1. root
2. me
3. career
4. vc
5. players
6. employee

As an employee, your compensation package generally includes:

• cash, which affects the burn rate of the company
• ISOs, which come from the employee option pool

Like Founders, employees are granted common shares. Unlike founders, employees generally have no access to the cap table, with no info on liquidation preferences and multiples and the size of the employee option pool. Further, as a minority holder in a minority “class” (employees), you have no control over future dilution of your own position.

§ Exit Examples

Let’s walk through some examples to understand equity value to you, an employee.

§§ Sad (Common) Case

Company raised $30mm cumulatively over N rounds, sells for $20mm. Cap table at the end is 80% VC firms, 20% founders+employees.

• The $20mm is returned to investors. The end!
• Founders and employees get nothing.

§§ Happy Case

Company raised $30mm cumulatively over N rounds, sells for $100mm. Cap table at the end is 80% VC firms, 20% founders+employees.

• $30mm automatically goes to investors (i.e. holders of preferred shares)
• The remaining $70mm is then distributed proportionally to all shareholders
• 80% (56mm) goes to investors
• 20% (14mm) goes to founders + employees
  • you managed to hold on to your initial 1% grant through dilutions by demanding “true-ups” at each fundraising round, and stayed at the company the entire time
  • of this 20%, 1 of the percents ($700k) is yours, most valued founding engineer

Your shares are worth $700k, but you still have to exercise those options at some strike price to be able to sell them. If the strike price is $1/share and the shares are worth $10/share (i.e. you have 70k shares), the profit-per-share is $9.

So your equity package ends up being worth $630k, pre-tax. ISOs, if exercised to sell, are taxed as ordinary income. This will put you in the highest income tax bracket. You can expect to pay ~40% of it in taxes, leaving you with $350k post-tax.

§§ Super Happy Case

Company raised $300mm cumulatively over N rounds, sellsfor $5B. Cap table at the end is 80% VC firms, 20% founders+employees.

• $300mm automatically goes to investors (i.e. holders of preferred shares)
• The remaining $4,700mm is then distributed proportionally to all shareholders
• 80% (3,760mm) goes to investors
• 20% (940mm) goes to founders + employees
  • you began your journey with 1% as the founding engineer.
  • over time, this dilluted to 20 basis points (0.2%)
  • your ownership is now worth $1.88m
  • your strike price, since you joined so early, is $1/share and the price is now $40/share
  • i.e. you have 47,000 shares
  • you’re in the black by $1.833mm
  • you will pay income tax of nearly ~40%; or $733.2k
  • you will net $1,099,800

§ Constructing a Model

Your actual model has to account for the:

1. probability that the company sells at all; or goes public
   • if a sale: probability that the sale price is more than invested capital
2. % of your equity that fully vests; i.e. how long you’re at the company
3. dilution experienced in future fundraising rounds
4. divergence between your strike price and future liquidity price(s)
   • strike prices are based on 409(a) valuations, which are usually super conservative
5. possibility that investors might have predatory terms, like preference multiples
   • this is uncommon in modern, major startup markets

These are each difficult to judge, and each carry the threat of marginalizing or zeroing-out your return.

Therefore, it’s prudent to value ISOs on <1% of the company at zero.

§ Meta Comment on Relative Share of Tax Burden

I included how much money returns to investors. Recall that 80% goes to invesetors, and 20% goes to employees and founders: i.e. the people who converted capital into assets.

Of the amount that goes to employees and founders¹, a hugely significant portion goes directly to federal and state governments (easily north of 30%). Which, as an employee, I am totally OK with.

A small amount (maybe 1-3%?) flows back to the company, in the form of cash used to exercise options.

Of the absolutely massive amount (80%) that flows to investors, 80% of profits are untaxed, because Limited Partners are typically tax-advantaged institutions (teacher’s pensions, university endowments, etc.). The remaining 20% of profits (flowing to already-wealthy GPs) are taxed at a preferential rate (capital gains instead of income).

Is this just? That cash flows to labor are heavily-taxed, whereas cash flows to capital and managers thereof are untaxed or lightly-taxed? An exercise to the reader.