Start up Employee Stock Options

So you been offered 3,000 or 200 or 15,000 or 100,000 stock options in a start up?  What does that mean?  How do you determine their worth now?  What should you expect them to be worth later?

First things first, let's look at the options themselves.  The stock options cannot be understood without knowing the "entire fraction" -- that is to say that the offered options are the numerator of a fraction.  To know the whole fraction, meaning the numerator as well as the denominator is the starting point for evaluating a stock option.  Having 3,000 stock option shares in a company with 30,000 total shares is 10%.   Having 200 stock options in a company with 30 million shares is nice but it may not be all that profitable.  Here again, the value of the shares is the ultimate determinant of value but one can't discern too much of anything based upon the raw number of options (the numerator alone).

The options should be worth nothing when they're granted.   Since options usually vest over time and the U.S. tax laws dictate that unless the options are provided to you at today's cost then it it is a current taxable event, one wants them to be worthless on the day they are granted.   If the options are granted at less than the fair market value, then the granting of them creates a taxable event.  So, the correct answer is that the options are valueless when you receive them.

So what will they be worth?  Knowledge of the numerator and denominator is necessary to begin this estimate.  What will the company be worth in 2, 3, or 4 years?   This answer is typically derived at looking at the valuation of public companies in the same or comparable industries.   The key ratio is usually the sales multiple.  That is what is the value of the company expressed as a multiple of its sales.  A company with $50M in sales that has a market capitalization of $200M has a sales multiple of 4.   So, what are the common sales multiples in your industry?   With that number in hand, the equation becomes estimated sales of your company times the industry sales multiple times your ownership fraction.  Or, $50M times 4 equals $200M and your .25% options equate $500,000.   So a little can be a lot with stock options.  Or a lot of options can be worth a little.

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Comments

[FN]

I realize you're trying to simplify things for your readers (which is great), but I think it's worth you mentioning liquidation preferences as they obviously have a huge impact on returns. In your example of the software company with $50MM in revenues valued at $200MM, odds are it has as much $100MM of capital invested in it. So an employee with 0.25% really owns 0.25% over and above the invested capital which is probably closer to $250K.

[Don]

FN,
Thanks for the well taken comment. FN refers to the common investment practice of a liquidation preference. The liquidation preference causes the investor's capital to be returned prior and ahead of any other sale proceeds. In the example above, the $100MM capital would be returned prior to any other proceeds -- "off the top" so to speak -- which reduces the amount that is available to everyone else. This is particularly impactful to common stock option holders as they typically have smaller holdings.

Again, thanks for the comment.

Don