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The Real Value of Stock Options

151 points by msoad 13y ago

mikestew 13y ago
Good advice buried in the article: work for the experience, not for the money. I hear it time and again, someone talking about the equity they got and how "if it takes off..." much money they could make. Then I get to be the wet blanket that explains slim odds, how much 0.5% really is, and dilution. I do have one quibble with the author, and that's about how options make employees "owners". Eh, not quite. First, they have the option to be part owners. Second, the options you get as a grunt on the front lines are often not the same as the ones founders and VCs get. IOW, you'll get to go to the back of the line when payout time comes.
- throwaway1979 13y ago
  Hold on ... the advice is to decide whether you want to earn or learn. After a certain age, lets say 32 to pick a random number, the marginal benefit of learning is less than earning.
  - toomuchtodo 13y ago
    Excellent point. I'm 30, with 12 years of experience. I still learn something new everyday, but I make sure to earn as much as possible doing it.
  - wwweston 13y ago
    It probably depends on what you're learning. Not all knowledge/experience has equal personal or marketplace value. I'm past your random number, and as you expect, there's opportunities with good education value I've turned down. There's still some I'd take a pay cut for.
  - greenyoda 13y ago
    Also, it's not really certain that you'll learn more at a startup than at an established company: - Most startups fail, so all you might end up learning is one particular way how not to run a startup, not how to run a successful startup. - Many startups are run by younger people who themselves may not have had very much experience shipping products or running a company. - Startups are under pressure to deliver quickly before the money runs out, so you might not spend as much time considering alternative approaches to problems, which is one of the ways to get deep understanding of a problem domain. The desire to move quickly might also pull them in the direction of quick and dirty solutions instead of solid engineering. On the plus side, you might end up with more responsibility for the product than you would get in a larger company, and there are many things you could learn from that experience.
    - blairbeckwith 13y ago
      I disagree with your first point. Everything you learn is not dependant on the outcome. There is much you can learn in a startup that may not be negated by the company failing: how to wear multiple hats, individual tactics that alone weren't enough to save the company, etc. etc.
    - rschmitty 13y ago
      Learning failures is just as important as learning successes. /lesson I learned in 5th grade science fair
      - jfb 13y ago
        Only if those lessons are applicable. Startups fail for lots of reasons, only some of which are generalizable.
- ChuckMcM 13y ago
  To its credit though when it works, even with modest options, it can work well. I joined Sun Micro the monday after they went public and those options, while small compared to other employees that were already employed, effectively quadrupled the economic value I got out of my first four years at the company.
  - georgemcbay 13y ago
    That's true enough, but even back then your case was not the norm, and while I have no hard data to back this up, I heavily suspect the situation is even worse now as contemporary companies seem much more willing to publicly fuck over option holders, ala Zynga or Skype.
- boxerbk 13y ago
  First, thanks for sharing the article! I agree that nominally the employees lives won't drastically change unless you are in an extraordinary situation. I do, however, believe that a culture of ownership is super important. Ownership, no matter how small, has a psychological impact on an employee and a generally strong impact on the culture.
emmett 13y ago
The real insight here is that the dominant bit is not how many options you get (though that's important), it's how good the company is. As an employee, you need to look at early-stage startups where you're being compensated with equity the same way that an investor would. If you can cut out the bottom 50% of startups, that's basically "doubling" the value of your equity.
- 727374 13y ago
  If you can 'cut out the bottom 50%' reliably, I think a lot of VCs would want to hire you.
  - snide 13y ago
    The easiest way to figure this out is simply to look at the founding members previous work. It's no different than hiring an employee. Past work is the best tell against future success. Granted this is tougher with higher level dudes, as it's hard to ascertain credit in success, but it usually works.
    - prostoalex 13y ago
      So choosing between - Harvard dropout - couple of Stanford grad students - seasoned guy who started a major national bookstore chain third sounds like a winner?
      - shard 13y ago
        You can throw in there the senior VP of an investment firm. The answer depends on whether you are trying to maximize expected value or the probability of hitting a black swan event.
    - sdoowpilihp 13y ago
      Effective hiring is incredibly difficult, and "past work" is never a sure fire indicator of ones aptitude for your companies' needs. A person hiring needs to consider how a candidate will fit within a work environment and get along with the current team (an otherwise very nice and highly skilled person sometimes just doesn't mesh with the way a team likes to work, not out of unwillingness on anyone's part, but simply out of the fact that we all have habits). Are they the sort of person that can hit the deadlines we need and doesn't mind the stress and extra hours involved? Will they be comfortable with our business philosophy and practices? What kind of outlook do they have on their career? What at this point in their life is important to them (career? kids? sailing around the world?) Hiring is messy, mainly because it involves humans. Past work may be a good chaff filter, but it's by far not the only consideration to finding a good candidate for your needs.
