Part 1 of the Employee Stock Options series.
Disclaimer: The following is for entertainment purposes only, this is what I do for fun. I am not a finance or tax professional, seek the advice of a professional for your unique situation. Ok, now read my opinions.
A brief definition of a stock option: the right to purchase a stock share at a predefined price (strike price), regardless of the theoretical value of the share. Exercising your right to purchase the share is called… exercising.
My first job that didn’t involve cooking and cleaning was at a startup in San Francisco. In addition to a salary, they offered me an Employee Stock Option grant. “What is this?,” I briefly thought before signing, legally indicating that I totally understood and agreed. “Is it like money?” A few years, startups, and option grants later, I decided the answer is: no, they are not like money at all. They are very much like lottery tickets, and you should value them accordingly. Like lottery tickets, they are unlikely to make you rich and more likely to return a small amount or even lose money.
The best way to win the lottery is not to play
People either believe their options are worthless or their path to riches. Given the odds, unless the startup is exceptional, they are probably somewhere between worthless or a nice bonus.
Startups incentivize employees by saying, “if you work hard to make the company successful, you will be rewarded this much” holds hands far apart. Everyone knows, or hears, of those lucky winners who were just in the right place at the right time. “She’s rich because stock options!,” someone would whisper to me. I would nod my head, “stock options are amazing!” This is an aspirational oversimplification, but for good reason: options are complicated and risky. There are a wide range of outcomes for employee stock options:
- The startup fails and you get nothing or lose money.
- The startup is bought or has an IPO and you get rich, a small bonus, nothing, or even lose money1.
The vast majority of employee stock options fall into nothing or lose money outcomes. Hopefully, this isn’t a surprise, as most startups fail. But even companies that sell for quite a bit of money can still result in you getting nothing or losing money; How is it possible that a piece of something you own is sold for money and you don’t get any of it?
Some tickets are better than others
Imagine you want to buy a bunch of lottery tickets because you have a special system for choosing numbers. The entry fee is $100, but you don’t have the money. You ask your friend to pay for the entry fee and she agrees because she believes in your system. In return, if you win $100 or less, you pay her back what you can. If you win between $101-199, you get to keep everything over $100. But, if you win $200 or more, then you will split the entire prize 50/50.
In this scenario, a startup and its employees are the lottery player, the venture capitalists are the friend paying the entry fee, and the lottery tickets are represented as two different kinds of shares. The venture capitalists’ shares are called preferred shares and yours are called common shares. Preferred shares are preferred because they get paid out first in the event of a sale or IPO. There are even more potential clauses that tip the deal even more in their favor (multiples, participation, and more).
Your shares are (probably) not worth as much as you think
“But they told me how much my shares are worth when I joined!,” you might be thinking. They probably showed you one version of their worth, but they usually don’t emphasize two caveats.
- Startups usually have inflated valuations based on the value of the latest preferred shares. Common shares are usually valued significantly less than preferred shares, but valuations often multiply the preferred share value by all (preferred + common) outstanding shares. This isn’t malicious (it’s complicated!), but it’s also not entirely honest.
- Risk. Unless you can immediately sell your shares for the stated price, you will have to wait until you can. There are many possible ways a startup can go between now and then, and they don’t always go up (especially after an IPO).
What are the odds
“Never tell me the odds!” – Startup Employees
So, how do you think about how much your options are worth, assuming your startup is typical? It’s better not to think about it in terms of dollars per share, but a distribution of possible outcomes. Try using this calculator. It’s a little complicated, so I’ll give you some tips:
- Go through each input and fill them out to the best of your knowledge.
If you have multiple grants, enter the numbers from each grant separately to evaluate each one at a time. Or, use the sum of all the grants and find the weighted strike price. For example:
- Grant 1: 100 × $10, Grant 2: 50 × $20
- ((100 × 10) + (50 × 20)) / (100 + 50) = $13.33
- Enter 150 for number of options and $13.33 for the strike price.
For “Company growth since last financing round,” follow this formula:
- ((Revenue today - Revenue at last financing round) / Revenue at last financing round) * 100
- If your startup plans to have a sale or IPO within the next year, select “Yes” for “Custom parameter assumptions” and change “Average time until exit” to 2 years.
After you fill everything out, you will get an approximate value in the blue box, but that doesn’t tell the whole story. If you want to explore your chances further, you can look at the charts below that. The “Estimated distribution of payoffs at liquidity event” graph is the most interesting because it shows you the distribution of possible outcomes. If you’re like me, you look at the steep rise at the end of the graph and feel like…
But you should look at the beginning of the graph where it typically shows a long flat line close to $0…
Wait, how do you read this thing?
The key to reading this graph is thinking of it as a visualization of possibilities, not probabilities. Every point in the graph is equally likely as another point in the graph. If you want to think about the probabilities, then it’s easier to think in ranges. I.e. If the line is at $0 up until the 50th percentile, that means you have a 50% chance of your all your options being worth $0 or more than $0.
Try picking the a point in the graph where you would be happy with the payoff. Now subtract the percentile from 100, and that’s your chance of getting that amount or more.
We have finally arrived at a framework to value your options: in probabilities and distributions. There is no way to boil it down to a single number without masking the risks and wide ranging outcomes.
This model was built using “average” VC backed companies. If you are at a particularly good or bad startup, you may want to shift the graph to the left or right. In either case, this model is just a baseline and illustrates a wide range of outcomes based on actual startups.
Now that you know how to value your options (like lottery tickets), there are important things to know about how they are taxed and some strategies you can take to minimize your risk of losing money.
You may purchase shares and the shares can go to $0 or below your purchase price.↩