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! )