deleted 13y ago
[deleted]
cespare 13y ago
"Additionally, since you’re going to exercise those options and immediately sell them, the gain in value will be taxed as ordinary income." Isn't this the point of pre-exercising options? At least in CA, I've been told that one should always pre-exercise ASAP so that if the options are ever worth anything substantial you've held onto them for at least a year, so it's long-term capital gains.
- klochner 13y ago
  The potential downside here is that you have to pay to exercise, which is lost money if the company folds. As long as the strike is low this makes total sense.
  - toomuchtodo 13y ago
    Negotiate additional compensation to pre-exercise?
    - klochner 13y ago
      It should be an easy negotiation - the money just goes back into the company, less the taxes you would have to pay on the additional compensation. In practice, you need to be a fairly significant employee to drive this kind of abnormal transaction.
    - hexedpackets 13y ago
      Isn't that just a needlessly complicated version of a stock grant, instead of stock options? What benefit would this have over negotiating for a stock grant instead?
- boxerbk 13y ago
  The other commenters pointed out that you would have to buy those options on day one. If you're lucky enough that you're company pays for you to exercise these options than, you will absolutely be able to benefit from long term capital gains. There are two issues, however, my understanding is that the IRS will tax all of your real income the year you exercise these options based on the payment you received to buy those options. So your $50k salary will be taxed as if you made $80k since the company paid you $30k for those options. There might be a workaround using a personal LLC, but I don't know tax rules that well. Also, in practice, I've always seen employees but the options on the day of the acquisition. I worked on the corporate development team at AOL, and this was almost always the case. We actually tried to find ways to help employees, but at the time of the acquisition there's very little you can do.
grellas 13y ago
This is a nice piece and I would certainly commend it to founders for its insights. Of course, much of Silicon Valley is a living testament to the fact that options can have incredible value for the right cases. Every startup has a rhythm to it and, if you are holding .5% of a "hot" startup in the form of options having a low exercise price, it normally is worth the gamble of biding your time, taking reduced pay, and seeing if the big payday will come. Many founders think in these terms and, if their startup fails to galvanize and moves instead in only fits and starts, will seek to cut their losses and move on. In this sense, the perceived value of the options as seen at the entry point does not turn on what average returns may be for such options considered generically among the entire universe of startups. It turns on more subjective factors such as whether the startup is doing something exciting, whether its key people make up a strong team, whether it has attracted quality backing, and the like. If those factors are there, then founders do not really view it as a matter of average returns across a broad class of startup types but rather view it as a matter of the likelihood of a big outcome for the particular startup being considered. That said, options can prove illusory in many cases and caution is definitely in order. It normally does not pay to hang in with an uneven venture in the vague hope that it can somehow turn things around and yield a great equity return for your small piece of the company. Among other things, if a venture goes through multiple rounds of funding, the liquidation preferences get to be so great that option holders may easily get a very reduced payout, or even no payout whatever, on acquisition. Also, if you hang around while all your options vest and then leave the company, you typically have only 90 days within which to exercise them or you lose them altogether. That means a cash payout that only increases your risk or, even worse than that, a large tax hit with no cash return if the stock price is high following a series of fundings. Of course, there are (as the author notes) many good reasons to be in a startup apart from equity payout and it may still be worthwhile to stick it out in a doubtful venture for a time owing to those other reasons. But don't stick with a dubious venture based primarily on the hoped-for equity payout in such cases because, in that case, the odds definitely are against you.
- technotony 13y ago
  Your analysis points to why the authors analysis is flawed. He calculates the expected value of the option and says that this leaves the value of the stock options to be very small. What he neglects to mention is that the employee is also granted a 'real option' which is his right, but not obligation, to leave the company if it does badly. This 'real option' significantly increases the value of stock options because the employee can leave after one year (or less) in the case that the startup is not on track to succeed. This means the forgone salary is reduced in the down scenario. Google 'real options' or 'strategic options' for the maths behind how to price these, it's a beautiful mathematical theory.
