Picture this: you are offered 2 jobs. One pays £65K a year. The other company only pays £50K a year and they also offer you 1,000 shares. If you’re optimising for money, which one should you choose?

Early stage start-ups cannot compete, salary-wise, with the big players on the market. To make up for the lower pay, they will often give away some shares on top of the salary to attract top talent. That’s why it is very likely you will be offered equity at some point in your career. And you’ll probably have a hard time figuring out how much it is worth in “real money”.

There are a lot of elements to factor in when evaluating a job offer that includes shares. Vesting period, striking price, taxes… let’s dive into it!

What is equity or "employee shareholding"?

Equity allows you to become a shareholder in your company. How? By letting you to purchase shares under preferential conditions. You will not immediately reap the benefits: it will take several years to generate capital gains allowing you to cash in the money.   

The main advantage of equity

Equity supplements your salary package with deferred, but potentially significant compensation, even more so if you join a company that is just starting up and that takes off later down the line. 

The younger the company, the more money its equity could end up representing. It makes sense when you think about it: a start-up has fewer resources with which to pay its employees and less insight into its future than a more mature company. For this reason, start-ups tend to be more generous with their equity than companies that are well-established in their market.

How does it work?

Share-based compensation may be open to all employees or be reserved for a subset of employees (e.g., only some or all managers). It allows you to purchase (or receive for free) company shares at a predetermined date and a set price.

Over the course of your career, you may come across the following schemes:

• ESOP (Employee Stock Option Plan)
• VSOP (Virtual Stock Option Plan)

The other advantages of equity

• You could make a lot of money which will help you build up financial assets in the long term (you could use these to buy property for example).
• There could be significant tax benefits.
• As a company shareholder (in the ESOP scheme), you may be able to weigh in on certain important decisions as well as gain insight into the company's projects and ambitions for future development.
• You could become a company shareholder at a reduced cost.

The main downsides of equity

• If the company is not doing well, the value of your shares goes down. So, think of equity as a possible additional source of income, but keep in mind that there are no guarantees.
• Employee shareholding is a type of deferred compensation. This means you will have to be patient and stick with the company long enough to reap the benefits.

"It is important not to confuse salary, which is secure and fixed, and stock-based compensation, whose benefits are hypothetical and in the long term."
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- Florent Artaud, Country Manager at SeedLegals 

What you need to know to estimate your potential earnings

• The number of allocated shares.
• The exercise price (or strike price), i.e., the price quoted for the share.
• The company's current valuation.
• The company's projections, which will allow you to estimate the evolution of your shares.

These last two points are essential to assess your potential earnings. Without them you have no way of estimating the current value of the company or of its potential for growth. You should never hesitate to ask your future employer or manager about this. 

How to estimate the value of your share-based payment

It is possible to have an accurate valuation during the period when the company is raising funds. When a start-up raises funds, it is valued at a certain amount. Simply apply this amount per share to the number of shares you hold to calculate your expected earnings. The tricky part is to get access to that knowledge... You should ask about it when negotiating your salary, but don't be surprised if a recruiter choses not to disclose that piece of information.

What to consider when assessing a company's potential

• The founder's "pedigree": an entrepreneur who has already been successful is more likely to succeed again because they know the dos and don'ts of entrepreneurship. Furthermore, investors are fond of "serial entrepreneurs". It is therefore likely that such companies will receive more funding than others. 
• The company's business and its growth potential: assessing this is slightly more complicated and will require you to do some research (by questioning experts, studying the competition, reading dedicated source materials etc.).
• The investors' "pedigree" (if a round of financing has already happened).

"Top funds attract top start-ups. If an investor has already provided funds for Instagram, Doctolib, and Weibo, the chances that the team will be successful is high."
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- Lucas Mesquita, co-founder of startups Revolte and Caption

In other words, on this front, VCs and candidates are in the same boat. Before you commit, try to assess whether the company has what it takes to achieve its goals and whether it will be worth your while to jump on board the entrepreneurial train.

