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.
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.