jacobscott 13y ago
I agree with the gist of the post, but there are some ways in which you can tip the scales in your favor: - Get an offer where you get your options up front and the company reserves the right to repurchase them. - Exercise your options immediately and file an 83b election. There will be no difference between fair market value and strike price, so your exercise-time tax liability should be zero. Obviously, this is easier if #options*strike_price is low. - Look for a low strike price. If the seed round was convertible debt, the strike price may still be low. - If you're trying to "go big or go home", look for a big gap between strike price and the price of preferred shares in the most recent round. - Work at a company that is a qualified small business at the time you (fully, see above) exercise your initial grant, and hold your stock for five years. This can make any capital gains almost entirely tax free (see e.g. http://www.morganlewis.com/pubs/Tax_LF_CongressExtendsSmallBusinessGainExclusion_11jan13 http://www.morganlewis.com/pubs/Tax_LF_CongressExtendsSmallB...) I am _not_ a tax/finance professional, so remember to take these with a grain of salt!
riazrizvi 13y ago
While it is helpful to have an empirical estimation of option value, I think it is a mistake for a job candidate to translate a compensation offer with a black-and-white tone: "50bp? Oh that means $33k". I ask myself how strong I think the business is, since 50bp in a weak business is probably worthless whereas 50bp in a strong business is probably worth a heck of lot.
- boxerbk 13y ago
  I absolutely agree. The point of this analysis was to show you a way to think about your options. If you believe the company you're joining has a much higher likelihood of success, you can change that assumption in the calculator.
  - riazrizvi 13y ago
    Nice. By the way what's the password for the spreadsheet? No edits can be made without it.
    - boxerbk 13y ago
      helloworld1. If that doesn't work, try capital H. I can't remember which I used. The main assumptions to change are unlocked. I locked the rest so people don't screw up a formula without realizing it. All cells in blue are assumptions in the file that you can change.
pedalpete 13y ago
Could somebody enlighten me to the expected balance of salary and equity? How far 'below market rate' is the average salary at a start-up where you're getting these small amounts of equity?
- bagels 13y ago
  I was offered by one company that posted on HN: $36k/year with 1% of the shares in options. I said no thanks. I know it doesn't answer any questions about averages, but I'm hoping that's at the bottom end of the distribution.
  - JonFish85 13y ago
    If you're getting integers, that's nowhere near the bottom end of the distribution.
    - bagels 13y ago
      I guess I meant I was hoping the salary reduction part was at the low end.
carlob 13y ago
There is a subtle error in the way this article is phrased. Since the outcomes are mutually exclusive you can sum them when computing the expectation. And you're also neglecting all the high probability-low gain outcomes.
- boxerbk 13y ago
  The high probability-low gain situations would actually lower the value of the options. This model was very generous to the right-skewed data. Low gain situations will typically be worthless because of VC liquidation preferences. Also, these acquisitions are typically unannounced, so it's impossible to guess their value. Can you explain the error with summing? I did sum the expected value of an acquisition and an IPO. Is that wrong? I'd like to fix it for others.
  - carlob 13y ago
    In general the expectation of making X is given by \int x dP(x). In simpler terms suppose you have a 9% chance of making $1000 a 1% chance of making $10k and a 90% chance of making $100, your expectation is .09*1000+.01*10000+.9*100 == 280 In you article you only take into account a fraction of the total probability that is equivalent to assuming that in the vast majority of cases you'll make exactly zero. That would mean lowering the previous estimate to $190.
    - boxerbk 13y ago
      Understood. My assumption was that in the vast majority of cases, you would make zero because either the company fails or the exit is so small that VC liquidation preferences would negate any common stock. You are right, it isn't clear in the article. Thanks!
varelse 13y ago
This admittedly simple analysis pretty much sums up my rules of thumb for why I don't accept startup jobs post seeding rounds. Along those lines, I just saw the first engineer at a startup make chump change compared to an absolute idiot who joined 3 months earlier and had 10x the equity and therefore got FY money out of the deal. This game changes dramatically if instead of 0.5%, one gets 5%. Which is to say get there 3 months sooner or don't go at all. All IMO of course.
malbs 13y ago
