Thinking About Your Stock Options

24 Jan
Recently, a recruiter posted the following on the SF Ruby on Rails Meetup Board:

“Hello everyone, For those of you who were not at the meet up the other night, I wanted to let you know that I am currently looking for Ruby on Rails developers for the fastest growing tech company in history! The company just turned down a multi-billion dollar offer and they are expected to go public this year. Now is a perfect opportunity to join a great company and work alongside some of the best engineering and entrepreneurial minds in the Silicon Valley. If anyone is interested in hearing more feel free to call or email me. Referral’s are appreciated.”

If I put on my CEO/CFO hat when I see companies like this, I think it is useful to consider how stock option compensation really works.

The following comes to mind in thinking about the opportunities for personal upside within a capital structure like this. Let’s take the example of Groupon:

1) Groupon recently rejected a $6 billion offer from Google and then ran their valuation metric north of $15 Billion. They then supposedly pulled in investment capital using this valuation.

2) The instant they pull in capital at a certain valuation, accounting rules require them to reset the prices of their option plan for new option grants.

3) Let’s say they had 6 billion shares outstanding (e.g. $1/share) at the time of the Google offer. They then reset their valuation to $15 billion to bring in more money. The shares are now $2.50/share.

4) Early stage pre-revenue private companies generally have option pricing of anywhere from 1/10th to 1/3rd of the valuation price of the most current round. The further along people are in developing a revenue model, the closer the price of the employee options are to share prices. Groupon is supposedly on a $1 billion revenue run rate. Let’s say that any option grants have a Strike Price of $1.00 per share. This means that to exercise your options you have to pay $1/share.

5) You get your shiny new Groupon offer as an individual contributor. They throw you a market competitive base salary and tell you that you get “1 miiiiillion Options!” (Austin Powers little finger held up to corner of mouth) with a four-year vesting schedule, a one year cliff, and a $1/share strike price. In my experience, most people don’t understand how capital structures work and will look at the total number of options and not at their % of the pie (in this case just under 2/100’s of 1%). As well, a one year cliff means if you leave for any reason before a year, including an “at will termination” you will lose all of your shares as a result of the cliff. If you leave after a year, to keep the shares you have earned, you usually have 90 days to exercise your options and buy your shares. In the last case, let’s say you have vested 250,000 options as a result of one year (just past the cliff). You will need to search your bank accounts and couch cushions for $250,000. At the time, while you may believe that the shares are valuable if the company is still private, you will not be liquid and so will need to carry the private shares and hope the value stays up.

6) From a macro standpoint, let’s look at the $15 billion company valuation. While everyone gets excited about finding the next Facebook (current private valuation of $50 billion), companies like Facebook that end up dominating a category are extremely rare and end up with a high valuation through a combination of timing and owning a unique asset. In the case of Facebook, this single network effect really is a dynamic with social networks. I don’t really feel that “aggregate purchasing companies” have this industry dynamic. This category actually reminds me more of the travel companies that popped up a decade ago. e.g. priceline, orbis, cheaptickets, kayak, etc. The people who entered this category early — in Seed, Series A, or B were the only ones to make real money from stock option appreciation. In general, the old saying about “trees growing infinitely to the sky” really applies when you start thinking about companies with a big valuation and their stock appreciation prospects.

7) I have been involved in a lot of companies both as an executive and investor. It is truly amazing how much value gets pissed away throughout the life of the company by mismanagement of the fundraising and capitalization process. If you intend to work at a startup, really interview the executives, and if you have the opportunity, the investors and board members as well. Ask to hear the business pitch they made to get investment dollars as well their opinions on what caused the first groups of investors to jump in. Ask them if anyone has rejected them and why. Right now management teams are eager to recruit technical talent. If they really want you and you ask to talk with these folks to hear about the company prospects, it will make you look more astute about how things work and they will see it as an opportunity to further close you. Try to get a sense if they, as executives, really care about the people working for them or if it is more of a cannon fodder approach to life.

8) Don’t get me wrong, working at a rapidly growing company could provide more intrinsic benefits than just the chance to get filthy rich from stock option appreciation. But, it always helps to go in understanding how all of the compensation pieces really work for you.

Lastly, just for a little perspective as to what life path informs my Weltanschauung and opinions. I have been an executive in a variety of venture-backed technology companies since 1991. My startup scorecard is 2 really big hits (27x’s money return to employees and investors on one of them), 1 modestly breakeven, and 3 bombs (I was CEO of one of those). At present, I am doing an early stage company I started last year focused on personal health/quantified self. Our Series A venture round closed in October with a valuation in the mid 7 figures (very cheap) and we will be bringing in our Series B in the next two quarters. We expect an uptick of at least double in our valuation, quite probably more. We will begin to collect revenue next quarter.

Sorry for the long post. If anyone has questions about what I have written above feel free to ask.

Jim Kean

Interested in joining an early stage startup with great financial prospects?
I am recruiting 2-3 engineers and a technical cofounder / head of engineering for my new company. To learn more, read:WellnessFX is Hiring. To apply, email me: jim@jimkean.com

5 Responses to “Thinking About Your Stock Options”

  1. Eric Kennedy February 7, 2011 at 2:31 AM #

    Great post and use of Groupon as an example. The reality of startup stock options is that they usually aren’t worth much unless you have more than 1% of a company. Only IPOs can make millionaires out of employees who start with less than 0.5%, and few startups make it to that stage. The ones that are on the cusp (Facebook, Groupon, LinkedIn, Kayak), are not giving out huge grants anymore.

  2. Jim Kean February 7, 2011 at 10:25 PM #

    Eric, thanks for stopping by. Good comments! There are several aspects to consider:

    1) Not only how much of the company you are receiving but the opportunity for your position to experience a valuation change in multiples. For example, 1/10th of 1% in a startup worth $10 million at its last financing and with the opportunity to increase $100 million on its next round will provide $100,000 return.

    2) There are several paths to liquidity. For example, let’s say the example grows and receives a billion dollar acquisition offer (versus IPO). The portion is $1 million.

    3) The closer that companies get to functional revenue production, higher valuations, acquisitions, and IPOs, the closer the strike prices of the option grants need to be to the actual company share valuations. The accounting rules will require this.

    4) This means that any individual profits made on your stock will need to come from actual revenue growth and company valuation increase.

    5) You are right. All grants are considered based on what is seen as the market rate for employees. The higher the valuation, the lower the grants.

    thanks,

    jim

  3. A.J. Johnson February 19, 2011 at 6:55 PM #

    Hello Jim,
    Thanks for the great article. What advice would you give someone who is considering working for a startup that wants to offer stock options and commission (this is a potential sales role) in place of base salary. What variables should I be looking at and is there a range that you would recommend negotiating? ie. equal value of options for negotiated salary.

    thanks in advance for your response!

    A.J.

Trackbacks/Pingbacks

  1. Stock options: a donkey and carrot? - February 9, 2011

    […] worked at several startups I found this post *much* needed. Many startups use stock options to attract technical talent at a steep discount. My […]

  2. Engineers Do Better in Startups « Jim Kean - February 16, 2011

    […] 1) Usually these companies have become so large and bureaucratic they tend to limit the abilities of top engineering talent to innovate and develop world changing services and platforms. They are static, slower growing biz models. 2) The valuations of these companies have run up so much the possibility of becoming “rich” from massive upside is reduced. I actually posted on a RoR Meetup board on this topic in response to a Groupon recruiter. […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: