A Newbie’s Guide to Startup Compensation (or “Stock Options will Make Me Rich!”)

My first experience with stock options was at the ripe age of 34 years old, when I was selling Jobby (retired) to Jobster (Gah, make the Web 2.0 names STOP!). Before that, I’d been running my own business for close to a decade– with good success, but there really wasn’t any sense in setting up an options plan.

So when selling our company and getting presented with a cash/stock options package, I was damn excited about the options. I dutifully did a bit of research to try to understand how they worked, asked some smart questions, and was a proud new owner of startup equity. 365 days later, I left Jobster– on good terms, but I chose not to exercise my options.

Now, as RescueTime is expanding its team, I’m on the other side of the equation– putting together stock option plans for new hires. So I figured it might be useful for folks we’re talking to for me to put together so thoughts and resources about startup compensation, particularly in the area of stock options. A big part of my motivation here is that I think most startups are QUITE content to let employees think that options are this magical ticket to wealth and prosperity… It feels dishonest.

3 Harsh Realities of Startup Options

1. Employees with decent salaries and options will almost NEVER get rich in a liquidity event. The people who might get rich with startup equity are the founders and the investors (not coincidentally, the people who took significant risks). There are obviously exceptions here– I read that Google minted 900 new millionaires when they IPO’d. Good for them. But when you do the math on probably exits for most startups, it’s good– but it’s not quite so rosy. VentureHacks has a breakdown of what startup employees might expect in terms of equity. Assuming you don’t get diluted with further investment down the road, a lead dev or director might expect 1% ownership (vesting over 4 years). So in the event of a $50,000,000 exit, they’d walk away with a cool $500k, IF they’d been there for 4 years or longer.

2. Options vest over 4 years. Everyone loves the idea of the overnight success with a quick-flip to Google. It’s vanishingly rare, but it does happen. When it does, the founders generally do okay, but what happens to the late-comers with unvested options is a question mark. Those unvested shares COULD accelerate (meaning they could all vest when the buy happens). Or they could convert to options in the purchasing companies stock (par value). That’s all part of the negotiation and it all depends on the leverage you have with the buyer.

3. How the options are set up very much effect how attractive the company is to a buyer. We’d LOVE to offer 100% acceleration upon change of control to our hires– that’d mean that all options would immedietely vest and our whole team would be rich and happy– but not particularly incentivized to stay and work for the buyer.

So are Options a Crappy Deal?

The best way to look at options are as a high-risk investment– it’s important to look at the cost of the investment, the chance that the investment will “hit”, the likely magnitude of the return on investment, and the percentage you’ll likely have in your pocket at the time of a liquidity event. Here’s the best way to look at the math.

  • The COST of the investment is the difference between what you could be making (your market value) minus the salary that you are offered. So if you’re worth $85k/yr and the offer is $75k/yr, you’re investing $10k per year in this high-risk opportunity. If you’re getting paid market value, then… Well, there’s no risk– and you shouldn’t be expecting much reward.
  • The CHANCE the investment will hit is a huge question mark. Think hard about the market for such a company. Who would buy it? Can you imagine Google and Microsoft fighting over the company?
  • The MAGNITUDE of the return is another question mark. If it’s a web startup, there’s lots of data out there about sale prices. The question is: how big is the opportunity? What are companies in your space getting bought for? It’s easy to test a few scenarios.
  • The PERCENTAGE of ownership is a bit of a moving target, but you can at least know where you start. Again, take a look at VentureHacks for a reality check.
  • So to boil it down in an example, let’s say we have an engineer who is getting .5% of the company vested over 4 years. He’s making $80k, but probably could make $90k at a company with limited equity opportunity. Let’s assume a target exit price of $50,000,000 (oh, happy day!).