my personal experience on options:- - I was offered holiday pay in lieu, or options @ 20% of their market value the options seemed like a much better deal, so I took it (as it turns out the smart punters took the holiday pay!) - After 6 months or so most people were terminated, at the termination meeting the CEO told us we would have 12 months to exercise our options if we chose to do so. - 2 months went by, I was then contacted by the new CFO and asked "Will you be planning on exercising your options in the next month, because otherwise they will expire", which was a surprise to me because we were told verbally (lol) that we had 12 months. - So now I was in a bind, pay more money to the company to buy my options, or just give up on seeing anything for my efforts, stupidly chose to exercise the options, which cost me a thousands - When it came time to deal with the tax office, I had to pay the tax on the market value of the options, which was going to slug me again, as it turns out the options weren't worth anything at all, which was good in one way - I didn't have to pay any tax on them. - Also turned out that the VC who had invested in the company had options that were fully vetted, or fully vested, I can't remember the details, but essentially it meant if the company ever actually earned any money, the VC shares had more weight, and in all likelihood, were the only ones who would actually get any money out of any sale my advice on people who are being offered options:- - get some external financial advice - make sure you read the fine print - if some VC has already invested, make sure you understand if there are any exceptions with regards to the options you've been offered - I know this is just obvious, but no matter how close or friendly you think you are with management (small teams this happens!) get everything signed and dotted
ogd 13y ago
Honestly the truth is that any startup that will pay you with options to compensate for a below market rate (either in salary or combined salary + cash bonus) is a scam and should be treated as such. Startups are great if you are a founder or if you are paid equally to what you could get in total current comp at a bigger company. If not, stay far, far away! I made the mistake of joining a startup once thinking I'd be getting rich off the options. Never again will I be so naive. Now the only two things I consider when joining a new company is 1. total current compensation (salary + benefits + bonus) and 2. potential for career growth. Options and startup equity should always be valued at 0 and not weigh at all to any job choice.
statusgraph 13y ago
What this analysis shows is the flaw of trying to reason with percentage: the modeling is too difficult and littered with assumptions. An alternative model: say you're offered $100/yr with 10k options a year with a nominal value of $5 and a strike price of $1. Superficially the offer is worth $140/yr. The startup's valuation is still important, because you can ask yourself questions about how likely they are to double it. It's much easier to project if the company can double to 10x it's value than what their exit is going to be. Say that startup is worth $1mm. If they can double it to $2mm you're going to be netting $100 + 10k(10-1) = $190k. But can they double it? Up to your impression of their business. That's a much simpler question than wondering about their exit many years down the line. (their competitors generally are the strongest signals) Observations: this is computed with options per year; most startups would put this as giving you 40k options over four years * the options companies give you generally have expirations and very poor liquidity so using their face value is generous. [1] * but on the other hand, options can potentially increase in value, so it's not wholly unreasonable to equate them to their face value * this approach cuts out nearly all early stage startups which give below-market salaries and weak equity grants. Getting 50bp of a $10mm startup over four years is $12.5k/yr face value. If market salary is $100 and they're offering $75 you're netting around $87.5. That's a pretty stiff cut. * dilution isn't relevant (assuming you have options on reasonable stock) * if the startup is doing well (say, after a year doubles their valuation) it's difficult to negotiate another grant because you're now paid quite a bit better. Conversely, if the startup is doing poorly time to ask for more. * you may be okay with the pay cut because of externalities (more interesting work, good for the resume, better commute, etc.) (ps. I normalized all salaries to $100k because it's easy to do percentages off of. Adjust by industry and specialization.) [1]: That said, if you have reasonable timing you can use this computation to negotiate comp when changing companies so you're not completely handcuffed. (basically converting your equity from one company to another)
brianchu 13y ago
1. I really disagree with the assumption that you're not going to get more than 0.5% at a seed-funded startup. It is really common, at least in Silicon Valley, for an engineer at a seed-funded startup to receive more than 0.5%, especially if they are taking a below-market salary. In fact, if you are one of the very first employees, you should definitely be getting more than 0.5%. 2. It is also very common, and by no means something particularly extraordinary, for an early employee (post-seed) to receive stock grants instead of stock options, which makes the situation even more favorable (especially if you declare the grant as income to the IRS early).
zero_intp 13y ago
This is a good read. Even without living in the valley, when I joined a startup during the dotboom these are all of the lessons I learned.
TomGullen 13y ago
Is dilution really a negative? Lets say I own 1/100 shares of a £100k company = £1k. The company raises £100k in a fund raising round and 100 new shares are issued. I now own 1/200 shares of a company worth £100k + £100k cash. My share is still worth £1k. Not only that, but if the company is good the extra capital should be utilised in a way with positive expected value, so the fund raising and subsequent dilution is actually good news for me with my 1 share.
Mordor 13y ago
The real value of a stock option is zero, with an expected value higher than that. Perhaps this is more about balancing realistic expectations and real income against the pursuit of a dream?

