Valuing Employee Options

Yesterday, I read an interesting exchange on Twitter about how to value employee options. All of it was sparked by this tweet:

The fundamental question is: if you're joining a company valued $20m and you're getting a 1% equity stake, are you getting $200k in addition to your salary? Kind of, but not exactly. Here are some assorted thoughts on the subject.

Caveat: I'm absolutely not a financial advisor, these are not promises or guarantees, etc. This is just food for thought. Everything in this post is based on my understanding from talking to people and reading a lot, plus some limited first-hand experience. If you think anything below is wrong, please let me know and I'll correct it.

Options and stocks are different

An option is not the same as a share of stock. Options have a strike price, and they are worth nothing below that strike price. For example, if you have 10,000 options to buy stock for $1 per share, and a share of stock is worth $5 during an acquisition or IPO, you make $4 per option. However, if the stock is worth $0.75 during an acquisition, you make nothing, even though the stock has some value.

Common and preferred shares are different

Investors get preferred equity in a company, and preferred equity comes with extra rights like senior liquidation preferences. What that means is that if a company exits, preferred stock holders (investors) get paid back before everyone else (founders and employees). This can dramatically change the pay-off for an exit. For example, let's say that over the course of several funding rounds, the founders raised $8m and sold 40% of the company. If the company is acquired for $12m, then investors get their $8m back first -- not $4.8m, which would be 40% -- and then everyone else splits $4m. However, if the company exits for $80m, then liquidation preferences are no longer an issue.

Because common and preferred shares have different rights, they have different prices. For early stage companies, preferred shares are often worth about 3x as much as common shares (see this Quora thread). This is actually good: when you get employee options, your strike price is the common stock price, so if the company does okay but not great, you still have some upside. (For example, if preferred stock is worth $3/share and common is worth $1/share, and the company is sold for $3/share, you'd get $2/share for your options. If your strike price had been $3/share, you'd have made nothing.)

Typical outcomes

I haven't seen great data on typical outcomes for employee stock options, but I think data on angel investor outcomes is a decent proxy. The best data I've seen for that is from a study called Returns to Angel Investors in Groups

Here's the key chart:

Angel investing returns

Basically, more than half of investments fail, 1/3 are small successes (1x-5X returns), 1/8th are big successes (5x-30x), and 1/20th are huge success (30x+). One thing to note is that for huge successes, employees and founders will get diluted over time, so your 1% stake might be more like 0.6% or 0.4% after 2-3 more rounds of funding. In that case, a 50x exit from when you joined will actually be more like 20x or 30x for you. (Which is still an awesome outcome.)

Let's say your 4-year grant is for 1% of a company valued at $10m. An overall estimate of what your options will be worth in 5 years might be something like:

50% chance your options are worth $0
30% chance your options are worth $100k-$300k
10% chance your options are worth $400k-$800k
5% chance your options are worth $1m-$2m
5% chance your options are worth $2m+

Note that for a 4-year grant, you're basically earning a quarter of the value each year. That is, there's a 10% chance your options will be worth an extra $100k-$200k per year of employment ($400k-$800 total for a 4-year grant).

Timing

The time since the last funding round can be useful for estimating what a company is worth. If companies that do well triple their valuation every 15 months, and you're joining 12 months after the last funding round, then that's great! Assuming the company isn't about to fold, there's a good chance the value of your options will 2X or 3X in a few months — at least on paper =).

What does all of this mean?

Stock options are basically a positive-expected-value lottery ticket. The expected value of your 4-year grant might be 2x-3x of its initial value, but with huge variance. If you work at 10 good VC-backed startups over 25 years, chances are that the options from 1-2 companies will be worth a lot, the options from 2-3 companies will be worth a little, and the remaining options won't be worth anything. Overall, if you're going to join a startup to work for the money, you're probably making a mistake — wall street or Google or Facebook are likely better options.

So why work at a startup?

There's no right or wrong answer here, and I hope this post makes the financial side a little bit less of a mystery.

Addendum (huge h/t to Andrew Chen for these suggestions.)

  1. In acquihires, the acquisition is usually structured so that common stock is worth very little or nothing, but employees who are joining the acquiring company get good (or great) retention packages.

  2. Typical dilution is 20-25% during seed, Series A, and Series B rounds, and then drops to 10% or less for larger growth rounds. So 3% just before the seed round might be worth 2.4% after the seed round, 1.8% after a Series A, 1.4% after a Series B, and 1.2% after Series C and D. This might sound like a lot of dilution -- and it is! -- but 3% of a seed stage company valued at $3m is much less money than 1.2% of a Series D company valued at $500m.

  3. It's rare to stay at a company for more than 2-3 years, but options typically have to be exercised and converted into stock within a few months of leaving a job. This can be cost prohibitive, especially if a company is doing extremely well. This creates a dynamic where you're either stuck at a company until they exit, or you can try to sell your equity on secondary markets like SharesPost or EquityZen. Some more progressive companies, like Pinterest, give employees more opportunities to exercise and sell options before an exit. Early exercising when you first join a company can address this problem, but has its own pros and cons. (I want to reiterate: I'm definitely not a financial advisor and I'm not recommending any specific course of action.)



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