For some reason colleagues, friends and relatives frequently seek out my advice when considering jumping ship from their cushy corporate jobs and joining a start-up. Aside from the questions about whether the actual business makes sense, the most common area of concern is how to value the stock option stake being offered in a small, highly risky and private company. My back of the envelope method seems to help, so I will share…
Step 1: Avoid Financial Analysis
The first temptation is to open up Excel and get down to business. This is a bad idea. The ultimate value of your equity is going to vary based on so many wildly varying and unpredictable factors that any real calculation will be overwhelmed by hubris and false precision.
The primary factor that will determine your stock option’s value is the valuation of the company at exit (IPO or acquisition). However, this is virtually impossible to predict with any certainty. If you had enough data to calculate the average equity value of venture investments at exit you might come up with a figure, say $25 million. But I’d wager that the median value of these investments was zero since so many fail. Although these sort of risk profiles can be calculated using Black Scholes, etc the end result will be highly dis-satisfying when you’re trying to make the complex and emotional decision about a career change. Instead I suggest a highly simplistic but easy to understand method that sacrifices precision for accessibility.
Step 2: Assume Success
If most VC-funded start-ups fail then the present value of your stock options could very well be zero. If you want to be conservative about your equity then you should leave it out of consideration entirely in your career choice.
But that’s not why you’re joining a startup. You’re joining a startup because you believe in the concept and management team, and because you have an inherently optimistic view of new things. For the sake of your financial analysis you should assume success. The enormous financial risk built into the stock options is already a given; the purpose of evaluating their value assumes you’ve accepted this risk.
If you disagree with this approach then you have three options:
- Don’t work at a start-up
- Assume your stock options are worth zero and decide whether to take the job anyway just for the adventure
- Follow the remaining steps, then divide the result in half to compensate for risk
Step 3: Guess an Exit Valuation
Once again, uncertainty reigns. Realistically you have absolutely no idea at what valuation your startup will exit. Comparablea are usually impossible to trust — just because you have a video startup does not mean you are going to sell for $1.6 billion. So instead, take a deep breath. Dismiss feelings of wide-eyed optimism and (most importantly) greed. Try to be as honest as possible with yourself about how successful you think this company could become over the next 3-5 years. Now characterize that success into a bucket:
|$10 million||Single product web 2.0 company; regional retail chain; niche advertising agency|
|$30 million||Software or service in valuable niche; profitable and growing consulting company|
|$100 million||Hot startup in defensible niche; hit media company|
|$300 million||B2B service with major clients; fast growing consumer online play|
|$1 billion+||Lucky bastards who stepped in it|
Please feel free to disagree with this chart and examples. The point is that you should pick an imaginary exit valuation based on your industry expertise and gut instinct.
Step 4: Open Excel
Ha! You knew there was going to be some Excel involved. The key drivers of the model are:
- Valuation at exit (calculated above)
- Dilution likely from further investment
- Number of years to exit
- Percentage of company offered in equity
A couple of comments on these drivers.
Dilution: You can definitely go to town trying to calculate how much dilution you’re likely to experience. Not unexpectedly, I come down on the side of rough guesses, rather than any complex calculation. The reality is that it can be as little as 10% to virtually 100%. Let’s make things simple — if the company is pre-VC at the time you join choose a high number like 50%. If the company has already had an “A” round, choose a lower number like 30%. Don’t worry about liquidation preferences and other arcana for these purposes.
Years to exit: I like the number 3. Feel free to use 5 if that makes you feel better or if you’re in a business like biotech with longer time horizons.
Percentage equity: Umm, you did ask how many shares are outstanding, didn’t you? I mean, you weren’t dense enough to only find out the number of stock options being offered and not what percent of the business that represents, right?
OK, so now do the simple calculation shown below…
Voila, you now have a SWAG for what the equity being offered is worth to you for each year of service.
Step 5: Using the Number
So what does that number, $150,000 per year mean and, more importantly, should you take the job offer? Remember our assumptions above. This number is a SWAG, and not only a SWAG but a highly optimistic one that intentionally excluded the possibility of failure. It is by no means a predictive view of how much the equity will actually be worth should you join the company. However, what this number allows you to do is say the following:
I’m very excited about the opportunity at [startup]. I understand that my base salary and bonus may be [significantly] lower than what I currently enjoy at my [cushy corporate job ; hedge fund ; consulting company ]. However, if the company is as successful as I think it could realistically be and I work my ass off to make it happen, I honestly think the equity could turn out to be worth [$SWAG] per year of my time. Therefore I have decided to [accept the position ; ask for more equity because SWAG is too low ; ask my spouse if they agree with my analysis].
Go ahead and say that paragraph out loud. If it doesn’t work for you, or if you find yourself stumbling over the SWAG part, take down your valuations a notch and try again.