151 points by msoad 13y ago

Good advice buried in the article: work for the experience, not for the money. I hear it time and again, someone talking about the equity they got and how "if it takes off..." much money they could make. Then I get to be the wet blanket that explains slim odds, how much 0.5% really is, and dilution. I do have one quibble with the author, and that's about how options make employees "owners". Eh, not quite. First, they have the option to be part owners. Second, the options you get as a grunt on the front lines are often not the same as the ones founders and VCs get. IOW, you'll get to go to the back of the line when payout time comes.

throwaway1979 13y ago
Hold on ... the advice is to decide whether you want to earn or learn. After a certain age, lets say 32 to pick a random number, the marginal benefit of learning is less than earning.
- toomuchtodo 13y ago
  Excellent point. I'm 30, with 12 years of experience. I still learn something new everyday, but I make sure to earn as much as possible doing it.
- wwweston 13y ago
  It probably depends on what you're learning. Not all knowledge/experience has equal personal or marketplace value. I'm past your random number, and as you expect, there's opportunities with good education value I've turned down. There's still some I'd take a pay cut for.
- greenyoda 13y ago
  Also, it's not really certain that you'll learn more at a startup than at an established company: - Most startups fail, so all you might end up learning is one particular way how not to run a startup, not how to run a successful startup. - Many startups are run by younger people who themselves may not have had very much experience shipping products or running a company. - Startups are under pressure to deliver quickly before the money runs out, so you might not spend as much time considering alternative approaches to problems, which is one of the ways to get deep understanding of a problem domain. The desire to move quickly might also pull them in the direction of quick and dirty solutions instead of solid engineering. On the plus side, you might end up with more responsibility for the product than you would get in a larger company, and there are many things you could learn from that experience.
  - blairbeckwith 13y ago
    I disagree with your first point. Everything you learn is not dependant on the outcome. There is much you can learn in a startup that may not be negated by the company failing: how to wear multiple hats, individual tactics that alone weren't enough to save the company, etc. etc.
  - rschmitty 13y ago
    Learning failures is just as important as learning successes. /lesson I learned in 5th grade science fair
    - jfb 13y ago
      Only if those lessons are applicable. Startups fail for lots of reasons, only some of which are generalizable.
ChuckMcM 13y ago
To its credit though when it works, even with modest options, it can work well. I joined Sun Micro the monday after they went public and those options, while small compared to other employees that were already employed, effectively quadrupled the economic value I got out of my first four years at the company.
- georgemcbay 13y ago
  That's true enough, but even back then your case was not the norm, and while I have no hard data to back this up, I heavily suspect the situation is even worse now as contemporary companies seem much more willing to publicly fuck over option holders, ala Zynga or Skype.
boxerbk 13y ago
First, thanks for sharing the article! I agree that nominally the employees lives won't drastically change unless you are in an extraordinary situation. I do, however, believe that a culture of ownership is super important. Ownership, no matter how small, has a psychological impact on an employee and a generally strong impact on the culture.

emmett 13y ago

The real insight here is that the dominant bit is not how many options you get (though that's important), it's how good the company is. As an employee, you need to look at early-stage startups where you're being compensated with equity the same way that an investor would. If you can cut out the bottom 50% of startups, that's basically "doubling" the value of your equity.

727374 13y ago
If you can 'cut out the bottom 50%' reliably, I think a lot of VCs would want to hire you.
- snide 13y ago
  The easiest way to figure this out is simply to look at the founding members previous work. It's no different than hiring an employee. Past work is the best tell against future success. Granted this is tougher with higher level dudes, as it's hard to ascertain credit in success, but it usually works.
  - prostoalex 13y ago
    So choosing between - Harvard dropout - couple of Stanford grad students - seasoned guy who started a major national bookstore chain third sounds like a winner?
    - shard 13y ago
      You can throw in there the senior VP of an investment firm. The answer depends on whether you are trying to maximize expected value or the probability of hitting a black swan event.
  - sdoowpilihp 13y ago
    Effective hiring is incredibly difficult, and "past work" is never a sure fire indicator of ones aptitude for your companies' needs. A person hiring needs to consider how a candidate will fit within a work environment and get along with the current team (an otherwise very nice and highly skilled person sometimes just doesn't mesh with the way a team likes to work, not out of unwillingness on anyone's part, but simply out of the fact that we all have habits). Are they the sort of person that can hit the deadlines we need and doesn't mind the stress and extra hours involved? Will they be comfortable with our business philosophy and practices? What kind of outlook do they have on their career? What at this point in their life is important to them (career? kids? sailing around the world?) Hiring is messy, mainly because it involves humans. Past work may be a good chaff filter, but it's by far not the only consideration to finding a good candidate for your needs.

