
The Real Value of Stock Options - msoad
http://benjyboxer.com/post/55714250364/the-real-value-of-stock-options
======
grellas
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
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.

~~~
codex
Another point further complicating the analysis is that companies which start
to do really well simply turn around and reduce the amount of subsequent
grants. There is less risk of failure; the expected value of the grant has
increased, so the company offers fewer shares to existing employees in the
next grant cycle. This effect can be significant as growth companies tend to
hire a lot of people (including hot shot VPs with huge price tags) and take
more rounds of funding, both of which can dilute initial grants substantially
before the liquidity event.

The author assumes no subsequent grants, but realistically everybody factors
subsequent grants into their back of the envelope calculations.

------
jacobscott
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_CongressExtendsSmallB...](http://www.morganlewis.com/pubs/Tax_LF_CongressExtendsSmallBusinessGainExclusion_11jan13))

I am _not_ a tax/finance professional, so remember to take these with a grain
of salt!

------
emmett
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
If you can 'cut out the bottom 50%' reliably, I think a lot of VCs would want
to hire you.

~~~
snide
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.

~~~
sdoowpilihp
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.

~~~
snide
That's true, but I never said sure fire.

I'm just saying if I'm looking to work for a startup as a non-founder, the
first thing I'd want to know is... what did the founders do before this? If
it's related and was successful that's going to give me more confidence than
just about anything else.

------
cespare
"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
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
Negotiate additional compensation to pre-exercise?

~~~
hexedpackets
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?

------
mikestew
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
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.

~~~
greenyoda
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.

~~~
rschmitty
Learning failures is just as important as learning successes.

/lesson I learned in 5th grade science fair

~~~
jfb
Only if those lessons are applicable. Startups fail for lots of reasons, only
some of which are generalizable.

------
brianchu
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).

------
carlob
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
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
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
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!

------
statusgraph
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)

------
TomGullen
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.

------
varelse
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.

------
riazrizvi
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
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
Nice. By the way what's the password for the spreadsheet? No edits can be made
without it.

~~~
boxerbk
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.

------
malbs
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

------
Mordor
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?

------
pedalpete
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
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
If you're getting integers, that's nowhere near the bottom end of the
distribution.

~~~
bagels
I guess I meant I was hoping the salary reduction part was at the low end.

------
zero_intp
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.

