# How much are startup options worth?

Posted: November 23rd, 2010 | Author: | Filed under: Startups | 36 Comments »

Startup pay kind of sucks.

This is not a well-kept secret.  A great startup with a dozen or so people will typically pay its employees about a third less than a big company.  Some will argue that that’s because of the value of the equity that startups give you.  I argue that that’s the price of doing something that’s more fun but of unproven economic value.

But regardless of why you’re doing it, there’s no question that startups ply you with ownership in the company, typically in the form of stock options.  They will argue that there’s tremendous value in those shares, more than you’ll get from a big company, but they tend to get all nervous-looking when you ask them how *much* value.  Now there’s no doubt that 1000 options on stock in a startup with 1mm shares outstanding (0.1%) has a lot more upside than 1000 options on stock in google (0.000003%).  This of course raises the simple question: what are they worth?

I’m going to give you a few tools you can use to take a swag at that value.  More importantly, I’m going to give you a checklist of key questions to pummel your potential new employers with that will simultaneously put you in a position of much greater knowledge, and making them think you’re a badass negotiator.

Note that many people would prefer you not know this stuff.  At most startups, the equity’s worth a lot less than you might imagine (as you’ll see below).  One of my favorite bloggers, Mark Suster, argues that you should just assume the equity is valueless and be pleasantly surprised if you find otherwise.  This is one of the reasons I admire Mark – he’s so good at closing candidates that before he does it, he takes on voluntary challenges.  It’s like he’s working on an xbox achievement.

Me? I want my potential new hires to know exactly what they’re getting, erring neither high nor low.  I don’t want them misled with a number that’s too big, or there’s hell to pay when they realize they’ve been had.  And I don’t want to sandbag, because closing a hire is hard enough without telling people to ignore the equity upside.  So that’s what I’m here to tell you: how to know if you’re getting a good deal from a startup.  And my secret ulterior motive is this: I usually give my employees a great deal on their equity.  That means that if they’re informed consumers, my companies’ offers look awesome compared to anything else they’re seeing.

The value of a whack of equity is this:

$ValueOfCompany * \frac{SharesYouGet}{FullyDilutedShares}$

Quite simply, it’s your percent ownership times the company’s value.  Seems simple enough, but it’s totally wrong.  There’s a little reason why and a big reason.  The little reason is that the above equation describes the value of shares.  You’re probably receiving options.  An option is worth less than a share.  How much less is excruciatingly difficult to model accurately.  It’s about the same before your first financing round, but it can be a meaningful difference if your company has taken on a few subsequent rounds of capital.

The big reason is something investors don’t like to talk about, but here it is: the existence of preferred, “investor” shares significantly devalues regular, common shares.

This isn’t some sort of rant: it’s basic economics.  You see, investors typically take rights when they invest that put them “in front” of regular investors.  If they invest a million bucks and the company sells for a million bucks, they get their money back and everyone else gets nothing.  It’s called a preference, and Brad has explained it much better than I can.  It has a colossal impact on the expected returns.  They also often have something called participation, meaning that after they get their money back, they continue to get returns as if they hadn’t.  And then they have a set of terms called “protective provisions” which (more Bradness) explicitly allow them to block actions that are in the best interest of the company’s shareholders, as a whole, and supported by a majority of shareholders.

Back when the IRS allowed such things, the rule of thumb was that common stock was worth one tenth as much as preferred stock.  And the “value of company” number, above, is a preferred stock number.  Yikes.

So that’s the bad news: options on common shares in a venture funded company have a pretty crappy book value.

If you thought the company was worth what the IRS does, you probably would just take Mark’s advice and ignore the equity.  But there’s other ways to look at it.

