Valuing startup stock options - mental models

I have been in startups for 10+ years now (Rippling.com, Zenefits.com, LikeALittle.com) and have personally hired 100+ engineers from my network. The first time someone joins a startup, from a FANG co, they have a hard time valuing the stock options they receive. Some of it is, the nature of the incentives on the table -- employees are on the opposite side of the negotiation and want to make sure they value the stock options at the lowest price possible to match whatever they are making in their mature company -- FANGs. I want to explain four mental models in this post. I rank it in the order of most pessimistic to the most optimistic and explain how different actors (founders, employees, investors) think about this.

(0) Most pessimistic view:

Stock options are worth zero and are lottery tickets. It should not be valued. You join a startup for fun but monetarily it does not make sense.

This could be directionally correct based on the stats and it is fair to think this way. This is also a zen way to think about things and helps one sleep well at night.

The issue for the founders is, it's very hard to hire non-believers and make the startup work. It's also an issue in practice to mix believers and nonbelievers culturally -- you'll have a very non uniform culture.

So one could perhaps devise a culture where maybe the range of % of pay invested in stock options is more like 5-10% instead of 50% (typically in the US). And the employees have an appropriate risk exposure, if this is the default view of most employees.

(1) Benchmark view:

So if you have to value these as lottery tickets that round to zero, how much of it should one get? An easy short cut tends to be to rely on salary/equity benchmarks. 

In my experience, this works the least well and is also very dangerous. The median startup is worth zero and the ones with a lot of momentum (i.e., the ones that matter) are far from the benchmarks. 

At Rippling, employees had very divergent equity offers and the delta was as big as 10x -- depending on what the person brings to the table. An ex-founder of a YC startup, who can run a large team was granted 10x the equity of someone who joined from a FANG and it was worth every penny. That was also their market -- next best option. 

Also the best cos worth joining -- with great people -- are worth a lot more than the mediocre ones, whose equity you should not be holding. Startups that go after $100B markets are worth a lot more than the ones that go after $1B markets. This is an industry where 1 + 1 = 10 (good team; good market;)

It is very hard to develop this taste and conviction. If you are new to startups, it's better to just assume, investors are better at figuring this out than you and default to assuming that the market prices these in. That's why equity benchmarks like employee #8 should get 0.4% don't really work in practice, esp in the outlier cos worth joining.

(2) Employee's starting point / median view:

OK, so let's say we are then skipping the qualitative factors, assuming market valuations prices it appropriately. We are also going to assume the employee is willing to believe that the startup stock is going to be a good bet and can possibly 100x. They want to play the roulette. They just want to be fairly rewarded for the risk they are taking today.

(a) Let's say a VC put $10M in at a $50M valuation and the employee accepts that is the fair market price.

(b) Let's also say that the employee currently makes $50K/year in FANG stock options, which they are leaving behind and want an equivalent amount of startup stock. 

(c) The startup stock is also not liquid unlike FB, so they want a discount of say 20%;

(d) So $50K over 4 years makes $200K and invested at a $40M valuation, implies they should own 0.5% of the company vesting over 4 years. This seems fair and reasonable.

When the employee goes to the market though, they find that no good startup with a good caliber of founders and VCs are actually willing to give them that much equity. It seems extremely unfair and that employees are being taken advantage of at startups. There is some logic to this frustration. 

But in my experience being a decade in startups, the startups that actually took advantage of employees are the ones that fail, don't attract a good caliber of investors/people. That's where the expected value is very poor and employees lose out a lot. Hindsight is 20/20, so how can employees tell before-hand? What's the math issue with the above argument?

There are actually two math issues with the argument:

(a) The illiquidity discount of 20% is double counting, because the investor faces the same illiquidity too. The price is despite illiquidity and everyone understands that if there was liquidity the price would be even higher.

(b) The employee is meant to earn $200K over 4 years and not instantly. The price of the stock over this time frame is either going to 3x per year or going to go to zero. If it goes to zero, the employee has now not put in 4 years worth of work and is instead freed up to work on another job. So the effective risk/commitment is a lot less than 4 years. In another scenario, if it actually works, and keeps doing 3x per year, employees in the later years, can end up making far far above market and will stay and collect the pay-off over the 4 years. i.e., walk early if it doesn't work and collect a huge pay off if it does work.

(3) Entrepreneur's next best option model:

So if the employee can't lock in a $200K vesting over 4 years at today's price, what is a fair price to lock in at? To understand this, one needs to ask, if the entrepreneur just paid out the stock options in cash instead, what effective dilution will they incur? It would be fair then for the employee to expect an equivalent amount of stock options today. 

The entrepreneur typically raises money for a 18-24 month run-way. And is usually fundraising about once a year. Each time you raise, typically the price is 5x the last round if very early stage, 3x the last round if mid stage (B, Cs) and then 2x the last round if late stage. 

My personal experience is consistent with this. LikeALittle.com did seed at a $10M valuation and in 9 months, did the series A at a $40M valuation. The company failed in another 9 months (coz the product could not retain the users). Rippling.com did seed at $30M; Raised series A, in 18 months at $250M; B in 12 mos at $1.35B;

So in this example, if you assume that the A price was $50M; And B in 12 mos at $150M; And C in 12 mos at $450M valuation. Then the stock $200K over this timeframe buys is: 

- $50K @ $50M => 0.1%

- $50K @ $150M => 0.033%

...

Quickly you see that only the first two years matter and the rest round down to zero. So it's about ~0.14%, which is very diff from the 0.4% we discussed above. In practice, in the markets though, I see that the clearing price is more around 0.2%; 

A short-cut is to take the first 2 years worth of equity value you are giving up in a FAANG, assume that you are buying equity at today's price for that, which vest over 4 years. If the stock doubles, in the first year, then you break-even and all is upside from there.

(4) The optimistic view:

The right reasons to join a startup are: You are a commando and can't do anything else. You are an addicted voyager and like the frontier life. You like the fast life.

Economically, it is actually very rewarding from an expected value perspective as well. In my experience, the employees of LikeALittle or Zenefits, who stuck with doing startups are all wildly rich -- I mean tens of millions of dollars, even though both those companies failed. I explain this phenomenon more in these two talks. It takes time to develop good taste and the movie directors/actors don't make their big bucks on their first hit film, when they are a no-body -- they make it on their second. It's a long game, so it's worth going in with the right expectations. In general, a startup with exceptional people involved (investors/employees) tends to be a good bet.

Remember, you are not a lottery ticket. Elon's companies have never failed -- every single one of them is worth billions today. 

I'll end this with a simple story. When Parker was fired from Zenefits, I wrote him an email, saying I want to join his next company. 3 people, including me, wrote that email and I'm glad Parker picked me. In my mind, Rippling succeeding was a very high probability event. I'll probably end up making a billion dollars from that decision alone. There were 2000 employees at Zenefits and only 3 wrote that email. Be the guy who writes that email -- the others are insane. Now the other 2, who did not end up working at Rippling, are also founders of cos worth $100m+ today. The early birds often do catch the worm.

Talks on the subject of startup hit rates:

1. Talk at my college.
2. Talk at InterviewBit.
3. Talk on Blockchains.
4. Talk with CodeChef.