equity as part of the compensation package, but employees rarely understand the value or how it fits into their financial plan. If faced with the opportunity to negotiate a better offer, how do you decide between salary and equity?

Salary vs. Equity: What’s The Difference

The advantage of being paid a base salary is that its a fixed amount of income that you can expect and plan your future around. Alternatively, in the context of compensation and investment, equity represents ownership in the company in the form of stock. Generally, the return on equity is often linked to company growth and performance. The purpose of equity compensation from an employer’s perspective is threefold: to attract and retain talent, align incentives, and reduce cash spending. 

  • Attract and retain talent. When a company demonstrates or has good predictability to manifest financial success, employees are incentivized to work for the company in hopes of their equity being worth a substantial amount of money in the future. 
  • Align incentives. Startups are usually strapped for cash, but even companies that can afford to pay higher salaries may prefer to give employees equity. The idea is that employees will work harder to achieve financial success for the company and increase the future value of their equity. In this way, equity can align employee incentives with company interests. 
  • Reduce cash spending. By awarding equity, a company can often pay less in salary compensation to employees now, with the hope of rewarding them with equity later. The cash savings can then be allocated toward other investments or operating expenses.

Types of Equity Compensation

Both private and public companies offer equity compensation for myriad reasons. Equity compensation can be granted in many forms, each with unique characteristics, benefits, challenges, and importantly varying tax implications. These characteristics will impact your overall financial plan, so you’ll want to identify your specific equity compensation type to understand its benefits and potential challenges.

From my experience, most Pre-IPO startups offer equity in the form of incentive stock options and non-qualified stock options. On the other hand, most Post-IPO and mature companies grant equity in the form of Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs). Recently, I’ve seen a few companies offer cash as an alternative, RSUs, at-the-money stock options, and out-of-the-money stock options — and gives the employee the choice to select what best fits their needs. 

For instance, let’s say you have a low-risk tolerance, and you’re starting a family or planning a wedding, the cash alternative would likely be the best choice. But if you’re in a financial position to take on more risk, taking the RSUs or even a mix of RSUs and stock options is likely the best strategy. Though I haven’t seen it in many plans, it’s a fantastic opportunity to further align your equity with your financial plan, and I sure hope it becomes widely adopted.

With that said, if you’re deciding between salary and equity here are some things to keep in mind:

Can you maintain your lifestyle on a lower salary?

Although they’re not mutually exclusive, equity compensation often goes hand-in-hand with a below-market salary. It’s critical to know your minimum number. If you can reshuffle your priorities and costs, so your reduced salary doesn’t make a significant difference in your lifestyle and ultimately your goals, then you’ve mediated much of the pay cut. It’s worth noting that cutting down might be a bit more challenging to do if you live in a high-cost city like New York City or San Francisco, where living expenses can put a dent in your income. 

What does your four-year career plan look like?

Awards of equity compensation are almost always subject to a vesting schedule. Vesting simply means that an employee is required to wait a specific amount of time before gaining full rights to the shares in the equity grant. The most common vesting schedule I’ve seen is four years, on a monthly basis, with a one year cliff. In essence, this means that 25% of stock vests each year for the first four years of that employees’ time at the startup, in monthly or sometimes quarterly increments. Generally, if an employee resigns or is terminated immediately, they get no equity. If they stay for years, they’ll get most or all of it. In any event, be sure to keep your career plans in mind when deciding between salary and equity. 

How strongly do you believe in the company and its mission?

The main risk associated with equity compensation is that there is no guarantee that you’ll gain from your equity’s appreciation in value. Many variables can influence whether your equity stake will actually pay off. Is it worth it to sacrifice a portion of your salary for the potential at winning big in the future? You’ll have to put your VC hat on because the answer will come down to how optimistic you are in the company’s future. 

Negotiating Your Offer

Everyone wants to walk away from the negotiation table with the feeling like they’ve won. When deciding between salary and equity, the key is to win at the right things. After you’ve done your research, take some time to determine what matters to you.

For startups, cash is the most precious resource, and founders may welcome individual requests to trade salary for more equity. Assuming you are offered a market rate salary and equity, and your employer is willing to make some trade-offs, you will need a framework to help you judge how much equity makes sense.

Your strategy will depend on the stage of the company you plan to join.

For early-stage startups, you’ll want to find out the company’s current valuation as well as the amount of shares outstanding. If you divide the company’s valuation by the number of shares outstanding, you will derive at the price per share. You can then divide the amount of salary you’re willing to sacrifice by the price per share to determine the number of stock options you should receive.

For example, imagine you’re offered $100k to join a promising early-stage startup and choose to forgo $10,000 of your salary for more equity. Assuming the company can raise at a $5 million valuation and there are 1 million outstanding shares, the company can raise money at $5 per share, and you can receive 2,000 additional shares for your willingness to sacrifice $10,000 of your salary. 