Another, quite reasonable way to consider the value of the options (or at least their value to you), is to look at what you predict they’ll be worth.  Most startups that try to sell the value of your options do this in an optimistic (some might say “false”) way.  I’ve heard the phrase “Our company just wouldn’t accept an offer of less than $500,000,000″ uttered by recruiters. But there’s a right way as well as a wrong way. The basic math for this one is: $SalePrice*PercentOwnership$ that means you take your shares, divide by total shares, and multiply by what you think it’ll sell for. Of course, nothing’s that simple. You have to: • Account for the possibility that the company may fail • Consider dilution from subsequent financing rounds • Subtract any preference • Account for any participation • Subtract bonus/retention/carveout packages and a bunch of other tricks that investors (and management) can use to manipulate the return curve. This becomes unbelievably complicated, since key factors are things like how good a negotiator your CEO is. To try and capture all of this, I banged out a set of heuristics (definition: “statements people will argue about”) that you can use to make a crude estimate. 1. Do you believe in the company? Really, really believe it’s going to be awesome? Feel in your guts that it’s going to be something amazing? 90% of new companies fail, so if you don’t, then you should assume your stock is worthless, and stop here. Also, you should go work elsewhere, because life’s too short. 2. Ask the company: “What is your expected exit range, and what comparables did you use to get there?” (in English: how much will you sell for, and who do you use as a basis for comparison). If you agree that this company looks like the comparables, then take the low number and divide it by 2. If they say it’s going to IPO, divide by 10 instead. This is X. 3. Ask how many rounds have been raised, and how much more they expect to raise before they exit. Add them together, then double them, to get Y. 4. Ask if there’s a preference, and if so, what multiple. Ask if there’s participation, and if so, is it capped. 5. Cube the preference (as in, 2 x 2 x 2). That’s Z. 6. If there’s a capped participation, add 1 to Z. If it’s uncapped, add 2. 7. Ask who’s on the board. If a majority of board members are employees/founders, do nothing. If it’s a 50/50 balance between founders and investors, add 1 to Z. If it’s tilted towards the investors, add 2 to Z. 8. Now for the grand finale: $X-(Y*Z)$ And that’s what they’re worth. Here’s an example: You’re being offered 0.1% of a great company that thinks they’ll exit for$250-500mm.  They’ve raised $5mm and expect to raise$10mm more.  Terms are 1x preference, capped participation. The board is evenly split between founders and investors.

X: 250/2=125
Y: 15*2=30
Z: 1^3+1+1=3

125-(30*3) = $35mm. You should consider your shares to be worth 0.1% *$35mm = $35k. I love startups. I love it when people get rich from startups. I want you to join a startup, and I want it to shower you with riches beyond your wildest dreams. I want you to blow all this math out of the water. It’s all guesstimates anyway… but it’s better than fencing left handed. Special thanks to Dave Schappell of Teachstreet, Rand Fishkin of SEOMoz, and Tony Wright for proofreading and edits. (You might want to subscribe or follow me on Twitter so you don’t miss new articles) • http://twitter.com/danshapiro Dan Shapiro I didn’t want to clog the article with an explanation of each of the heuristics I provided, so here it is in the comments. #1 is pretty self-explanatory. #2 is the expected value, halved because an awesome startup with every chance of success still fails half the time. If you’re swinging for the fences (shooting for IPO), you’re way more likely to either fail or get so much preference ahead of the common that you never see anything. #3 is because everyone underestimates the amount they’ll need to raise. #5 The huge penalty is for two reasons. One, because it’s tremendously bad for the common. Two, because it often means something worse: the company’s up against a wall, the CEO’s a bad negotiator, everyone’s expecting the common to be worthless so they have to make it up in preferences, etc. #6 Again, the direct impact isn’t as bad as this makes it out to be, but a CEO who does a good job negotiating preferences is a leading indicator of other good things: s/he knows how to generate demand for the company, has leverage, knows how to squeeze every ounce out of a deal, etc. This is basically a proxy for if the CEO will do well during negotiations to sell the company. #7 A common-dominated board will tend towards common-friendly exits, and indicates a CEO who does well in negotiations. Again, this is all guesswork, particularly trying to figure out the all important “will the CEO do a good job selling the company” factor. But I think it’s a decent swag. • http://www.istanczyk.com Ian is it possible for a young person to *not* get screwed the first time they’re granted options from a startup? If not before, then maybe now. Thanks. p.s. they should teach you this in college….seriously. • James Pfft.. I *am* left handed. Good information and advice though. • http://twitter.com/danshapiro Dan Shapiro If you follow this, you won’t get screwed. But if the question is “is it possible for a young person to get rich” – then the options are to find the next Google (aka “win the lottery”) or found the company yourself! • http://twitter.com/Neuromancer Maurice Walshe Good info but only$35k! some of the share saves in BT returned around £40k (tax free) if you maxed it out at £200/m not much or a return for a 30% pay cut and that’s not counting profit related shares or any of the special awards some of the more senior people got given

good post, thanks Dan!

