Valuing Startup Options
Nearly everyone who goes to work for a startup gets options, and the first question they ask is “how much are these options really worth?” When you are considering a job offer, particularly competitive job offers, it’s important to understand the value of the whole package. Putting a value on an option grant in a pre-IPO startup is quite challenging, and there are many opinions. I’d like to share the way I think about option valuation.
The Wrong Way
First, let’s start with the wrong way to value stock options. It goes something like this:
- Wow, I’ve got 10,000 options with a strike price of $0.70
- The stock price at the last round of investment was $2.50
- My options are worth 10,000 * $1.80 = $18,000
What’s wrong with this? Several things. First, your options are for common stock, while the investors were buying preferred for their $2.50. If your company did the 409A valuation correctly, then the fair market value of what you have an option on is probably right around what the strike price is. For more on 409A and how strike prices are set, see Brad Feld’s posts on 409A.
Second, the terms of investment probably include some amount of participating preferred, dilution protection, and a variety of other complicated things which protect the people who put in the millions of dollars and paid for the lawyers. If you can get them, the details of these agreements are interesting. To understand them, you’ll probably want to read Brad Feld’s posts on term sheets.
In fact, if you are interested in the details of how startups are financed, you could do worse than just read everything at Feld Thoughts. But my assumption here is you just want to know whether Company A or Company B is making a better offer. So read on.
For a contrarian perspective, you can read Venture Hacks, which disagrees with me and says you should focus on share price. They also have a whole post on analyzing startup job offers. Further evidence there are many ways to think about this.
What Really Gives Your Options Value
If you aren’t a founder or an executive, your options are like lottery tickets. This is because there are three potential outcomes for a startup: a huge win, a weak sale, or total failure. Unsurprisingly, in total failure your options won’t be worth anything. Somewhat surprisingly, you are likely at a deep disadvantage in a weak sale.
All those terms of investment to protect the people who put in millions of dollars mean that they get the lions share of the proceeds. Generally they get their original investment back, and probably a hefty share of whatever is left over. What constitutes a weak sale varies by the terms, but it is probably anything up to three times the amount of money that has been invested. In such a sale even the money that is left over may be complicated with additional terms, like earn outs or management carve outs. In a weak sale, there isn’t enough cash to make everyone happy, so people are going to be counting the pennies and taking care of their own. If you are an engineer who was late to the party, your interests will probably not be protected.
So the only situation in which you will make out well is the big win. In a big win, like an IPO or a big flashy acquisition by a public company, there is plenty of money to make everyone happy. The VCs are having the kind of result they can tell all their friends about. If the term sheets were reasonable, then all of those preferential treatments are gone and everyone is treated equally according to the fraction of the company they own. Even the little guys like you will make out OK.
Because the big win is the only situation in which you make significant money, it’s the only one you need to think about when valuing your options.
The Information You Need
Focusing on the big win, there are three pieces of information you need:
- What fraction of the company do you own?
- How much will the company be worth if you win big?
- How likely is the big win and how far off?
If you knew all these things, some simple multiplication and net present value analysis would tell you what your options are worth. So how do we get this information?
What Fraction of the Company do You Own?
Any option grant is going to tell you how many shares you get. But what is really important is how large a fraction of the company those shares represent. To figure that, you need to know is how many total shares have been approved for issue. The company should be willing to tell you this. Chris Dixon has a great post about this in The one number you should know about your equity grant. That post says it better than I could: you need to know the fraction, and the company must be willing to tell you.
How Much will the Company be Worth If You Win Big?
The second term in the equation is how much the big win is worth. There are a number of ways to look at this, all of them require doing some amount of homework. I recommend collecting a variety of answers, to get a distribution and a sense of what is going on.
The first technique is simply to ask your contacts at the firm how they are thinking about exits. You probably want to preface this with an acknowledgement that you know nothing is certain, and of course they are building a company for the long term and not looking for a quick flip. On the other hand, flipping is good, and this is probably your best opportunity to learn how the management team is thinking about it.
The second is to learn more about the investors. If the company has followed a traditional VC fundraising model, without any down rounds, then you can look at the total capital invested to estimate the expected big win return. In order to invest money, each of the VC partners had to justify the potential for the investment to return five to ten times as much money back in a successful exit. To learn more about the economics behind this, see Fred Wilson’s posts on Venture Fund Economics. You can assume the investors own 50-70% of the company unless you know otherwise. So if you multiply the invested capital by 10, you get a reasonable estimate of where they thing a big win would fall.
The third is to look at historical exits in your space. There are a number of resources here. The first is google. Since you are only interested in big wins, you can look at IPOs and impressive acquisitions. For IPOs, data is easily available. For acquisitions by public companies, you sometimes have to dig to 10-K filings. There are also reports published by organizations like Software Equity Group which can help you understand the merger and acquisition activity and economics.
One possible outcome of these three techniques is that you get wildly different answers. For example, the historical exits and the invested capital might not make sense, indicating the investors are deluded or expecting something improbable. Or the management teams expectations are out of line with historical activities. None of these measurements is accurate enough for a mismatch to be a deal breaker, but it might be something to look into.
How Likely is the Big Win?
The third term is how likely your big win is. If you read the post on venture fund economics, you’ll see that the investors hopefully think it is about 33% likely, or they did when they put money in. As a new employee joining a startup, you should come to your own conclusion here.
You also need to estimate how far off the win is. This is another place where just asking your contacts at the company can be informative. One thing to note is that it takes 7 years on average for a venture-backed company to mature. Of course, there is a lot of variance here.
What to Do With This Information
Given these values, you can calculate the value of your option grant. Multiply your percent ownership by the value of a big win, multiply the result by the likelihood of the win, and then discount by 5% for each year in the future.
For example, if you are being offered 0.1% of a company with a 30% chance of a $400 million exit in 4 years, your value would be:
0.1% × $400 million × 30% × (.95 ^ 4) = $96,000
Plugging in your own numbers should get you a helpful result. If you have a variety of estimates for the values (and you should), do multiple calculations, and get a sense for the variety of results and what impacts them.