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How to value startup stock options when comparing job offers

Every once in awhile, I'm asked by a friend to help evaluate job offers from mid to late stage startups. The market for talent is competitive in Silicon Valley (newsflash!), and it isn't uncommon for a talented engineer to end up with half a dozen offers from brand name private companies. A common feature of most of these offers is an option grant on a four year vesting schedule. Often, these options are worth as much if not more than the base salary offered, and so evaluating competing offers on a financial basis can get pretty complex.

Typically, candidates will consider the value of the options at the most recent price for its shares, but there are big problems with this approach. To really understand the value of these offers requires having an opinion about the value of the company, something that is far outside the domain expertise of most tech talent (not to mention many tech investors). At the same time, companies have every incentive to provide the rosiest possible picture of the value of the options they are offering. The result is that many young tech workers make meaningful financial decisions in the dark, or worse are deceived by tactics meant to exaggerate the value of their compensation.

Unfortunately, this problem is very hard to solve with a blog post. There's no formula to evaluate what a startup is worth, and startups differ enormously in terms of preference terms given to investors and liquidity options given to employees. Ultimately everything is "worth" what someone will pay for it, and so valuation is intrinsically subjective and subject to fads and hype-cycles. Still, there are some common pitfalls and the problem is big enough that it is worth taking a crack at it. To do so I'll walk through a framework that describes roughly how I go about this when asked to help.

Step 1: Collect information from the employer/online sources.

Here's what you want, in an ideal scenario:

1) The strike price of the options

2) The vesting schedule

3) The last round valuation (per share as well as in dollars, post-money)

4) The last round date and lead investors

5) Details on the terms of the last round. Ask about the liquidation preference given to investors and the potential future dilution from it (more on this in step 4)

6) The company's employee count over the past few years (get a LinkedIn premium account to do this)

7) The company's policy on employee liquidity, if it is a unicorn or otherwise at a later stage

It can be nerve-wracking to ask for so much, but this is a big financial decision and (IMO at least) employees deserve to know these things up front.

Step 2: Figure out what your options are worth at the last round valuation provided by the company.

Simple at the outset: last round share price less the strike price times the number of shares.

Step 3: Evaluate how the company is doing relative to that round's expectations.

Startups are momentum machines and the trajectory of the company is a decent indicator of future success. Many well known companies are actually quietly struggling, and shares may be worth far less than their last round valuation.

Employee growth is one helpful measure- anyone with a LinkedIn premium account can view the historic headcount of most companies. If this number is flattish, or shows signs of layoffs, that is a negative indicator of the health of the company. Here's an article I wrote earlier this year doing this analysis on unicorns. There are no hard and fast rules, but faster growth is usually better and most public high-growth tech companies are growing headcount 20%+ per year.

Another way to get at this is to ask about how the company is doing relative to the plan it showed investors before its last fundraise- often how the company is doing versus expectations is more important for the valuation relative to the last-round share price than how it is doing in absolute terms.

If the company is willing to provide metrics, look at revenue over time and take note of whether it looks like an exponential curve, linear or logarithmic. It isn't perfect but it is another way to gut check the potential future success of the company.

Finally, give extra credit to a firm that has raised money from a name-brand VC that you've heard of. It isn't the end all and be all, but there is a cluster of firms that has historically had great returns and it doesn't hurt to place a bet alongside them rather than a relative unknown, all else equal.

Use this work to approximately relate the company to its last round valuation: if it has been doing well by most measures, there's a good chance it is worth far more. If it has flatlined and missed expectations, it may well be worth the same or less as the last round price.

Step 4: Watch out for dilution pitfalls and correspondingly sketchy valuation marks.

Some of the most cynical activity going on in Silicon Valley is when startups raise rounds using fancy preference structures in order to artificially boost the public-facing valuation. Employees typically get common stock that doesn't have these terms, meaning that the listed last round share price might be totally divorced from the value of your shares.

Here's a scenario that has been all too common: a startup is trying to reach for a certain valuation threshold (cough, $1bn, cough) but won't get there on the merits. Instead, it offers investors a special deal: if they invest at a share price that equates to a $1bn valuation, they will be guaranteed a 20% return per year from the date of their investment through an exit. Investors are often willing to pay a vastly higher valuation than they otherwise would with that kind of guarantee, and why not? They get the 20% return in any scenario, as long as the company has enough value to pay it to them by diluting the other shareholders.

Of course, this can be a disaster for other shareholders. Say $200m is invested with the terms described above, and four years pass. The company has a great exit, but it is disappointing relative to the last round valuation: a $500m sale to a competitor. The $200m invested is owed a 20% return per year, which works out to just over $400m due to the last round investors. Add in a few prior rounds of more traditional preference shares from VCs and there will be almost nothing left over for common shareholders, who are diluted into oblivion.

As that example makes clear, these sort of super-preference shares are totally different from common shares, but the price paid for them is often used in the press and by the company to track its valuation and share price. Employees (and recruiters) often use valuations derived this way to estimate the value of option grants, leading to epic overestimations of the true market value of the compensation package being offered. Don't let a company take advantage of you this way: check to make sure any preferred stock has standard preference terms (usually a 1x liquidation preference), and if you find out that super-preference shares are involved understand that your shares are worth less than them in many scenarios.

Note: Actually even the standard 1x liquidation preference shares are, as a rule, worth more than common, but this only tends to rear its head in circumstances where the total value of your options is already pretty small because the company is struggling.

Step 5: Consider liquidity.

If a company is near an IPO or sale (you can often find references to this in the press or just ask, generally bigger startups are closer), it is more likely that you'll have the option of selling your shares in the near future. An early stage company comes with the potential for a big increase in the value of your shares over time, but the tradeoff is that you're likely to have to wait 5+ years for a chance to sell. If the company is large and mature but doesn't show signs of coming public anytime soon, as them what options they have for employees to cash out if they so choose. Policies vary widely.

Wrapping up

As you can probably tell, my framework is based on the premise that companies will present you the rosiest picture possible and focuses on testing for downside risks to balance that out. If a company has been hitting its numbers, is growing revenue and headcount exponentially and hasn't raised using an esoteric preference structure, it is probably a relatively good bet relative to the last round valuation of the shares it is offering. If the opposite is true in each case, I'd be wary.

Of course, compensation is only a small piece of the job decision pie, but if you're considering competing offers hopefully this piece provides a bit of a framework for how to think about them. If you've worked through things and are still stuck, feel free to shoot me an email and I'll do my best to help out.

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