• http://bothsidesofthetable.com msuster

thanks for kind words.

the one thing to consider: places where people obsess about options create cultures where everybody is always talking about options, calculating the value of options and disappointed when the company hits a bump in the road and everybody grumbles because their option value might have changed. I saw this through the first dot-com boom & bust.

I prefer people who are “in it” for other reasons. And hopefully they’ll have a pay day one day on the options anyways.

• http://www.marcoullier.com/blog Anonymous

Back when they brought in a management team to spin IGN out of Imagine Media, the new team constantly talked about how much money everyone was going to make. The common refrain (behind closed doors, of course) was “No, jerk. YOU’RE going to make a ton of money. You have all the equity.”

I counsel all of my potential hires that if they want to make a pile of money in startup stock, they need to go start their own business, because odds are, even my stock is going to be worthless. The focus should be on making something great so that they have more opportunities to start their own company when inspiration strikes.

• Ne

Thanks for this post. Wish, I had read it before I actually joined the startup, where I need to work like donkeys. Only hope was stock options, but the actual value does not look that lucrative now : (

• http://blog.fastfedora.com/ Trevor Lohrbeer

As an interesting point of data, I was talking to someone from SVB Analytics the other day and they mentioned that based on their research, 65% of all VC-backed companies return no value to the common shareholders.

• Riposte

“The little reason is that the above equation describes the value of shares. You’re probably receiving options. An option is worth less than a share.”

This is misleading because an option is not worth less than a share. (Actually, technically speaking an option is usually worth more than a share because it has both an intrinsic value and a time value.) It is because the class of shares to which your option (common stock, usually) relates is worth less than the class of shares which investors get (preferred stock, with all these additional rights which bump up their value).

That does sound like a dysfunctional situation. I’ve never seen it first hand, thankfully. But I don’t think that being transparent up front about compensation necessarily creates such a situation. I think that comes from how you lead the company and the team *after* they accept. And I can only imagine how hard it was to manage that during the worst of the bubble…

• Guest

Hi!

What does “mm” mean? Millimeters? I don’t understand it. I also see things like “$35mm” – do you mean “$35 M”? that is, 35 Million Dollars?

Just trying to understand, I’ve not seen the nomenclature you are using, nor have I seen it in a dictionary.

Thanks!

• scott

yep, its a common shorthand for million, I believe “thousand thousand” is the derivation.

• Anonymous

Another great Mark Suster piece is about learning (startup experience) versus earning (big % ownership):http://www.bothsidesofthetable.com/2009/11/04/is-it-time-for-you-to-earn-or-to-learn/For all but the biggest startup successes, if you’re not part of the founding team you should focus on learning from the experience instead of cashing in.It will be a challenge getting most hiring managers and even the CEO to state terms beyond valuation and % ownership off the top of their head. The valuation and percent sold (dilution) are more memorable than the pages of legalese for a funding round. When I was deciding whether to convert options to stock, the founder of the company I work for wasn’t familiar with either term and we had to get our lawyer to read over the stock documents with me. Luckily we just have a 1x liquidity preference with no participation — the preferred shareholders get their money back or they get their pro-rata share of the company, whichever is larger. Unlike the concise equations above, the terms are all spelled out over multiple paragraphs. Options are worth less than an equal number of shares of stock because of the strike price and the difference between short term taxes for options and long term capital gains for stock. Thanks to the IRS 409a rules, strike prices are valued higher than the 1/10th of preferred stock convention from pre-2004. Even restricted stock can cause an unanticipated tax hit on vesting (unless a Section 83b election is taken), so it’s best to focus on the experience over the potential payout.

• http://www.danshapiro.com/blog Dan Shapiro

Very, very true. The best reason to work at a startup is because doing it is awesome. The second best is to learn, so you can do your own. Hitting a big win is not a great reason to be a startup employee. :)

• http://www.danshapiro.com/blog Dan Shapiro

Fascinating! I actually suspected it was a little higher. Good to have a number to that.

• http://www.danshapiro.com/blog Dan Shapiro

That’s OK! Kick butt, network, and make yourself an invaluable team member with a great reputation. You’ll be more proud of it than any big company gig, and the next one you do will be even better. And who knows? Maybe this one’s the payday!

• Anon

They teach it if you’re a finance major. The Black Scholes model still gives me nightmares.

