Startup equity compensation: What all founders should know

Startup equity compensation represents ownership stakes that companies offer to founders, employees, and sometimes advisors as part of their total compensation package. Rather than paying exclusively in cash, startups distribute actual shares of the company to align team members with long-term business success.

This approach alters traditional employment relationships by making employees who receive equity compensation partial owners of the business. For employees, their financial upside becomes directly tied to the company's performance, creating powerful incentives to drive growth. The equity's value materializes when the company experiences a liquidity event, such as an acquisition or public offering.

Startup costs often consume significant capital in early stages, which is why companies rely heavily on equity compensation for strategic and financial reasons. Offering meaningful equity stakes allows these businesses to compete for top-tier talent without depleting their runway through excessive salary costs.

Equity compensation is both a talent acquisition tool and a strategic financial decision for founders. Companies that structure equity packages effectively can attract skilled employees while preserving cash flow for operations and growth initiatives.

Helps attract top talent on a budget

Skilled professionals often accept below-market salaries in exchange for ownership stakes when they believe in a company's growth potential. This trade-off becomes valuable for cash-constrained startups competing against larger organizations that can offer higher base compensation. Early employees understand that their equity could generate significant returns if the company succeeds, making this structure attractive to candidates who want ownership in their work.

Aligns incentives

With equity compensation, employees become stakeholders with direct financial interest in company performance. When team members own shares, they benefit directly from increased company valuation through their own wealth creation. This ownership mentality can drive employees to work harder, think strategically about business decisions, and stay committed during challenging periods.

The alignment extends from individual motivation to collective team dynamics. Since everyone's equity value depends on overall company success, employees can collaborate more effectively and make decisions that benefit the entire organization rather than just their specific departments.

Increases retention

Vesting schedules attached to equity grants create incentives for employees to remain with your company long-term. Most equity compensation includes multi-year vesting periods, meaning employees forfeit unvested shares if they leave early. This helps to reduce turnover costs and allows startups to retain institutional knowledge and key relationships. As a result, the company doesn't spend additional cash on retention efforts, while employees receive potentially more valuable compensation through equity appreciation.

Enhances cash flow flexibility

Startups face constant pressure to extend their operating runway while funding growth initiatives. Using equity instead of higher salaries frees up cash for product development, marketing campaigns, and other operational expenses. Ultimately, cash flow management becomes more predictable when companies structure compensation packages with equity components. Fixed salary costs remain lower, while variable equity costs only impact the company's cap table rather than immediate cash outflows.

Founders need to understand basic equity terminology to make informed decisions and communicate with investors, employees, and advisors. These terms form the foundation of equity discussions and cap table management.

Equity

Equity is ownership in a company, typically expressed as a percentage of the total business. When you own 10% equity in a startup, you hold a 10% claim on the company's value and future profits. Equity holders participate in the company's financial upside through increased valuation, dividends, or proceeds from an exit event.

Shares

Shares, or stock, are the individual units that divide company ownership. If a startup issues 10 million shares and you own one million shares, you hold 10% ownership. Companies can create different classes of stock with varying rights, such as voting privileges or liquidation preferences.

Stock options

Stock options give employees the right to purchase company shares at a predetermined price, called the strike price, after meeting certain conditions. Options differ from actual stock ownership because recipients must exercise their options by paying the strike price to convert them into shares. Employees typically receive options that vest over time rather than immediate stock grants.

Vesting

Vesting determines when equity recipients earn full ownership of their granted shares or options. Standard vesting schedules spread equity grants over multiple years, requiring continued employment or service to earn all of their shares. If someone leaves before fully vesting, they forfeit the unvested portion back to the company.

Cliff

A cliff is the minimum time period before any equity vests. Most startup equity includes a one-year cliff, meaning recipients receive no equity if they leave within the first 12 months. After the cliff period, a substantial portion vests immediately, followed by gradual vesting for the remainder.

Cap table

The cap table, formally known as a capitalization table, documents all company ownership, showing who owns how many shares and what percentage each stakeholder holds. This document tracks founders, employees, investors, and advisors, along with their respective ownership stakes. Cap tables evolve with each funding round, new hires, and equity grants.

