The Real Value of Stock Options
Simple stock option calculator – I used this for all of the calculations in this blog post
Several of my friends have been considering job opportunities at startups in New York. Typically, their job offers have included below-market salaries and option grants. When I chat with them about their offers, they’ve been attributing way too much value to the stock options offered. I’ve generally explained to each of them why stock options are nice, but are worth much less than may think. I don’t persuade them against accepting the offer because I think you should be willing to take a pay cut to learn and do more at a startup than you would learn and do at a big company. I just tell my friends that they should never optimize for options, but optimize for an experience. Mark Suster wrote something similar to this in a post – Is It Time for You to Earn or to Learn. Throughout the rest of this post, I’ll explore the math behind the value of a stock option in a seed-funded startup and explain why those options aren’t as valuable as you may think.
Many companies convince engineers and other talent to join those companies at a below-market salary in exchange for stock options. I believe stock options are valuable, but only in that they make everyone an owner of a company. Owners work harder and put up with more to make a business successful. I brought up the fallacy of the value of stock options at a VC-panel, and was quickly shot-down by this panel. Since they didn’t answer my questions, I thought I’d do some research and present the mathematical case as to why the monetary value of an option is much less than you might expect.
For simplicity, I made some very important assumptions (below) that anyone who is reading this should be aware of. Generally, I tried to choose the assumption that would make an option more valuable at the time of an exit to over-emphasize the value of stock options. All of the calculations in this post can be found in this file – you can also download and customize it for your own use. I invite you to change the assumptions to fit your specific situation. On a side note, please let me know if you find any errors in the file – thanks.
I’ll quickly explain why your options aren’t worth very much even if you’re one of the top 10 employees at a seed-funded company. You would be very lucky to receive much more than 50 basis points of a company (0.5%) when you join after a seed round. That 50 basis points will be diluted by future funding rounds. At the time of the unlikely large M&A acquisition or IPO, you will have to buy your options at the valuation those options had when they were granted (the strike price). Additionally, since you’re going to exercise those options and immediately sell them, the gain in value will be taxed as ordinary income. Finally, this all assumes that you will stay with the company that granted those options for more than 4-years. You will lose any options that didn’t vest if you left earlier. How many of you have worked for a company for more than 4 years?
If you assume the company you work for is the average seed-funded startup that has an average M&A exit (defined by the assumptions listed below), your 50 basis points will be worth approximately $179,000 (after taxes) in 4 years. Unfortunately, the probability of this happening is low – in fact, it’s about 10% for seed-funded companies. So the expected value of that option is really only $17,600 in 4 years or presently valued at $10,100 with a 15% cost of capital.
Now, let’s assume you really hit it big, and your company IPOs in 7 years. Your 50 basis points at an average seed-funded startup with an average IPO (again, defined below) would be worth approximately $2,354,000 (after taxes). Again this is a very rare outcome. It only happens to about 1.4% of seed-funded startups. So the expected value of that big payday is only $33,700. Unfortunately, an IPO usually takes longer than an M&A exit, so you’ve now held onto those options for 7 years. The present value of those options with a 15% cost of capital is approximately $11,800.
So your company has hit the jackpot; congratulations! You’ve probably done more and learned 1000x more than you would have if you chose a different job. On the flip-side, despite that exit, those options you were counting on changing your life aren’t worth as much as you dreamed. In the IPO case, you’ve just taken home approximately $2mm. That’s a huge payday, but the expected value is so much less because of how rare this is. If you combine the present value of an M&A exit and an IPO, the expected value of the options granted on your first day are $21,900. You would be indifferent if you accepted a pay raise of approximately $7,700 for the next four years.
Again, I believe options are very important to generating a great culture in a startup where everyone is an owner and feels strongly about accomplishing the mission of the company. Just don’t accept a big pay-cut for those options. Accept that pay-cut because you’re about to embark on a rare opportunity to grow your career at a startup.
Assumptions and Important Data
- The number of seed funded companies from 2000-2012 and the average investment in those companies was obtained from the most recent PWC MoneyTree Report.
- The average IPO market valuation, age of a company at the time of an IPO, and the number of companies that IPO each year from 2008-2012 were collected from the NVCA 2013 Yearbook.
- At each stage, the VC investment has a 1x liquidation preference and has participating preferred equity.
- None of the VCs in a company receive anti-dilution protection.
- At the time of investment, the seed investor receives 30% ownership; the 2nd round receives 25% ownership; the 3rd round receives 20% ownership; and the 4th round investor receives 15% ownership.
- The employee receives 0.5% of the company in the form of 4-year vesting stock options at the valuation following the seed investment.
- The employee fully vests prior to an acquisition or IPO.
- The employee’s effective income tax rate is 40%.
- The employee’s cost of capital is 15%.
- The employee doesn’t receive another option grant in the future.
- The employee exercises his stock options 6 months after the IPO – Fyi, most companies lock-up their option holders for 6 months following an IPO.
- An average acquisition happens 4 years after the seed funding of a company. Fyi, I had to guess this number.
- Prior to an acquisition a company receives 2 rounds of financing similar to an “Early Stage” and “Expansion Stage” investment as defined by the MoneyTree Report.
- The average disclosed M&A deal is worth $134mm. This is way higher than reality because of right-skewed data as well as the majority of unannounced M&A deals being on the small-side.
- An average IPO happens 7 years after the seed funding of a company – NVCA 2013 Yearbook.
- Prior to an acquisition a company receives 3 rounds of financing similar to an “Early Stage,” “Expansion Stage,” and “Late Stage” investment as defined by the MoneyTree Report.
- The average market valuation of a VC-backed IPO on the first day of trading from 2008-2012 was $1.44Bn – again, very right-skewed thanks to Facebook and a couple other huge IPOs in the past couple of years.
- The 6-month average return on a VC-backed stock following an IPO is 10.5% - Ernst & Young.
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