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Many business books have only one good idea. This book has three, which is nice:

1. The business environment is in great shape for early exits – If you want to sell a company for $5-30 million, there are a lot of buyers, they have gotten easier to find, and the deals have gotten simpler. For many more businesses than in the past, an early exit is feasible.
2. Align your exit timeline with your investors to make an early exit possible – If you take traditional venture money, that is a commitment to swing for the fences. It can be very difficult to accept a $5-30 million exit after you have raised even seed money from a VC, because they are depending on your company to consume growth capital and deliver the kind of returns that their funds require.
3. Employ an outside party to manage the exit – The book really drove this point home, presumably because the author is making a career out of this role. It was an interesting perspective to me, not something I hear much about in the blogosphere, and something I’ll have to investigate further.

Unfortunately there were a few problems with the execution of the book:

• Lack of rigor – Peters’s financial models are quite simple, and generally not backed up by broadly sourced data. The traditional-versus-early-exit model that makes the cover of the book and drives home the point about avoiding VC is purely hypothetical numbers, for example.
• Canadian heavy - Writing about what you know is great, but more information about key geographies like the United States would have helped make the book more credible. There is plenty of research and statistics available, and the author only scratched the surface.
• Simplistic Angels versus VCs viewpoint – There are a lot of opinions flying around about what makes someone a super-angel, or what makes a seed-stage VC firm. Suffice to say the book’s black and white distinction between angels and VCs is simplistic. I would have expected more reasoned discussion of investor types, given that investor alignment is a key point.
• Insufficient detail – The later chapters in the book, notably around pricing, are insultingly light on detail. I realized that pricing is complicated and it’s best to work with a professional, but that’s no excuse for introducing net present value of cashflow and then leaving everything else as an exercise for a consult.
• Too much of a commercial – I understand that the point of this book, and many others, is to promote the author’s services. However, there were too many pages dedicated to the need for such services, and too few to the nuts and bolts of what would be done or how value would be realized. That, in the end, is the real problem with this book. I was hoping the author would tell me more of what he knows, since I’ll probably never have the opportunity to hire him directly.

The author has a blog (angelblog.net), and it remains somewhat unclear to me why he put the effort into a book rather than sticking with the blog format. Much of the information in this book is available on his blog and around the blogosphere. I had been hoping for more new work, or more depth. Unfortunately I did not find it.

If you’re considering starting a company with an eye to early exits, it’s easier to read this book than to track down 100 good blog posts on the topic. Unfortunately, you’re going to need the blog posts either way to fill in the gaps.

Consider the music business. In nearly every segment, from performers to promotion to distribution, there is far more talent and capital being applied than will ever be able to be profitably returned. People get into the music business as a life choice. Nashville is full of artists just barely getting by, but thankful to be in the business. On the web there are hundreds of startups trying out dozens of business models for selling/giving/pushing/pulling music. Hardly any of them are making profits, and none of them are seeing big exits. But money and talent keeps flowing in, whether it is hedge fund veterans backing LimeWire or  Google trying several strategies.

When there is too much capital, the bad can start to crowd out the good. There are only so many early adopters, and they get tired of hearing about all the new things. Your competitors are losing money on every sale, making it up in volume, and setting customer expectations all wrong. Lavish launch parties, expensive marketing campaigns, and picky consumers drain your resources. Incumbents with natural or historic monopolies become demanding and exploitive of new partners. A new entrant who tries to be above the fray doesn’t find anyone doing business at that level.

Music isn’t the only market with this problem. Many other media segments have it too, including video games, Broadway theater, and film. For most of its history the airline business has been losing investor’s money. Nearly any tech-VC fad, particularly one with light capital or intellectual property requirements, can fill up with suckers. The restaurant business may be subject to the same problem, and the nightclub business probably is.

If you know you are in a market full of suckers, it might still be possible to build a successful business. You can find an angle to exploit people who want to be in the market, either in the style of The Producers (generally illegal) or in the style of Ticketmaster (potentially illegal). You can be consistently and significantly better than everyone else, like many Hollywood directors or Apple’s iTunes. Or use the market to prove out your idea and build your brand, but make your money in a more diverse market, like Moontoast (whose presentation at WebInnoinspired this post).

At the poker table, it’s not very often that a sucker turns his two-seven offsuit into a full house. When it comes to startups, there are a lot more ways for people with capital and skills to spoil the game for everyone. If you look around the table and everyone else looks like a sucker, you might be one too.

Similarly, you don’t work on great technology at a startup.  Startups, by and large, aren’t about technology — at least, not the Web 2.0 startups like Facebook, Foursquare, Twitter, Groupon, etc.   They are about business model discovery.  So if you are fundamentally a technologist at heart, whose heart sings when you’re making a better file system, or fixing a kernel bug, you’re not going to be happy at a startup.   At least, not if the startup is run competently.

Ted might have a point about Web 2.0 startups, but there are still  technology startups in software. These startups generally need to prove out their product and market rather than their business model. Business model innovation is sometimes part of the exercise. But more often the company is executing on a standard business model, with some need to validate the market, a greater need to validate/implement the technology, and most importantly a need to link the innovative technology to an addressable market. Much has been written about this, because it is the traditional structure of startups.

