Valuing Stock Options for Startup Employees

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[ 2020-December-05 19:55 ]

When accepting a job or working at a startup, you need to understand what startup options might be worth. In this article, I'll describe the simple models I use. I learned about options during the 7 years of my career running a startup (failed), then working for one (still doing well!). Stock options are a complicated subject, and I will not explain anything other than how I personally estimate their value. My advice is probably wrong. Like any financial decision, you should research your choices carefully. If you want to understand startup stock options in depth, I recommend the book Venture Deals: Be smarter than your lawyer and your venture capitalist.

Trivial model: Your options are worthless

Assume your stock options are worth $0. If this is true, will you still take the job, or stay with your employer? If the answer is no, I recommend looking for other jobs. There are many, many ways that startup stock will become worthless. The company can go bankrupt. It can have financial trouble, and dilute existing investors in order to raise money (research: "down round"). It can be purchased for a small enough amount of money that investors get all of it (research: "liquidation preference"). It can continue to exist for a long time, either as an independent company, or be acquired by another private company for stock. The average outcome for a startup is that it is worth $0, since most startups fail. You should estimate how likely you think this is, based on what you know about the company. However, you should be pessimistic, since even high-flying companies can run into challenges (e.g. WeWork, Theranos, and many, many others). I like to assume that common stock even for good startups has approximately a 50% chance of being worth $0.

This does not mean you should never consider working for a startup. However, you should have good reasons other than the potential financial reward. The reliable way to earn a lot of money in the software industry, at least for the last 20-30 years, is to work at a big publicly traded company. However, small companies have other advantages. Working at a small company gives you more responsibility and an environment with a higher rate of change. In the best startups, this means you can learn different skills, and might learn at a faster rate than at a large company. I think that startups provide much better insight into how businesses work. You will get more exposure to important concepts like revenue, cost of good sold, and the cost to acquire customers. At large companies, other job functions are very remote, so you are isolated from having to know anything about them.

As a personal disclosure, at the time of writing, I am working at Datadog, which I consider a big company. However, working at startups taught me an enormous amount about the business of software. I do not regret my choices, even though I would have made more money working at Google, Twitter, or any other publicly traded company. (Although that could still change! Come on Bluecore, I'm rooting for you!) I would also consider working for another startup, or even starting my own again at some point in the future.

Financial model: Value the company

The next approach is to estimate how valuable the company is. You can then compute your stock value = (company value)×(ownership fraction). This is very hard, and professional investors make or break their careers on their ability to do this. However, even a simple model is useful, as long as you recognize that it is probably wrong. I like to assume that I have a 50% chance of the stock being worth $0, a 40% chance of getting the money I use to exercise the options back, and a 10% chance of the stock being worth something. This means that my risk-adjusted "expected value" of the stock is approximately 1/10th the estimated value. Another way of saying this is you should believe that your options have some chance at being worth 10× what you will pay to exercise them. If this sounds crazy, you should walk. You should adjust the chance of the stock being worth something based on your opinion of the company, since every company is different. But again, be pessimistic! It is easy to be sentimental for companies that you have worked for, or where you know employees personally.

To compute the ownership fraction, you should ask the company for the total number of outstanding shares, including the options pool. Private companies are sometimes hesitant to provide this information. If they don't want to divulge, I like to tell them that means I have to assume the stock is worthless when comparing their offer to other companies. This should motivate them to share some information, or you should take a job elsewhere. It is a bad sign if your employer lacks transparency for a basic thing like company value.

The numbers I like to use to estimate the company value are:

Regret minimization

After I have some rough idea of what the company might be worth, I like to imagine how I will feel in the future in two scenarios:

I find it useful to think about what choices I will regret the least. Avoiding regret is why I usually advise people leaving a startup to exercise some of their options (e.g. $100-1000), even if they think the company is not doing well. If I walked away from options after working at a company, then later learned those options would have been worth something, I would be very annoyed. If I own even a token amount, I can feel like I've shared in any potential future success, while limiting the amount I can lose.