deleted 13y ago

[deleted]

cespare 13y ago

"Additionally, since you’re going to exercise those options and immediately sell them, the gain in value will be taxed as ordinary income." Isn't this the point of pre-exercising options? At least in CA, I've been told that one should always pre-exercise ASAP so that if the options are ever worth anything substantial you've held onto them for at least a year, so it's long-term capital gains.

klochner 13y ago
The potential downside here is that you have to pay to exercise, which is lost money if the company folds. As long as the strike is low this makes total sense.
- toomuchtodo 13y ago
  Negotiate additional compensation to pre-exercise?
  - klochner 13y ago
    It should be an easy negotiation - the money just goes back into the company, less the taxes you would have to pay on the additional compensation. In practice, you need to be a fairly significant employee to drive this kind of abnormal transaction.
  - hexedpackets 13y ago
    Isn't that just a needlessly complicated version of a stock grant, instead of stock options? What benefit would this have over negotiating for a stock grant instead?
boxerbk 13y ago
The other commenters pointed out that you would have to buy those options on day one. If you're lucky enough that you're company pays for you to exercise these options than, you will absolutely be able to benefit from long term capital gains. There are two issues, however, my understanding is that the IRS will tax all of your real income the year you exercise these options based on the payment you received to buy those options. So your $50k salary will be taxed as if you made $80k since the company paid you $30k for those options. There might be a workaround using a personal LLC, but I don't know tax rules that well. Also, in practice, I've always seen employees but the options on the day of the acquisition. I worked on the corporate development team at AOL, and this was almost always the case. We actually tried to find ways to help employees, but at the time of the acquisition there's very little you can do.

grellas 13y ago

This is a nice piece and I would certainly commend it to founders for its insights. Of course, much of Silicon Valley is a living testament to the fact that options can have incredible value for the right cases. Every startup has a rhythm to it and, if you are holding .5% of a "hot" startup in the form of options having a low exercise price, it normally is worth the gamble of biding your time, taking reduced pay, and seeing if the big payday will come. Many founders think in these terms and, if their startup fails to galvanize and moves instead in only fits and starts, will seek to cut their losses and move on. In this sense, the perceived value of the options as seen at the entry point does not turn on what average returns may be for such options considered generically among the entire universe of startups. It turns on more subjective factors such as whether the startup is doing something exciting, whether its key people make up a strong team, whether it has attracted quality backing, and the like. If those factors are there, then founders do not really view it as a matter of average returns across a broad class of startup types but rather view it as a matter of the likelihood of a big outcome for the particular startup being considered. That said, options can prove illusory in many cases and caution is definitely in order. It normally does not pay to hang in with an uneven venture in the vague hope that it can somehow turn things around and yield a great equity return for your small piece of the company. Among other things, if a venture goes through multiple rounds of funding, the liquidation preferences get to be so great that option holders may easily get a very reduced payout, or even no payout whatever, on acquisition. Also, if you hang around while all your options vest and then leave the company, you typically have only 90 days within which to exercise them or you lose them altogether. That means a cash payout that only increases your risk or, even worse than that, a large tax hit with no cash return if the stock price is high following a series of fundings. Of course, there are (as the author notes) many good reasons to be in a startup apart from equity payout and it may still be worthwhile to stick it out in a doubtful venture for a time owing to those other reasons. But don't stick with a dubious venture based primarily on the hoped-for equity payout in such cases because, in that case, the odds definitely are against you.

technotony 13y ago
Your analysis points to why the authors analysis is flawed. He calculates the expected value of the option and says that this leaves the value of the stock options to be very small. What he neglects to mention is that the employee is also granted a 'real option' which is his right, but not obligation, to leave the company if it does badly. This 'real option' significantly increases the value of stock options because the employee can leave after one year (or less) in the case that the startup is not on track to succeed. This means the forgone salary is reduced in the down scenario. Google 'real options' or 'strategic options' for the maths behind how to price these, it's a beautiful mathematical theory.