Web 2.0 startups are trendy right now because they are disturbingly capital efficient. Companies like Diapers.com and Groupon have negligible technology risk. Proving out the business model costs very little money in the age of Everything as a Service (EaaS). They generate good stories about selling virtual goods before they exist, of zero-inventory supply chains and zero-employee companies. Investors like the idea of low risk high reward returns, even if they are still uncomfortable with the decreased emphasis on capital.

But while those companies are grabbing headlines and mindshare there is plenty of deep technology innovation going on in startups. There are more innovative database startups at various stages in their life than I can remember right now (e.g. Vertica, Clustrix, Tokutek), not to mention the NoSQL startups (Cloudera, Basho), messaging companies (Solace, Kaplan, 29west), visualization companies (Panopticon, Spotfire), and hundreds of other software startups with a sizable technical product innovation challenge ahead of them. And there are plenty of recent success stories that wouldn’t have been able to build their company without great technology (VMware, Google, Amazon).

It’s great that business model innovation is well enough understood that it is top of mind for developers. Understanding what key innovations are required, be they business or technical, and what are the most efficient ways to validate them, is key to success in any startup. It’s too bad that some engineers think that there is no longer a place for great engineering at startups. Not all startups require great engineering, but many still do.

Ted’s trying to defend Google against claims that Facebook is poaching all the engineers. From where I stand, he’s right. Plenty of great engineers are going to work at Google, more than are leaving. And Google is able to run projects like ChromeOS, LLVM, and AppEngine. Projects that wouldn’t be the same in a startup.

But if you were going to find fault with Google in this, consider: Googlers now believe they are doing engineering that can’t be done anywhere else. If that was true, it would mean they don’t have anything to fear from startups. Believing that is a step towards the hubris and ossification that Google is working so hard to avoid.

In business school you are likely to encounter the Theory of the Firm. If you haven’t been to business school, but you grew up in the modern west, it may seem strange to think that you need a theory to explain the existence of big companies. But actually, big companies are a recent innovation, something that came about in the later part of the Industrial Revolution, the early 20th century. Adam Smith, when conceiving the famous Invisible Hand of capitalism, had no concept of the international megacorporation. His pin makers worked in small groups, with the free market guiding their interactions.

If the markets are efficient, there ought not be any need for corporations. People can freely associate to pursue their various goals, exchanging money for goods and services, each pursuing their own ends. In fact, a large corporation represents an imposition on the free market, where a group of people (employees) decide to transact with each other and the owners of the corporation under special rules. The question at hand is why they do that, and why are some specializations best kept inside the firm while others are commonly contracted out.

The large corporation may be a phenomenon of the 20th century, brought about by efficiencies of scale, inefficiencies of communication, concentrations of management and financial expertise. Or there may be fundamental value to the corporation. The theory of the firm enables us to reason about why companies exist, and whether they will persist.

The most widely understood theory of the firm is that of Ronald Coase, based on trasnsaction costs. In Coase’s model, having a service provider within the firm is economically advantageous when the cost of transacting for a service or asset with an outside party exceeds the inefficiency of bringing the service or asset inside the firm. To answer whether a given function belongs inside the firm, from office cleaning services to recruiting to software development, examine the costs associated with contracting for the function, compared to the efficiency gained from getting the service on the free market. This theory is very attractive for the modern lean startup. In the 21st century more and more functions, from graphic design to office space, are being standardized, commoditized, and delivered on liquid markets like 99designs. As communications technology improves, transaction costs go down, and firms should get smaller. These are exciting times.

But there are other approaches to understanding the firm. The paper which precipitated this blog post, Eric Van den Steen’s Interpersonal Authority in a Theory of the Firm (via Marginal Revolution), finds substantial value in the firm to create goal-alignment. In his model, consider two parties with two business opportunities (for example, building a product and selling it) deciding how to pursue them. If their two opportunities have are substantially interdependent, but their decisions are made independently, then each is in danger of being spoiled by the other. If instead one party takes a controlling role, offering the other party appropriate incentives, then the likelihood of being spoiled drops out and it is more likely that both business opportunities will be successful. And further, the optimal incentives in this case looks more like salary than like partnership, because the goal is to get the employee to do what they are told, rather than what they think will be most successful.

The take-away for the lean startup is that you must include in your firm the people, skills, and assets from whom you require alignment to a common goal. You can outsource anything where the practitioner can pursue their own profit maximization and not impact your focus. The meta take-away is that the theory of the firm is still open to innovative interpretations. For anyone interested in studying entrepreneurship, it’s important to understand the economics underlying the organizations that are being created.

The Wrong Way

First, let’s start with the wrong way to value stock options. It goes something like this:

1. Wow, I’ve got 10,000 options with a strike price of $0.70
2. The stock price at the last round of investment was $2.50
3. 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:

1. What fraction of the company do you own?
2. How much will the company be worth if you win big?
3. 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.