Dilution

Dilution occurs when companies issue new shares, reducing existing shareholders' ownership percentages. If you own 50% of a company and it issues new shares representing 20% ownership to investors, your stake decreases to 40% of the total. While your percentage shrinks, the company's increased value from new capital can make your smaller slice worth more.

Fair market value (FMV)

Fair market value represents the current price of company stock, typically determined through professional 409A valuations. Companies must establish FMV when granting stock options to comply with tax regulations and set appropriate strike prices. FMV provides the baseline for calculating taxable events and option exercise costs.

Equity allocation is one of the most important decisions founders make since it impacts team motivation, investor relations, and long-term company dynamics. Smart allocation strategies prevent conflicts while ensuring all stakeholders receive fair compensation for their contributions to your startup.

Fair equity distribution requires transparent processes and clear criteria. Founder disputes can stem from perceived inequities in equity splits, making upfront planning important for maintaining team cohesion. Companies that establish allocation structures early avoid contentious negotiations later when stakes feel higher.

Founders

Co-founder equity splits often determine long-term working relationships and decision-making power within the company. Equal splits work well for teams with similar contributions and commitment levels, while unequal distributions may reflect differences in experience, capital investment, or role responsibilities. Common allocation methods include fixed splits based on anticipated future contributions versus dynamic models that track actual time, money, and resource investments.

Founder equity should include vesting schedules or reverse vesting arrangements. If a co-founder leaves early, the company can reclaim unvested shares, protecting remaining founders from scenarios where departed team members retain large ownership stakes without ongoing contribution. Most founder vesting spans three to four years with appropriate cliff periods.

Early employees

Startups typically reserve 10% to 20% of total equity for employee compensation through option pools, which is a set of shares reserved for future employees. Early employees might receive 0.5% to 2% equity grants depending on their role, seniority, and joining stage. Engineering hires, sales leaders, and other key positions often receive larger allocations than support roles.

The employee option pool has strategic purposes for both current compensation and future startup fundraising since investors expect companies to maintain adequate pools for ongoing hiring needs. Before funding rounds, investors often require expanding or refreshing the option pool, with dilution typically borne by existing shareholders rather than new investors.

Investors and advisors

Investor equity varies by funding stage and negotiations. Seed investors might receive 15% to 25% ownership, while Series A rounds can involve 20% to 30% dilution depending on the company's valuation and capital requirements. Founders should plan fundraising strategies to avoid any excessive dilution in early rounds while maintaining enough ownership for motivation and control.

Advisor equity grants typically range from 0.1% to 1% depending on the advisor's involvement level and contribution timeline. Strategic advisors with deep industry connections or specialized expertise might receive larger grants, while occasional mentors receive smaller allocations. Advisor equity should include performance milestones or time-based vesting to confirm value delivery.

Working capital strategies often influence equity allocation timing and structure. Companies with strong cash positions can offer more competitive base salaries with smaller equity components, while cash-constrained startups may weight compensation more heavily toward equity grants.

Startups can structure equity compensation differently, each carrying varying tax implications, vesting requirements, and recipient obligations. Once you know these options, you can choose the appropriate compensation options for your employees and stakeholder groups.

The right equity type can depend on company stage, recipient role, and tax considerations. Early-stage companies often favor stock grants for founders and options for employees, while later-stage startups may use restricted stock units for senior hires.

Stock options

Stock options give recipients the right to buy company shares at a set strike price after meeting vesting requirements. Options are the most common type of equity compensation for startup employees because they offer upside potential without immediate tax bills or upfront costs.

You can use two main option types. Incentive Stock Options (ISOs) work only for employees and offer better tax benefits when you meet certain holding requirements. Non-Qualified Stock Options (NSOs) can go to employees, contractors, and advisors but don't have the same tax benefits.

