The Real Value of Stock Options

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.

- 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...)

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

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.

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.

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.

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).

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)

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.

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.

- 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

How far 'below market rate' is the average salary at a start-up where you're getting these small amounts of equity?