The main schemes

ESOP (Employee Stock Option Plan)

The stock option scheme has three main steps:

1/ The company allows you to subscribe for a given number of shares for an amount, fixed in advance, which is usually discounted.

2/ After a given period (no more than 3 to 5 years), you get to buy the shares at the agreed price. The right to exercise your option is usually contingent on your presence in the company. If, in the meantime, the share has increased in value, you will realise an initial capital gain, known as the "capital gain on acquisition." You also become the owner of the share and a shareholder in the company.

3/ Afterwards, it is up to you whether to keep the share (in the hope that it will increase in value) or to sell it to pocket a profit (called "capital gain on the sale").

The goal is, of course, to realise capital gains when you acquire the shares ("option exercise gains" or "capital gain on acquisition") and when you sell them ("capital gain on the sale").

The advantages of the ESOP

• The potential discount.
• The capital gain on acquisition
• The capital gain on the sale

Additionally, by becoming a shareholder in the ESOP scheme, you gain voting rights to support or block decisions made by investors and company founders.

Example 

2022: 1000 stock options are allocated to you at the exercise price of 10 euros per share.

2025: you exercise your option on the 1,000 shares. The unit value of a share is now 30 euros. ➡️ Your capital gain on acquisition is 20,000 euros ([30-10] x 1000).

2026: you sell your 1,000 shares at 40 euros per unit.Total amount received: EUR 40,000 ➡️ Capital gain on the sale: EUR 10,000 (40,000 – 30,000)

The disadvantages of the ESOP

30% of German start-ups use the ESOP scheme which is often used to supplement salaries which are lower than the market rate. This is because 50% of start-ups struggle with recruitment and consider hiring to be a "major challenge." Over 1 in 4 start-ups struggle to compete with their larger competitors who offer more attractive compensation packages. You should take advantage of this.

In the ESOP scheme, the company grants you a small part of its capital. Even though your fixed salary may be lower than that of the employee of a more mature company, your income will increase as the company grows.

However, be warned, the money you will make via the ESOP scheme is contingent on the success of the company and your longevity within the company.

In other words, if the company fails, or if you end up switching companies early on, you will have worked for a salary lower than market rates for nothing! It is therefore up to you to assess the company's potential before negotiating your salary: is the company more likely to make mega bucks or to go bankrupt?  

Taxation

The upside: you only pay taxes once you have exercised your option.‍

‍The downside: the capital gain on acquisition is subject to income tax. In other words, you will pay taxes without knowing if you will ever profit from the resale of your shares.

VSOP (Virtual Stock Option Plan)

80% of German start-ups have used this form of remuneration. This is because the company will only give you the promised shares if it is sold or if it goes public.

Before that, you are a "virtual shareholder." You do not hold any real shares. As such, you do not have the voting rights of shareholders, nor do you have access to information that might give you insights into the company's future (or help you protect your rights).

Advantages of the VSOP 

• For the uninitiated, the VSOP is easier to understand than a stock option scheme. You simply get a share of the proceeds of the sale of the company.
• There's no financial risk: you only pay tax when you get the money. So, no advance payment is necessary. You only pay if you cash in.

Disadvantages of the VSOP

• Tax optimization is not possible. VSOPs are taxed as income and not as capital gains. They are therefore subject to both social security and income tax. As a result, their returns are lower than those of the ESOP.
• Without voting rights, you don't really have a say in the future of the company. You end up in the back seat with no leverage to defend your rights.

Conclusion

Now that you know everything there is to know about equity, it is up to you to make the right choice. The ESOP, which is fiscally less demanding, allows you to build up potentially valuable capital. It is ultimately up to you to optimise the terms with your employer to make sure they keep their promises.

In any case, you now know how to avoid the most common employee mistakes when it comes to equity: don't ignore this potentially lucrative aspect of your compensation package, don't sign an agreement without thoroughly checking it, and make sure you don't leave the company without taking full advantage of it.

Summary