    Our engineer is spending $10k per year to have a shot at a $62,500 per year. If he spends the full four years there, he’s “invested” $40k for a shot at $250k (a 6x+ return– not bad). When you run the same scenario with a billion dollar exit, it’s starting to look a lot prettier. When you run it at a Flickr-sized exit ($20m), it’s not looking like that great of a bet. If you want to get into the finer points, you should probably consider the benefits as well as the cost of the options.

    The only way to buy more reward is with more risk. Some founders will be willing to give up lots more equity if you’ll work for less, but it’s honestly fairly rare if they’ve reached the point where they have enough cash to hire people for them to be terribly eager to part with lots of equity. There’s obviously a small army of “idea guys” out there who would happily give you huge piles of equity if you’ll work for free. And, of course, the best way to get rich with equity is to start your own company.

    If you don’t fancy rolling the financial dice by “investing” in a startup, most startups are probably happy to pay you market rate and dial down your options… But either way, there are lots of career perks that you’re buying by working in a startup. Which brings me to…

    You’re Buying More than Just a High Risk Investment

    Needless to say, most options aren’t a very good investment. A chance at a 5x return is great, but most startups are facing longer odds than 5 to 1– so you should be damn sure that you believe in the company, the team, and (most importantly) your ability to influence the outcome.

    I think it’s important to note that our engineer in the above example is buying a heckuva lot more with his $10k… Though they are things with a very subjective value.

  • He’s buying startup experience. If you plan on spinning up your own thing someday, there is no substitute for working in a startup to learn what works and what doesn’t. You don’t have to sign on with a experienced startup founder… It’s good enough to get paid to watch them make mistakes that you can avoid when it’s your turn.
  • He’s buying a “clean slate”. If you get to a startup early enough, there is lots of blue sky. The early days of product development (for many people) are the most rewarding.
  • He’s buying startup cred. When it comes time to spinning up his own thing or getting his next gig, it’s a big plus to have that background. It’s obviously a HUGE plus to be part of a winning team (if an exit happens).
  • He’s buying relationships. One of our investors says that 99% of his deal flow comes from people he’s previously invested in or people on their teams. Working at an early stage startup is an opportunity to meet investors and other important startup folks– good leads for future endeavors.
  • He’s buying a work environment that is comparatively bullshit-free. Little bureaucracy, few meetings, flexible work schedule/environment, etc. If you’ve ever had an environment like this, you know how addictive it is and how elusive it is in larger companies.
  • He’s (hopefully) buying a chance to work on a product he likes/wants to use.

Obviously, all of these perks are really only perks for people who see themselves working on/in startups in the future… For people like this, the $10k price tag (when you roll in the high-risk investment op) is a great investment. For folks who are just chasing the idea that they are going to get rich taking decent-paying jobs with post-funding startups, they are in for a long series of disappointments.

(note: if other folks have insights on startup compensation/options, please chime in. Despite writing a Newbie’s guide, I am, admittedly, a bit of a newbie! :-) )

  • http://www.technotheory.com Jared Goralnick

    Thanks for this, Tony! As someone who's worked at many startups but never been around through an acquisition, it's great to hear from someone who's at least been through it. I also appreciate the links you mentioned.

    I've been thinking a lot about options for options, and appreciate your perspective. Fortunately I've got more than a 1% stake in my present endeavors ;-).

    Much luck on the $50M, er, $1B exit…

  • http://blog.aisleten.com Micah

    Excellent write up, especially the part about how it's not all about money.

    One note: I may have missed it somewhere in there, but you might want to note that often there's an expiration on the options. Where I work, it's tied to when you leave. So, if I quit, I have 60 days to exercise my options, which means actually plunking down money to buy the stock. I'm betting a lot of people don't realize that you may have to spend some money in order to get your stock.

    Or, I could be totally wrong about that part too :)

  • http://www.daniellemorrill.com Danielle Morrill

    Hi Tony, I found this post helpful and have already forwarded it to some of my friends. I am curious to hear your thoughts on the (diminishing?) value of receiving options as a company takes subsequent rounds of funding. I'm familiar with dilution (at least in principle), but haven't found many clear examples of how the math works.

