{"id":232,"date":"2010-11-23T13:27:46","date_gmt":"2010-11-23T21:27:46","guid":{"rendered":"http:\/\/www.danshapiro.com\/blog\/?p=232"},"modified":"2010-11-23T22:56:32","modified_gmt":"2010-11-24T06:56:32","slug":"how-much-are-startup-options-worth","status":"publish","type":"post","link":"https:\/\/www.danshapiro.com\/blog\/2010\/11\/how-much-are-startup-options-worth\/","title":{"rendered":"How much are startup options worth?"},"content":{"rendered":"

Startup pay kind of sucks.<\/p>\n

This is not a well-kept secret.\u00a0 A great startup with a dozen or so people will typically pay its employees about a third less than a big company.\u00a0 Some will argue that that’s because of the value of the equity that startups give you.\u00a0 I argue that that’s the price of doing something that’s more fun but of unproven economic value.<\/p>\n

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.\u00a0 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.\u00a0 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%).\u00a0 This of course raises the simple question: what are they worth?<\/p>\n

I’m going to give you a few tools you can use to take a swag at that value.\u00a0 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.<\/p>\n

\""I<\/a>Note that many people would prefer you not know this stuff.\u00a0 At most startups, the equity’s worth a lot less than you might imagine (as you’ll see below).\u00a0 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<\/a>.\u00a0 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.\u00a0 It’s like he’s working on an xbox achievement.<\/p>\n

Me? I want my potential new hires to know exactly what they’re getting, erring neither high nor low.\u00a0 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.\u00a0 And I don’t want to sandbag, because closing a hire is hard enough without telling people to ignore the equity upside.\u00a0 So that’s what I’m here to tell you: how to know if you’re getting a good deal from a startup.\u00a0 And my secret ulterior motive is this: I usually give my employees a great deal on their equity.\u00a0 That means that if they’re informed consumers, my companies’ offers look awesome compared to anything else they’re seeing.<\/p>\n

Let’s start with the basics, which are completely misleading.\u00a0 Then I’ll get to the important stuff.<\/p>\n

The value of a whack of equity is this:<\/p>\n

\"value<\/p>\n

Quite simply, it’s your percent ownership times the company’s value.\u00a0 Seems simple enough, but it’s totally wrong.\u00a0 There’s a little reason why and a big reason.\u00a0 The little reason is that the above equation describes the value of shares<\/em>.\u00a0 You’re probably receiving options<\/em>.\u00a0 An option is worth less than a share.\u00a0 How much less is excruciatingly difficult to model accurately<\/a>.\u00a0 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.<\/p>\n

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<\/strong>.<\/p>\n

This isn’t some sort of rant: it’s basic economics.\u00a0 You see, investors typically take rights when they invest that put them “in front” of regular investors.\u00a0 If they invest a million bucks and the company sells for a million bucks, they get their money back and everyone else gets nothing.\u00a0 It’s called a preference, and Brad has explained it much better than I can<\/a>.\u00a0 It has a colossal impact on the expected returns.\u00a0 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.\u00a0 And then they have a set of terms called “protective provisions” which (more Bradness<\/a>) 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.<\/p>\n

Back when the IRS allowed such things<\/a>, the rule of thumb was that common stock was worth one tenth<\/em> as much as preferred stock.\u00a0 And the “value of company” number, above, is a preferred stock number.\u00a0 Yikes.<\/p>\n

So that’s the bad news: options on common shares in a venture funded company have a pretty crappy book value.<\/p>\n

If you thought the company was worth what the IRS does, you probably would just take Mark’s advice and ignore the equity.\u00a0 But there’s other ways to look at it.<\/p>\n

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.\u00a0 Most startups that try to sell the value of your options do this in an optimistic (some might say “false”) way.\u00a0 I’ve heard the phrase “Our company just wouldn’t accept an offer of less than $500,000,000” uttered by recruiters.\u00a0 But there’s a right way as well as a wrong way.<\/p>\n

The basic math for this one is:<\/p>\n

\"SalePrice<\/p>\n

that means you take your shares, divide by total shares, and multiply by what you think it’ll sell for.\u00a0 Of course, nothing’s that simple.\u00a0 You have to:<\/p>\n