Nearly
everyone who goes to work for a startup gets options, and the first
question they ask is “how much are these options really worth?” When
you are considering a job offer, particularly competitive job offers,
it’s important to understand the value of the whole package. Putting a
value on an option grant in a pre-IPO startup is quite challenging, and
there are many opinions. I’d like to share the way I think about option
valuation.
The Wrong Way
First, let’s start with the wrong way to value stock options. It goes something like this:
- Wow, I’ve got 10,000 options with a strike price of $0.70
- The stock price at the last round of investment was $2.50
- My options are worth 10,000 * $1.80 = $18,000
What’s wrong with this? Several things. First, your options are for
common stock, while the investors were buying preferred for their
$2.50. If your company did the 409A
valuation correctly, then the fair market value of what you have an
option on is probably right around what the strike price is. For more
on 409A and how strike prices are set, see Brad Feld’s posts on 409A.
Second, the terms of investment probably include some amount of
participating preferred, dilution protection, and a variety of other
complicated things which protect the people who put in the millions of
dollars and paid for the lawyers. If you can get them, the details of
these agreements are interesting. To understand them, you’ll probably
want to read Brad Feld’s posts on term sheets.
In fact, if you are interested in the details of how startups are financed, you could do worse than just read everything at Feld Thoughts. But my assumption here is you just want to know whether Company A or Company B is making a better offer. So read on.
For a contrarian perspective, you can read Venture Hacks, which disagrees with me and says you should focus on share price. They also have a whole post on analyzing startup job offers. Further evidence there are many ways to think about this.
What Really Gives Your Options Value
If you aren’t a founder or an executive, your options are like
lottery tickets. This is because there are three potential outcomes for
a startup: a huge win, a weak sale, or total failure. Unsurprisingly,
in total failure your options won’t be worth anything. Somewhat
surprisingly, you are likely at a deep disadvantage in a weak sale.
All those terms of investment to protect the people who put in
millions of dollars mean that they get the lions share of the proceeds.
Generally they get their original investment back, and probably a hefty
share of whatever is left over. What constitutes a weak sale varies by
the terms, but it is probably anything up to three times the amount of
money that has been invested. In such a sale even the money that is
left over may be complicated with additional terms, like earn outs or management carve outs.
In a weak sale, there isn’t enough cash to make everyone happy, so
people are going to be counting the pennies and taking care of their
own. If you are an engineer who was late to the party, your interests
will probably not be protected.
So the only situation in which you will make out well is the big
win. In a big win, like an IPO or a big flashy acquisition by a public
company, there is plenty of money to make everyone happy. The VCs are
having the kind of result they can tell all their friends about.
If the term sheets were reasonable, then all of those preferential
treatments are gone and everyone is treated equally according to the
fraction of the company they own. Even the little guys like you will
make out OK.
Because the big win is the only situation in which you make
significant money, it’s the only one you need to think about when
valuing your options.
The Information You Need
Focusing on the big win, there are three pieces of information you need:
- What fraction of the company do you own?
- How much will the company be worth if you win big?
- How likely is the big win and how far off?
If you knew all these things, some simple multiplication and net present value analysis would tell you what your options are worth. So how do we get this information?
What Fraction of the Company do You Own?
Any option grant is going to tell you how many shares you get. But
what is really important is how large a fraction of the company those
shares represent. To figure that, you need to know is how many total
shares have been approved for issue. The company should be willing to
tell you this. Chris Dixon has a great post about this in The one number you should know about your equity grant. That post says it better than I could: you need to know the fraction, and the company must be willing to tell you.
How Much will the Company be Worth If You Win Big?
The second term in the equation is how much the big win is worth.
There are a number of ways to look at this, all of them require doing
some amount of homework. I recommend collecting a variety of answers,
to get a distribution and a sense of what is going on.
The first technique is simply to ask your contacts at the firm how
they are thinking about exits. You probably want to preface this with
an acknowledgement that you know nothing is certain, and of course they
are building a company for the long term and not looking for a quick
flip. On the other hand, flipping is good, and this is probably your best opportunity to learn how the management team is thinking about it.
The second is to learn more about the investors. If the company has
followed a traditional VC fundraising model, without any down rounds,
then you can look at the total capital invested to estimate the
expected big win return. In order to invest money, each of the VC
partners had to justify the potential for the investment to return five
to ten times as much money back in a successful exit. To learn more
about the economics behind this, see Fred Wilson’s posts on Venture Fund Economics.
You can assume the investors own 50-70% of the company unless you know
otherwise. So if you multiply the invested capital by 10, you get a
reasonable estimate of where they thing a big win would fall.
The third is to look at historical exits in your space. There are a
number of resources here. The first is google. Since you are only
interested in big wins, you can look at IPOs and impressive
acquisitions. For IPOs, data is easily available. For acquisitions by
public companies, you sometimes have to dig to 10-K filings. There are also reports published by organizations like Software Equity Group which can help you understand the merger and acquisition activity and economics.
One possible outcome of these three techniques is that you get
wildly different answers. For example, the historical exits and the
invested capital might not make sense, indicating the investors are
deluded or expecting something improbable. Or the management teams
expectations are out of line with historical activities. None of these
measurements is accurate enough for a mismatch to be a deal breaker,
but it might be something to look into.
How Likely is the Big Win?
The third term is how likely your big win is. If you read the post
on venture fund economics, you’ll see that the investors hopefully
think it is about 33% likely, or they did when they put money in. As a
new employee joining a startup, you should come to your own conclusion
here.
You also need to estimate how far off the win is. This is another
place where just asking your contacts at the company can be
informative. One thing to note is that it takes 7 years on average for
a venture-backed company to mature. Of course, there is a lot of
variance here.
What to Do With This Information
Given these values, you can calculate the value of your option
grant. Multiply your percent ownership by the value of a big win,
multiply the result by the likelihood of the win, and then discount by
5% for each year in the future.
For example, if you are being offered 0.1% of a company with a 30%
chance of a $400 million exit in 4 years, your value would be:
0.1% × $400 million × 30% × (.95 ^ 4) = $96,000
Plugging in your own numbers should get you a helpful result. If you
have a variety of estimates for the values (and you should), do
multiple calculations, and get a sense for the variety of results and
what impacts them.