Your Equity: More Than Just a Number
For many start-up employees, a significant part of their compensation comes in the form of equity, most commonly through Employee Stock Option Plans (ESOPs). These aren't shares themselves, but the right to buy a certain number of company shares at a fixed,
predetermined price in the future. This fixed price is called the 'exercise price' or 'strike price'. The idea is simple: if the company grows and its value increases, you can buy shares at your low, locked-in price and potentially sell them for a much higher market price, turning your hard work into tangible wealth. Before you can purchase these shares, you must 'vest' them, which typically happens over a period of time, like a few years, as a way to ensure you stay with the company.
The Pre-IPO Reality: The 409A Valuation
Before an IPO, you'll often hear about the company's valuation, but the number that matters for your stock options is the 409A valuation. This is an independent appraisal of the fair market value (FMV) of the company's common stock. Its primary purpose is to set the strike price for employee stock options. Tax laws require that the strike price be at or above this FMV to avoid creating immediate tax problems for employees. This valuation is usually done at least once a year or after a major event like a new funding round. Crucially, the 409A valuation for common stock (what employees get) is almost always significantly lower than the 'headline' valuation announced during a funding round, which applies to preferred stock held by investors.
Why Investor Valuations Are Different
The valuation you read about in the news after a venture capital funding round is not the 409A valuation. That higher number is based on preferred shares, which come with extra protections and rights that common shares lack, such as liquidation preference (getting paid first in a sale). Furthermore, a 409A valuation applies a 'discount for lack of marketability' (DLOM) because, as a private company, your shares can't be easily sold. This discount can be substantial, often making the 409A valuation 30-70% lower than the preferred stock valuation. So, don't be alarmed by the gap; it's a normal and necessary part of how private company equity is structured.
The IPO Valuation: A New Playing Field
The Initial Public Offering (IPO) is the process where a private company becomes public, listing its shares on a stock exchange. The IPO valuation is determined by investment bankers through a process called a 'roadshow,' where they gauge interest from large institutional investors. This valuation is forward-looking and based on market appetite, company performance, and growth projections. It is typically much higher than any previous 409A valuation because the shares are now liquid and can be traded freely by the public. This gap between your low strike price (based on an early 409A) and the high IPO price is where the potential for significant financial gain lies for employees.
From Paper Wealth to Real Money
Having valuable options is one thing; turning them into cash is another. The process involves exercising your options—paying the strike price to convert them into actual shares. This step itself can trigger a significant tax event. In India, the difference between the Fair Market Value (FMV) at the time of exercise and your exercise price is considered a 'perquisite' and is taxed as part of your salary income. This means you could face a large tax bill before you've even sold a single share. After the IPO, there's usually a 'lock-up' period of around six months during which employees are restricted from selling their shares. Once the lock-up ends and you sell your shares, any profit you make (the sale price minus the FMV on the day you exercised) will be subject to capital gains tax.