• http://www.stormdriver.com StormDriver

I totally agree with Eric below that if composition options are not lucrative enough you should focus on the learning experience. It can be a tremendous opportunity if the start-up has a potential. You get to be flexible, there are few bureaucratic hurdles and they encourage experimentation and innovation because every start-up basically depends on these qualities. They also have an advantage over bigger companies in terms of flexibility; they can quickly introduce new features and modify existing features without great overheads or ego clashes.

• Strikeprice

An option is worth less than a share, because if you have an option, you still need to pay the strike price to get the share.

• Anonymous

I have never seen mm mean anything other than millimeters. Really weird.

• http://www.myStockOptions.com Bruce Editor myStockOptions

Good insights and advice on how to think about stock options in a private company. There are a few additional thoughts to also consider:

1. Likelihood of IPO compared to company getting acquired. You will do much better in an IPO. For many employees, except for founders and key executives, the amount they get from an acquisition is often equal to a good bonus. On http://www.myStockOptions.com we have heard many stories through the years and I would say that is a common remark.

2. Know what type of options you are getting: Incentive Stock Options (ISOs) or nonqualified stock options (NQSO) and whether you can exercise them immediately in exchange for stock that must then vest. The tax treatment is different, particular if you plan to exercise the options while the company is private and before you think it will get bought. You cannot sell shares to cover taxes.

3. Check to see if there is any trading market in the stock on sites such as SecondMarket and SharesPost. This will only be for large private companies.

4. For small private company, ask if it is a Subchapter-S corporation. If it is, that means the profits and losses will flow through to shareholders, which will be you at exercise. If profitable, find out if they distribute profits at least for the taxes owned.

I also suggest you look on http://www.myStockOptions.com in the Pre-IPO section (http://bit.ly/gbt3A6 ) at the various articles and FAQ for additional insights, particularly on tax topics.

Bruce Brumberg, Editor, http://www.myStockOptions.com and http://www.myNQDC.com

• http://www.thecuriousentrepreneur.com Andrew Skotzko

At the end of the day, it’s all about passion: how much do you love the product and the team? This is most important. Options are important, but if you can, I think it makes sense to think of them a little bit like the money you take to Vegas: write it off in the beginning, and if you make anything, then sweet! Gravy. This of course assumes you are more in learn mode than earn mode.

One additional question that’s worth getting an answer to, when evaluating startup options: in the case of an exit, is there any acceleration? If so, how much acceleration?

• Anonymous

This is not a well-kept secret.  A great startup with a dozen or so people will typically pay its employees about a third less than a big company.  Some will argue that that’s because of the value of the equity that startups give you.  I argue that that’s the price of doing something that’s more fun but of unproven economic value.

• Anonymous

the thing to think about: locations exactly where individuals obsess regarding
choices produce ethnicities exactly where everyone is definitely referring to
choices, determining the worthiness associated with choices as well as let down
once the organization strikes the bundle within the street as well as everyone
grumbles simply because their own choice worth may have transformed.

• http://www.im3.co.uk/ SEO Sheffield

The phylum of organisms most closely linked to the evolution of land plants is the (mc)?

thanks for the great education.

• Guest1

Is a privately-held company obligated to tell you how many total shares of common or preferred stock they have issued? I know this helps to determine your percent of ownership of the company.

• http://www.danshapiro.com/blog Dan Shapiro

No. But you can, and should, make it a prerequisite of working for that company.

• gogo

Hi Dan,

You say that if the company is says they are going IPO, then divide by 10. Why is that?

What if my company is about to go IPO in the next 6-12 months? What should I divide by?

Great article BTW. Thanks for writing it!

• http://www.danshapiro.com/blog Dan Shapiro

There’s a range of possible good outcomes. They’re ruling out all but one of them. That’s like saying you’re playing poker and will fold anything less than a straight flush. (There are some problems with this comparison, but that’s the gist of the reasoning).

But if the company claims they’re *about* to IPO, then they’re not the kind of company I am describing when I refer to a “startup” and you should ignore most of what this article says.

But you should also know that at least half (by my estimation) of the companies that strongly hint they’re going to IPO in the next 6-12 months to their employees, potential or otherwise, don’t. IPO plans fall through all the time.

And what’s more, if the company’s about to IPO, pre-IPO shares will have a much smaller bump. So you’re betting on the company’s long-term success on the stock market, which is a whole ‘nother thing entirely.