2015-07-23

Part 1: Misinformation in Startup Equity Compensation

The pattern I see repeatedly in online articles regarding startup equity compensation is 80% accurate, 20% wrong. Because the information tends to be almost correct, it's easy to overlook the ways in which it is inaccurate. Here's one example:

Experienced shareholders (and Venture Hacks readers) focus on the current value of their shares and the company's prospects. Investors in public companies with wacky capital structures don't fancy that they own 0.0003% of a company that is worth $1B. Instead, they multiply today's share price by the quantity of their shares to determine their share value. They track percentage ownership and valuation, but they focus on share price.

Focus on your share price, not your valuation -- Venture Hacks

The article is very useful overall. But if you take it for what it is, you miss something that many startup employees forget about, especially in the heat of the moment of negotiating a job offer. I made this mistake once too.

You own call options, not equity.

Let's say you just got a job offer at Rocketship Startup Z that gives you a $120,000 base salary and $240,000 in options vesting over 4 years. It's easy to think that your annual compensation is $180,000/year with equity upside.

But recall that your $240,000 option package is in options, not equity. The $240,000 by itself is actually just a price tag for how much you'll have to pony up if you leave the company before it goes public. What it gives you is the right to buy $240,000 worth of the company's stock (at the current price).

This number does not represent the monetary value you can expect to gain. I think we are psychologically wired to overlook this.

In the most simplistic terms [1], the value of your option package is

value = (strike price) * (# of options) * (expected % increase in the company's valuation)

If Rocketship Startup Z is currently valued at $10 billion and your options' strike price is equal to the current value of the company's common stock, then the company must double its valuation for your option package to actually net you $240,000.

So when you are an employee with options, share value (like the article says) is less important than how much the valuation will grow in the future. In the extreme case that the company's valuation remains flat, your $240,000 option package is worth $0.



[1] For the sake of simplicity, I have overlooked things like liquidity preference or later round dilution.