For mid-stage Pre-IPO startups, the trade-off should be based on the number of shares an employee could purchase at the current stock option price. Let’s say an employee wanted to forgo $10,000 of salary for the opportunity to buy more shares, and the current option price was $2 — the company will likely advocate granting an additional 5,000 shares. 

As I mentioned beforehand, tax ramifications of equity can be far more complicated than salary earnings. Equity compensation can be quite convoluted — but with the appropriate resources and a viable strategy in place, you may be able to leverage your equity within your financial plan to meet your goals sooner than you know.

Introduction to Stock Purchase Plans

In the world of tech, it’s common—and frequently expected—that startups offer their employees’ company stock as part of their compensation package. If you’re a Millennial in tech, and your company offers an employee stock purchase plan, then take note because you’re sitting on an opportunity of wealth. Your employee stock purchase plan, or ESPP, might be one of the best benefits in your compensation package. Personally, it’s one of my favorites. If your employer offers an ESPP and you are not participating, you may be leaving thousands of dollars on the table. To maximize your ESPP’s value, it is critical to know some key dates and terms and understand the plan’s mechanics. Enter: an introduction to stock purchase plans.

ESPP 101: The Nuts and The Bolts

You know the saying, “there’s no such thing as a free lunch?” That doesn’t apply here because your ESPP is essentially free money. For this reason, most tech companies will use it to attract, reward, and incentivize their best talent. At it’s simplest, an employee stock purchase plan offers a way for tech employees to purchase company stock seamlessly and on favorable terms. Primarily, they allow participants regular, ongoing purchases of company stock through accumulated after-tax payroll deductions.

Moreover, participants can purchase company stock at a discount from the stock market price available to the general public. This discount is the free money I was referring to a moment ago. I’ve reviewed plenty of compensation packages for the Millennials in tech we serve as clients and have seen discounts ranging from 5% and 15%.

A Deal Too Good To Be True

What makes an employee stock purchase plan so appealing is the potential for both a discounted price and a lookback provision. As the name implies, the lookback feature allows employees to purchase shares based on the price at the beginning or end of the offering period, whenever share prices are lower. 

For instance, let’s say the stock price is $100 per share at the start of the offering period. Your purchase price is $85 per share with the 15% discount. 

  • If the stock price goes to $200 per share, you’ll earn a hefty 135% ($200-$85/$85).
  • Even if the stock price stays at $100, you’ll earn a 17.65% return from the discount ($100-$85/$85).
  • Even if the stock price drops to $50 at the end of the offering period, your discount gives you a favorable purchase price of $42.50, as a result of the lookback feature.

As far as Uncle Sam is concerned, the money deducted from your paycheck will be taxed like the rest of your salary. However, for Millennials in tech who can delay instant gratification, you’ll be rewarded with preferential tax treatment from the IRS. Correspondingly, if you are willing to hold the shares for at least two years from date of grant and one year from the purchase date, any tax liability is deferred until the shares are sold. Like my mom used to tell me growing up, “patience is a virtue.”

A noteworthy reminder: if your company pays dividends to its shareholders, the deal gets even better. You’ll receive a check for the dividend amount each quarter for the stock you hold. If your company has a dividend reinvestment program, you have yet another opportunity to take advantage of dollar-cost averaging to buy even more shares of company stock.

Key Dates In Your ESPP

Now that we’ve touched on the mechanics, let’s get familiar with key dates, events, and terms associated with most ESPP’s. It’s helpful to think of these key dates as a timeline of the typical stock purchase plan’s life cycle. 

Enrollment date: Known as the grant date is usually the first day of the offering period. The grant date is vital in ESPPs that are qualified plans, and it starts the clock for tax purposes. 

Enrollment or offering period: During this period, payroll deductions are accumulated to purchase company stock. Most ESPP’s have offering periods that last anywhere from 6 months to 24 months. 

Purchase period: Purchase period: Some tech companies use the terms “offering period” and “purchase period” interchangeably when the time frames are identical. Alternatively, when companies establish an offering period of longer than six months, there are usually interim purchase periods. Your company will purchase your shares at the end of the two six-month periods within the 12-month offering period. For example, a single offering period could be from January 1 to December 31. In this scenario, the first purchase period might start on January 1 and end on June 30. The second purchase period might start on July 1 and end on December 31.

Purchase date: Payroll deductions accumulated during the offering period will be used to purchase shares of company stock at the discount price on the purchase date. The purchase date is pre-determined and is usually the last business day of the offering or purchase period.

Reaping The Benefits

Investing in any individual stock is relatively risky: we all can acknowledge that. The most significant risk by far is not having a strategy or game plan to manage your shares as they begin to accumulate. Markets go up, and markets go down. It’s inevitable. In fact, this volatility is what causes an efficient market to demand higher returns for those who can keep faith. With risk comes reward, and hanging on for the long term is more often than not, rewarding. It’s unlikely to become wealthy overnight by participating in a stock purchase plan. Nevertheless, over time, the gains can be attractive. All the more reason for Millennials in tech to develop a holistic approach to stock compensation. If you’re not sure how or where to start, we’d be more than happy to help!