    Also, I've heard that companies often won't share your percentage of ownership with you. Is this what you've seen? How can this number be calculated?

  • http://cyberfox.com/blog Cyberfox

    Greetings,
    Having been through two very successful IPO events a decade apart (MCAF in 1992 and PYPL in 2002), I can tell you that it's definitely doable to get a million dollar event (on paper, at least) for a non-founder employee. Of course you have to be smart about the money if you're going to keep it. :)

    I've also been through two companies where I had/have options, but those options are, and are likely to continue to be, worthless, and two where I left before my initial shelf vested. Still, out of 6 startups, all of which were fun at the time, two major successes is better than most people get.

    The real idea (to me) is that you can do work you are excited about doing, in an environment where _your_ decisions affect the success of the company, get paid for it, and have a non-zero chance of getting a particularly excellent pay-out if you make the right decisions and build something people really care about.

    Sure, as an employee (instead of founder) there are factors out of your control, but in a startup you have much more control than an employee in an established company, along with more risk and commensurately more potential reward.

    In my experience few people optimize their salary quite to the extent that they can reasonably say, 'Okay, I'm taking a $10K pay cut from what I could be making, in exchange for an extra 0.X% of the company'. Most folks in the successful startups I've been part of just looked at their base salary (and typical benefits), decided if they could live with that, and ignored the options as being merely a potential bonus.

    Actually with the first company I went public with, employees didn't even have 'stock options' until we began the process of going public. Typically employee stock options weren't something that line employees got, back then.

    People often call it the 'stock option lottery', but I can't think of any lotteries that pay you to participate, and you can improve your chances of winning by doing great work.

    – Morgan

  • http://cyberfox.com/blog Cyberfox

    Greetings,
    To throw in my voice, @michah: that's a good point (there's actually almost always an exercise-by date even if you _don't_ leave the company), and it's also worth talking about the different tax consequences of early exercise, same-day exercise and sell, and exercise and hold for > 1yr.

    @Danielle, you can basically calculate your percentage of potential ownership based on the number of shares granted divided by the number of shares outstanding. It's hard to get that number out of most private companies before (and sometimes after) joining them.

    Dilution by subsequent rounds of funding is often bad. I had a 200:1 reverse stock split happen on one company I'd worked for, which meant I got 1 share for every 200 I previously had, and then they added new shares and sold them to raise more money. There's also squirrely issues with preferred stock.

    The basic answer (in my experience) has been that the more rounds of funding, the less likely a liquidity event is, so make sure you're comfortable with your salary _first_. Rare is the company who actually 'just needs a little bridge loan to get to profitability'.

    – Morgan

  • http://www.rescuetime.com webwright

    Hey Morgan– I agree that a million dollar payday is a possibility, but liquidity nowadays seems to be limited to M&A– generally smaller dollar amounts. The IPOs you see don't have the run-up that they used to have. Interesting to look at:

    http://startup.partnerup.com/2008/01/02/2007-ac

    That's a list of acquisitions in 2007.

    http://searchstorage.techtarget.com/news/articl

    Those are the top Tech IPOs in 2007 (a much shorter list of companies that had a long, hard, and expensive road).

    I think the first boom minted quite a few more (paper?) millionaires than this one has (or will).

  • http://www.rescuetime.com webwright

    As Morgan said (hey Morgan!), you definitely need to know the outstanding shares to know percentage. If you don't, it's really meaningless. 1,000 shares is a lot if there are 2,000 shares outstanding. Not so much if there are 10,000,000.

    Subsequent rounds will dilute your position, but ideally, the cash influx will make your shares more valuable. So if you owned 50% of a $1,000,000 company and then took another million in funding, you'd then own 25% of a 2,000,000 company. In theory (and on paper) than has the same value– the idea is that additional funding can be leveraged to make the company more valuable. In practice, that money is sometimes used to “stay alive” rather than move the ball, so it leaves you with less equity.