jacobscott 13y ago

I agree with the gist of the post, but there are some ways in which you can tip the scales in your favor: - Get an offer where you get your options up front and the company reserves the right to repurchase them. - Exercise your options immediately and file an 83b election. There will be no difference between fair market value and strike price, so your exercise-time tax liability should be zero. Obviously, this is easier if #options*strike_price is low. - Look for a low strike price. If the seed round was convertible debt, the strike price may still be low. - If you're trying to "go big or go home", look for a big gap between strike price and the price of preferred shares in the most recent round. - Work at a company that is a qualified small business at the time you (fully, see above) exercise your initial grant, and hold your stock for five years. This can make any capital gains almost entirely tax free (see e.g. http://www.morganlewis.com/pubs/Tax_LF_CongressExtendsSmallBusinessGainExclusion_11jan13 http://www.morganlewis.com/pubs/Tax_LF_CongressExtendsSmallB...) I am _not_ a tax/finance professional, so remember to take these with a grain of salt!

riazrizvi 13y ago

While it is helpful to have an empirical estimation of option value, I think it is a mistake for a job candidate to translate a compensation offer with a black-and-white tone: "50bp? Oh that means $33k". I ask myself how strong I think the business is, since 50bp in a weak business is probably worthless whereas 50bp in a strong business is probably worth a heck of lot.

boxerbk 13y ago
I absolutely agree. The point of this analysis was to show you a way to think about your options. If you believe the company you're joining has a much higher likelihood of success, you can change that assumption in the calculator.
- riazrizvi 13y ago
  Nice. By the way what's the password for the spreadsheet? No edits can be made without it.
  - boxerbk 13y ago
    helloworld1. If that doesn't work, try capital H. I can't remember which I used. The main assumptions to change are unlocked. I locked the rest so people don't screw up a formula without realizing it. All cells in blue are assumptions in the file that you can change.

pedalpete 13y ago

Could somebody enlighten me to the expected balance of salary and equity? How far 'below market rate' is the average salary at a start-up where you're getting these small amounts of equity?

bagels 13y ago
I was offered by one company that posted on HN: $36k/year with 1% of the shares in options. I said no thanks. I know it doesn't answer any questions about averages, but I'm hoping that's at the bottom end of the distribution.
- JonFish85 13y ago
  If you're getting integers, that's nowhere near the bottom end of the distribution.
  - bagels 13y ago
    I guess I meant I was hoping the salary reduction part was at the low end.

carlob 13y ago

There is a subtle error in the way this article is phrased. Since the outcomes are mutually exclusive you can sum them when computing the expectation. And you're also neglecting all the high probability-low gain outcomes.

boxerbk 13y ago
The high probability-low gain situations would actually lower the value of the options. This model was very generous to the right-skewed data. Low gain situations will typically be worthless because of VC liquidation preferences. Also, these acquisitions are typically unannounced, so it's impossible to guess their value. Can you explain the error with summing? I did sum the expected value of an acquisition and an IPO. Is that wrong? I'd like to fix it for others.
- carlob 13y ago
  In general the expectation of making X is given by \int x dP(x). In simpler terms suppose you have a 9% chance of making $1000 a 1% chance of making $10k and a 90% chance of making $100, your expectation is .09*1000+.01*10000+.9*100 == 280 In you article you only take into account a fraction of the total probability that is equivalent to assuming that in the vast majority of cases you'll make exactly zero. That would mean lowering the previous estimate to $190.
  - boxerbk 13y ago
    Understood. My assumption was that in the vast majority of cases, you would make zero because either the company fails or the exit is so small that VC liquidation preferences would negate any common stock. You are right, it isn't clear in the article. Thanks!

varelse 13y ago

This admittedly simple analysis pretty much sums up my rules of thumb for why I don't accept startup jobs post seeding rounds. Along those lines, I just saw the first engineer at a startup make chump change compared to an absolute idiot who joined 3 months earlier and had 10x the equity and therefore got FY money out of the deal. This game changes dramatically if instead of 0.5%, one gets 5%. Which is to say get there 3 months sooner or don't go at all. All IMO of course.