ISO recipients often don’t pay immediate tax when exercising options, but gains may qualify for capital gains taxes when they sell stock. However, the exercise spread can trigger Alternative Minimum Tax calculations. NSO holders pay ordinary income tax on the difference between exercise price and current stock value,

In order to avoid tax penalties, you need to set proper strike prices through 409A valuations. The strike price must equal or exceed the stock's fair market value on the grant date.

Restricted stock awards (RSA)

Restricted stock awards give actual company shares with limitations such as vesting schedules or performance requirements. Recipients become immediate shareholders but can't sell or transfer their shares until their restrictions end. This works well for founders and early employees when company valuations are still low.

The main advantage is employees or founders get immediate ownership rights, including voting privileges and dividend participation. Recipients benefit from any appreciation starting from the grant date rather than the exercise date, unlike options that require future purchase decisions. Accounting software for startups can include equity management features to track restricted stock vesting schedules and tax reporting requirements.

Restricted stock units (RSUs)

Restricted Stock Units are promises to deliver stock or cash value upon vesting, rather than immediately sharing grants. Most early-stage startups avoid RSUs because of their complexity and immediate tax implications. RSUs work better for mature startups approaching public offerings or companies with established secondary markets.

RSUs automatically convert to shares upon vesting without requiring payments or exercise decisions. This eliminates the financial risk that option holders face when deciding whether to exercise based on current valuations versus strike prices.

The main drawback is immediate tax liability upon vesting. Recipients owe ordinary income tax on the full stock value when units convert to shares, regardless of whether they can sell those shares immediately.

Vesting schedules control when equity recipients earn full ownership of their grants, and this protects your company from people who join briefly and leave with valuable equity. For employees, vesting creates strong reasons to stay long-term since leaving early means losing unvested equity.

Standard vesting setup

Most startups use a four year vesting schedule with a one year cliff. Under this structure, employees earn 25% of their equity after one year, which is known as the cliff. If they leave before the one-year mark, they get nothing. After the cliff, the remaining 75% vests monthly over the next three years until they're 100% vested after four years.

Some companies use quarterly vesting instead of monthly, but the timeline stays the same. Startups may extend vesting to five years, especially for senior executives, but four years remains the industry standard.

Founder vesting

Founders should put their own shares on vesting schedules too. While this may seem strange since founders already own their equity, reverse vesting protects the team if someone leaves early. If a founder quits in year two of a four-year vesting schedule, the unvested shares can be returned to the company.

Most founder vesting runs over three to four years, similar to employee schedules. This can also be crucial for securing funding as investors often require founder vesting before they'll fund your company. They want to know that founders are committed long-term and won't walk away with large ownership stakes after getting investment money.

Cliffs and partial vesting

The cliff period acts as a trial period for both sides. During the first 12 months, either party can end the relationship without the employee keeping any equity. This protects you from giving valuable ownership to people who don't stay with your company long term.

After the cliff, employees keep whatever has vested even if they leave. For example, someone who leaves at 18 months into a four year schedule would keep about 37.5% of their total grant (25% from the cliff plus 6 months of monthly vesting).

Performance or milestone vesting

While time-based vesting is most common, some companies use milestone vesting for specific roles. This ties equity to achieving certain goals like product launches, revenue targets, or customer milestones. Performance vesting works well for advisors or executives where it’s beneficial to link compensation to specific outcomes.

Milestone vesting requires more management and clear goal-setting upfront since you need to define exactly what triggers vesting and what happens if circumstances change. This approach can motivate employees but adds complexity to your expense management and administrative processes.

As a part of this process, document all vesting terms clearly in equity agreements. Make sure employees understand their vesting timeline and what happens if they leave at different points to prevent confusion and disputes later.

Dilution happens when your company issues new shares, which reduces everyone's ownership percentage. For example, you and your co-founder each own 50% of your startup. You raise funding and give investors 25% of the company. Now you and your co-founder each own 37.5% instead of 50%. Your percentages went down, but the company should be worth more with the new investment.

Dilution adds up over multiple funding rounds. Founders might start owning 100%, then drop to around 70% after a seed round, 50% after Series A, and 35% after Series B. This is normal and expected when you raise capital.

