What The Heck Are My Startup Options Worth?

A version of this article previously appeared in Forbes.

When joining a startup, there are seven important questions you should ask in order to answer the question: “What the heck are my stock options worth?”

You just received a job offer from a startup which includes 50,000 stock options. That is wonderful…or is it?

I reviewed and approved hundreds of employment offer letters at my various startups, all of which included stock option grants. The number of otherwise intelligent prospective employees who never ask relevant questions about their stock options was frankly shocking.

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Questions To Answers

I am sorry to disappoint the MBA crowd, but estimating the value of your startup stock options is not something you can do using the Black-Sholes option pricing model. In contrast, estimating the potential ultimate value of your startup options requires you to intimately understand the venture’s business model, the execution capabilities of the core team and the veracity of the company’s financial projections.

To this end, politely and persistently ask the following questions until you obtain enough information to estimate each of the variables in the formulas shown below. Answering these questions will allow you to reasonably estimate what your options may ultimately be worth.

1.     How many shares will I be granted?

The size of your initial option grant should be articulated in your Offer Letter, as well as in a separate Stock Option Agreement. In most cases, your shares will vest over a four-year period, with a one-year cliff. Under such an arrangement, if you leave your company within the first twelve months, for any reason, you will not vest any shares. Once you have completed your first anniversary of employment, vesting usually occurs on a monthly basis. Any vesting terms that do not conform to these standards should be challenged.

2.     What is the company’s total capitalization?

To help the CFO understand your request, indicate that you are seeking a “fully diluted” view of the company’s capitalization. Also, be sure that all “authorized” options are included, which will ensure that the capitalization figure includes granted and ungranted options.

3.     How many additional options will be authorized?

Authorized options include those which have not yet been granted. In order to calculate your potential future dilution, estimate the number of additional options that will be authorized and added to the option pool.

The size of a startup’s option pool will vary, depending on its maturation. However, the pool’s size, as a percentage of a company’s Total Capitalization, is generally between 15% and 20% at a company’s maturity. If an option pool is significantly below this range, it may be an indication of either; (i) a company that is stingy with its options, or (ii) significant future dilution may occur, once the option pool is increased to accommodate future option grants.

It is very common for companies to increase their option pool over time and a well-run company will manage a capital budget as a means of estimating its future option grants. As such, it is very reasonable to ask for an estimate of additional options to be authorized before the company’s exit.

4.     How many additional shares will be issued to investors?

As is the case with future options, a well-managed company can reasonably estimate the amount of investor capital it intends to raise in the future, along with an estimation of the valuation(s) at which such investment(s) will be made.

Future capital requirements are based on a variety of unknowable factors. However, it is imperative to understand the company’s underlying assumptions with respect to its future capital needs. A response of, “We have no idea,” is indicative of a company that is either: (i) poorly managed, or (ii) does not respect its prospective employees enough to provide them with a thoughtful response. Do not settle for a non-answer to this important question.

5.     How many options will I be granted in the future?

Clearly, the number of any additional options you will receive will be dependent on your tenure and performance. Some companies provide their employees with small options grants annually, usually in conjunction with either year-end or the employee’s anniversary hire date, while others seldom make such “refresh” grants.

6.     What is Management’s best estimate of the Company’s valuation upon an exit?

This variable is obviously an educated guess, at best. Even so, your prospective employer should be able to provide you with a valuation range that would be acceptable to the management team.

7.     What is the Exercise Price of my initial options?

This should also appear in your Offer Letter and Stock Option Agreement. Do not be satisfied with a response such as, “The exercise price will be defined by the Board of Directors, based on the Company’s Fair Market Value.” Ensure that your exercise price is defined in writing before you accept the position, even if it is subject to subsequent Board approval. Also, be sure you know the company’s latest 409A valuation.

Options Are Just That

Once you obtain the answers to the above question, you will have enough information solve the following four equations. At first glance, these formulas may appear complicated, however; the math is actually simple. To minimize potential confusion, the variables used multiple times are color-coded.

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I have been fortunate to work with great teams who were able to create enough value that our options were worth a significant amount of money. However, the reality is that many startups’ options are never worth anything. As such, consider any compensation derived from your options as an unexpected windfall. Working with kind, motivated and smart people who you will learn a great deal from is a far more important consideration than the potential value of your option grant.

Follow my startup-oriented Twitter feed here: @johngreathouse. I promise I will never tweet about killer burritos or pettable puppies.

John Greathouse

John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara’s Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.

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Tags:
  • Really happy that I read this. One does not get into the “startup investing game” to solely win a bunch of money, but really to be of service to a good team and get them moving. If the shares produce a payout, so be it.

  • Lenny

    agree with this Douglas… Go in for the experience and lessons. Treat the stocks as a possible bonus.

  • John Greathouse

    “Money Doesn’t Lead To Happiness, But Happiness Can Lead To Money.” Mark Douglas, Co-Founder and CEO of SteelHouse

  • Kenneth Stein

    Note that investors will likely be issued “preferred” shares of stock. Because preferred shares entitle a shareholder to certain rights that are not provided to holders of common stock (anti-dilution, liquidation preferences, etc.) preferred shares are generally more valuable than an equivalent number of common shares of stock. Investors will likely obtain preferred shares while employees are granted options for common stock.

    A rule of thumb is to value preferred shares at 10x that of common.

    What do you think about multiplying future investors shares by 10x John to account for this difference?

  • John Greathouse

    Hey Ken – very good point. I was assuming an outcome in which P/S and C/S all convert upon an exit, at which point preferences are a moot point. However, you are correct that P/S can have an extrinsically higher value, depending on the terms granted to the investors and the composition of the exit.

    As such, I don’t agree with the 10x assumption, but you are correct that employees should understand and take into account that their common stock may end up being worth less than the stock held by investors.

    Thanks for chiming in here.

  • Jim A.

    In a good outcome, common and preferred are typically (though not always, depending on the terms of the preferred) worth the same amount per share. While a company is still private, you are right that there is a difference between the amount one would pay for a share of preferred stock and a share of common stock. Though don’t be fooled by the spread that you find with most “409a” valuations, which typically value common shares at about 25-40% of the value of preferred (in the old days option strike prices were 10%, but no longer).

    In practice, we’ve seen numerous “secondary sales” where founders sell some common stock in private companies. Often in conjunction with a preferred financing where there was more buying interest than selling interest. The discount off of the preferred price can be as little as 10%, or as much at 40%, depending on the situation and the stage of the company. HTH.

  • Adam Miller-Howard

    Good article John — looks like your major arguments converge with this blog post:

    http://www.offerletteradvisors.com/blog/a-rough-guide-to-valuing-your-options

  • Mike Sharma

    Very helpful article. I have been working with HR on determining new hire sock options recently (I work for a Boston startup called Spoken English Practice – website http://www.spokenenglishpractice.com , if you are interested) and I have found how much of a oversimplification Black-Sholes really does. Your approach makes a lot more sense!

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