malbs 13y ago

my personal experience on options:- - I was offered holiday pay in lieu, or options @ 20% of their market value the options seemed like a much better deal, so I took it (as it turns out the smart punters took the holiday pay!) - After 6 months or so most people were terminated, at the termination meeting the CEO told us we would have 12 months to exercise our options if we chose to do so. - 2 months went by, I was then contacted by the new CFO and asked "Will you be planning on exercising your options in the next month, because otherwise they will expire", which was a surprise to me because we were told verbally (lol) that we had 12 months. - So now I was in a bind, pay more money to the company to buy my options, or just give up on seeing anything for my efforts, stupidly chose to exercise the options, which cost me a thousands - When it came time to deal with the tax office, I had to pay the tax on the market value of the options, which was going to slug me again, as it turns out the options weren't worth anything at all, which was good in one way - I didn't have to pay any tax on them. - Also turned out that the VC who had invested in the company had options that were fully vetted, or fully vested, I can't remember the details, but essentially it meant if the company ever actually earned any money, the VC shares had more weight, and in all likelihood, were the only ones who would actually get any money out of any sale my advice on people who are being offered options:- - get some external financial advice - make sure you read the fine print - if some VC has already invested, make sure you understand if there are any exceptions with regards to the options you've been offered - I know this is just obvious, but no matter how close or friendly you think you are with management (small teams this happens!) get everything signed and dotted

ogd 13y ago

Honestly the truth is that any startup that will pay you with options to compensate for a below market rate (either in salary or combined salary + cash bonus) is a scam and should be treated as such. Startups are great if you are a founder or if you are paid equally to what you could get in total current comp at a bigger company. If not, stay far, far away! I made the mistake of joining a startup once thinking I'd be getting rich off the options. Never again will I be so naive. Now the only two things I consider when joining a new company is 1. total current compensation (salary + benefits + bonus) and 2. potential for career growth. Options and startup equity should always be valued at 0 and not weigh at all to any job choice.

statusgraph 13y ago

What this analysis shows is the flaw of trying to reason with percentage: the modeling is too difficult and littered with assumptions. An alternative model: say you're offered $100/yr with 10k options a year with a nominal value of $5 and a strike price of $1. Superficially the offer is worth $140/yr. The startup's valuation is still important, because you can ask yourself questions about how likely they are to double it. It's much easier to project if the company can double to 10x it's value than what their exit is going to be. Say that startup is worth $1mm. If they can double it to $2mm you're going to be netting $100 + 10k(10-1) = $190k. But can they double it? Up to your impression of their business. That's a much simpler question than wondering about their exit many years down the line. (their competitors generally are the strongest signals) Observations: this is computed with options per year; most startups would put this as giving you 40k options over four years * the options companies give you generally have expirations and very poor liquidity so using their face value is generous. [1] * but on the other hand, options can potentially increase in value, so it's not wholly unreasonable to equate them to their face value * this approach cuts out nearly all early stage startups which give below-market salaries and weak equity grants. Getting 50bp of a $10mm startup over four years is $12.5k/yr face value. If market salary is $100 and they're offering $75 you're netting around $87.5. That's a pretty stiff cut. * dilution isn't relevant (assuming you have options on reasonable stock) * if the startup is doing well (say, after a year doubles their valuation) it's difficult to negotiate another grant because you're now paid quite a bit better. Conversely, if the startup is doing poorly time to ask for more. * you may be okay with the pay cut because of externalities (more interesting work, good for the resume, better commute, etc.) (ps. I normalized all salaries to $100k because it's easy to do percentages off of. Adjust by industry and specialization.) [1]: That said, if you have reasonable timing you can use this computation to negotiate comp when changing companies so you're not completely handcuffed. (basically converting your equity from one company to another)

brianchu 13y ago

1. I really disagree with the assumption that you're not going to get more than 0.5% at a seed-funded startup. It is really common, at least in Silicon Valley, for an engineer at a seed-funded startup to receive more than 0.5%, especially if they are taking a below-market salary. In fact, if you are one of the very first employees, you should definitely be getting more than 0.5%. 2. It is also very common, and by no means something particularly extraordinary, for an early employee (post-seed) to receive stock grants instead of stock options, which makes the situation even more favorable (especially if you declare the grant as income to the IRS early).

zero_intp 13y ago

This is a good read. Even without living in the valley, when I joined a startup during the dotboom these are all of the lessons I learned.

TomGullen 13y ago

Is dilution really a negative? Lets say I own 1/100 shares of a £100k company = £1k. The company raises £100k in a fund raising round and 100 new shares are issued. I now own 1/200 shares of a company worth £100k + £100k cash. My share is still worth £1k. Not only that, but if the company is good the extra capital should be utilised in a way with positive expected value, so the fund raising and subsequent dilution is actually good news for me with my 1 share.

Mordor 13y ago

The real value of a stock option is zero, with an expected value higher than that. Perhaps this is more about balancing realistic expectations and real income against the pursuit of a dream?