Smart founders plan ahead for dilution. Investors often want you to create or expand your employee option pool before they invest. This means the dilution from future employee grants comes from existing shareholders, not the new investors. If investors want a 20% option pool and you currently have 10%, you'll need to add 10% more, which dilutes everyone who owned shares before the round.

You can protect your interests by raising only what you need and getting the best valuation possible. Be sure to keep your cap table clean and avoid giving away too much equity early to people who don't add major value, as every percentage point you give away early is harder to get back later.

Nonetheless, don't fear dilution too much. The goal is strategic dilution where you bring in investors and team members who increase the company's total value, which increases the total value of your shares even when your ownership stake decreases. Startup growth strategies often require external funding to scale quickly. The key is making sure each funding round and each equity grant makes your smaller slice of the business more valuable than your previously larger slice of a smaller pie.

Good investors bring money along with expertise, connections, and credibility that can accelerate your growth. When evaluating dilution, consider the total value creation potential, not just the ownership percentage you're giving up.

Equity compensation involves legal and tax rules that you need to handle correctly. Making mistakes here can cost you and your employees significant amounts of money or create legal problems. Get professional help to set up these structures and processes properly from the start.

Anytime you issue stock or options, you're dealing with securities laws. You need proper legal documentation like board approvals for stock grants, filed paperwork for option plans, and compliance with federal and state securities rules. Professional help, including a startup attorney, can help you avoid costly mistakes like invalid stock grants or lawsuits later.

If you create a stock option plan, you need a 409A valuation to set the strike price for options. This is an independent appraisal of your company's fair market value. In the U.S., this prevents severe tax penalties since options must have a strike price at or above the current fair market value when you grant them. Most startups hire valuation firms to do this annually or after each funding round.

If you offer equity to your employees, be sure that all equity offers should be clearly written in offer letters or equity grant agreements. There shouldn’t be confusion about vesting terms, what happens if someone leaves, or tax implications. Use standard agreements from legal counsel to avoid problems. Consider using business deductions where appropriate to offset some of the costs associated with equity compensation administration.

How taxes work for different equity instruments

Each type of equity compensation has different tax rules. Knowing these differences helps you choose the right equity structure for your situation and prepare your team for what to expect.

Restricted Stock/83(b)

If you or your early employees get restricted stock, consider filing an 83(b) election within 30 days of the grant. Without an 83(b), the IRS taxes the person each time some stock vests, based on the value at that time. This could lead to significant tax bills as your startup grows and the stock becomes more valuable.

With an 83(b) election, you pay tax upfront on the low initial value, then typically only face capital gains tax when you eventually sell. This can save massive amounts of taxes and avoid situations where someone owes tax on paper gains they can't actually cash out.

Incentive stock options (ISOs)

ISOs can qualify for favorable tax treatment if you handle them correctly. There's no income tax when you exercise these options, and your gains can be taxed as capital gains instead of ordinary income. However, exercising ISOs might trigger Alternative Minimum Tax in some cases. If you hold ISOs and don't sell the stock for at least a year after exercise and two years from the grant date, your gains are taxed at the lower long-term capital gains tax rate.

Non-qualified stock options (NSOs)

NSOs don't have special tax benefits. Any difference between the stock value and strike price gets taxed as ordinary income when you exercise, and your company also has to withhold taxes. This is why many companies prefer ISOs for employees and use NSOs for contractors or international employees who can't get ISO benefits.

Restricted stock units

RSUs get taxed as soon as they vest since the person automatically owns shares or their cash value at vesting. This creates immediate tax liability on the full stock value, which can be significant. Companies sometimes delay RSU delivery until a liquidity event to help manage this tax burden.

You can avoid common equity mistakes by following proven strategies. These practices help you structure equity compensation that works well for everyone while protecting your company's interests.

Plan equity early

Create your cap table from the start and allocate shares for founders, an option pool for employees, and space for future hires. Planning ahead prevents scrambling later or over-promising equity when you don't have enough to give. A clear plan also helps in discussions with investors and new team members, similar to how operating budgets help you plan other business expenses.