    [edit: It important to note that all sorts of crazy stuff can happen on subsequent funding rounds-- they can functionally do stuff to dramatically change the position of people who've left the company-- to incentivize the folks who are still slogging away]

    At Jobster, they were pretty open book with the # of outstanding shares (we are at RescueTime as well). I would insist on knowing the # of outstanding shares– if they wouldn't share that #, I'd focus entirely on the salary.

  • http://adamac.blogspot.com Adam

    @Danielle, some companies won't tell you the percentage of the company that your options represent but they should be willing to tell you how many shares are outstanding. This will allow you to calculate for yourself the percentage of the company you are being optioned. Presumably it's too easy for legal issues to arise when you tell an employee that they are getting a certain percentage of the company and that number doesn't turn out to be exactly right – a number of options is exact.

    In reality you want to know the total number of fully diluted shares outstanding, with preferred converted to common. Of course it would be nice to understand all of the terms of the everyone's employment, investment agreements, liquidation preferences, participation, etc. to really understand how the picture would look in an exit. Most of these details are going to be closely held, but some will freely share them.

    If the company you're considering working for doesn't even have the decency to give you a rough idea of what percentage of the company they are offering you, I would strongly urge looking elsewhere. This is a pretty strong indication that management has little respect for its employees and is not going to be forthright in the future. How are you even supposed to evaluate such an offer? A million-option grant looks pretty good until you find out there are a trillion outstanding.

  • http://47hats.com Bob Walsh

    Excellent post Tony – thank you!

  • http://cyberfox.com/blog Cyberfox

    Greetings,
    Hey back…

    You're right, in a lot of ways, that the current boomlet is going to be a little lower key, but one of the things I notice from those lists is that the companies who actually have a product/service they sell (as opposed to media outlets, where they only make money by advertising) are consistently going for more. 'Profitable' isn't a dirty word anymore. :)

    As for the IPO's not having the run-up, I completely ignored the 'opened at $20, jumped to $200' type of IPO. Opening at $12, and jumping to $20 is _awesome_, and is what made me a paper millionaire back in 1992. (Being profitable for 2 years before going public, and an obscene profit margin helped.)

    As for your article, you also should note the differences between Non-Qualified options and Incentive Stock Options, as they have very different tax implications.

    – Morgan

  • http://www.simplifyed.com Dezmon Landers

    Tony,

    This is a great article on how to look at startup compensation from both sides. I particularly like the section entitled “Your buying more than just a high risk investment”. It really helps entrepreneurs formulate an incentive argument that doesn't necessarily cost us much in terms of equity and cash.

    Great job and keep it coming!

  • http://www.davidshenventures.com DShen

    love the cost benefit analysis! at last a clear presentation!

  • http://www.istgah118.ir istgah

    very nice and interesting thankx!

  • http://blog.rajgad.com Amit C

    Hello Tony,

    Very useful rightup and specially thanks for the market figures link to venture hacks.
    About your .5% example, the math really helped put the amounts in perspective. Does the following variation make sense.
    One point, for the $50M exit, won't there be a different breakup for preferred and common, while the .5% is for common. So, in effect, it would be 0.25% or less. Then there are common variations like removing invested money before, different multiple for each category and so forth. So, now it is down to maybe 12%. That is $15k return with risk for $10k per year.

    Amit

  • http://blog.rajgad.com Amit C

    Hello Tony,

    Very useful rightup and specially thanks for the market figures link to venture hacks.
    About your .5% example, the math really helped put the amounts in perspective. Does the following variation make sense.
    One point, for the $50M exit, won't there be a different breakup for preferred and common, while the .5% is for common. So, in effect, it would be 0.25% or less. Then there are common variations like removing invested money before, different multiple for each category and so forth. So, now it is down to maybe 12%. That is $15k return with risk for $10k per year.

    Amit

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