Be transparent with your team

When offering equity to employees or co-founders, explain exactly what the numbers mean. Don't make vague promises without context, and always explain that dilution means that that 5% represents their share right now, but future investment rounds will reduce that percentage. Setting realistic expectations builds trust and prevents disappointment later.

Use standard vesting for everyone

All equity grants should have appropriate vesting schedules with cliffs, including founder equity. This protects your company and shows investors that your team is committed to long-term growth. Never give immediate vesting on large equity stakes or you might end up with people who no longer contribute but still own significant pieces of your company.

Don’t over-dilute early

While dilution is necessary eventually, avoid giving away too much equity in the very early stages. It's tempting to offer big chunks to early hires or advisors, but you may regret it when you need equity for an executive or investor funding. Keep some reserve so you can make important hires later.

Regularly reevaluate compensation

As your company grows, review whether your equity grants stay competitive with market rates. Use data from third-party services to make sure your offers are fair. Plan for refresh grants to reward employees who stick around past their initial vesting since this maintains long-term motivation and prevents them from looking elsewhere.

Consider legal and tax deadlines

Be sure to keep any legal or tax deadlines in mind throughout this process. For instance, file 83(b) elections within 30 days for stock grants. Track option exercise windows since employees often have just 90 days after leaving to exercise their options. Missing these deadlines can cause major tax problems for you and your employees.

Document and track everything

Use cap table management tools or detailed spreadsheets to track all grants, vesting schedules, and ownership changes. Keep records of board approvals and signed agreements since administrative errors in equity can lead to serious disputes and legal issues later. Good record-keeping protects everyone and makes audits or due diligence much easier, just like proper expense tracking helps you manage other business costs.

Consider working with financial management tools to track equity compensation alongside your other business expenses and financial obligations. This helps you see the full picture of your compensation costs and the cash flow impact.

Startup equity compensation is one of your most powerful tools for building a successful company. The decisions you make about equity will shape your startup's future, and smart founders use equity strategically to attract top talent on limited budgets, align team incentives with company success, and preserve cash for growth while building motivated, committed teams.

The complexities around different equity types, tax implications, and legal requirements show why professional guidance matters. Whether you're choosing between stock options and restricted stock, planning for dilution across funding rounds, or ensuring compliance with securities laws, getting it right from the start prevents costly mistakes later on. Companies that master equity compensation create sustainable competitive advantages by building a culture of ownership where everyone wins when the company succeeds.

While you're structuring equity compensation to attract and retain talent, be sure to consider the financial stack that supports your growing team. Brex's spend management software and integrated corporate cards are designed for startups and scaling businesses, offering high credit limits based on your business fundamentals rather than personal credit scores. This means that when you equip your employees with spending power that scales with your company's growth, you can embed their cards with expense policies to maintain tight financial control while getting real-time visibility into expenses.

Managing equity compensation alongside your company's broader financial needs requires integrated solutions that grow with your startup. Brex's startup business account combines high-yield accounts with expense management automation and accounting automation software, giving you the financial foundation to support both your equity strategy and day-to-day operations. When your team members exercise their options or receive equity payouts, you'll have the banking infrastructure to handle increased cash flows and more complex financial management needs that come with startup success.

Before switching to Brex, Treet, a seed-stage startup that helps fashion brands launch resale sites, was slowed down by manual reimbursement and reconciliation processes. Brex transformed what were time-intensive workflows into streamlined and automated procedures with Brex corporate cards, business banking accounts, and spend management features.

“We’re using Brex for all of our company expenses, including our annual offsite. With Brex budgets, our employees have autonomy to use their card to help out the team or for one-off expenses like dinner with a colleague,” said Jake Disraeli, co-founder and CEO at Treet. “Until we hire a CFO, I’m handling the day-to-day financial management. As an early-stage founder who wears a lot of hats, having tools like Brex makes it so much easier.”

Sign up for Brex today to ensure your financial stack is ready to help your startup grow.