How to Value Start-Up Equity
You’re probably not doing it right.
Executive Summary
Use this calculator, which incorporates “Vesting Schedule Optionality”
Silicon Valley is a mess right now.
Smarter, better, faster. Cut the red tape. Get shit done.
We have all these great battle cries and yet thousands of talented techies work in enterprises mired in the same kinds of bureaucracy and risk aversion that purportedly created all this opportunity for “disruption” in the first place.
In our red hot market for talent, why are top-notch techies choosing to spend hours stuck in traffic on a corporate bus with bad Wi-Fi and no snacks – when they could choose to join a fast-paced start-up instead?
I don’t mean to be a hypocrite; I personally learned a lot as a Product Manager at Google and can easily imagine going back one day. However, after making the jump into a start-up, speaking with hundreds of product managers and engineers about their careers, and personally experiencing the rise and fall of a VC-backed company, I have come to learn that one problem in particular plays a major role in maintaining the status quo, and we need to fix it:
Most people misunderstand the value of start-up equity grants.
The simple math is simply wrong.
Let’s imagine you hate your boss.
A speculative, $50 million company reinventing title insurance offers to match your current salary and grant you 0.4% of the company in stock options vesting over 4 years.
You whip out the calculator on your iPhone…
- $50 million x 0.4% = $200,000 of total value
- $200,000 / 4 years of vesting = $50,000 of annual compensation
$50,000 pales in comparison to the $175,000 of stock and bonuses that you earn each year from your Big Tech company, so you laugh at the founder, switch to a new team with a different pointy-haired boss, and get back on the bus smiling with renewed, quiet confidence. Oops!
What if I convinced you that this equity grant is probably worth $265,000 of annual compensation — not a mere $50,000?
I’m going to do this by letting you in on a secret:
Investors set valuations, but employees of speculative companies often get much greater value per share.
Investors can’t quit. Employees can.
Unlike investors, employees get to choose each and every day whether to keep on investing (i.e. working) on the terms locked in at the beginning of their involvement.
The option to quit anytime creates immense value for employees of speculative start-ups.
Imagine you join a $7 billion virtual reality company with no product, and then a year into your 4 year vesting schedule they launch some gizmo received as poorly as the spectacle of Google Glass. You know what you’re going to do? You’re going to quit! You’re going to recycle the remaining 3 years of your equity grant’s vesting schedule into a more valuable professional endeavor. The investors, on the other hand, will likely lose all of their investment. They can’t decide, like you can, “This isn’t going how I’d like… Can I have three-fourths of my investment back?”
Now imagine the opposite scenario. You join a $53 million messaging company that continues to grow quickly until 2 years later that same company is valued 28 times higher at $1.5 billion. You are now hugely overpaid: you may now be vesting $1 million per year worth of stock, and no matter how many online classes or motivational seminars you completed over that time, it’s hard to imagine the value of your labor has appreciated so quickly. But good news — you get to stay! As long as you keep doing your job, your employer probably can’t fire you without instigating an expensive lawsuit or demoralizing company culture.
In summary, employees flip a double-sided coin. 70% of startups fail, and when they do their employees aren’t stuck at them. But when things go well, employees fully participate in all their expected upside. I call this asymmetry Vesting Schedule Optionality because it derives from the “option” that employees can exercise to stop investing their efforts at any point in their vesting schedule.
Vesting Schedule Optionality can be worth a lot.
Vesting Schedule Optionality may sound like a wonkish corner consideration, but it can easily magnify the value of your equity grant by more than 5 times! Let’s see how the original 0.4% of a $50 million company can actually have the same expected value as $265,000 per year of cash.
$265,000 per year has an expected value of $1.2 million in 4 years.
Imagine yourself 4 years into the future, flush with cash after pulling in an extra $265,000 every single year. Heck, let’s even imagine that you invested every nickel into the stock market and netted a solid 10% return. How much do you end up with? I’ll save you the math… $1.2 million.
0.4% of the start-up has an expected value of $0.5 million in 4 years.
For reasons that I will justify later, let’s imagine an 85% chance that the start-up goes bust, offset by a 15% chance that your stock nets you a neat $3.2 million payout. To get the expected value, we simply multiply your potential payout by its probability: $3.2 million x 15% = $0.5 million.
However, the option to quit adds $0.7 million of expected value to joining the start-up.
If you take the advice of this article, you will try to join start-ups at which you will learn the company’s inevitable financial outcome as quickly as humanly possible.
Learning after one year that the company is destined for failure allows you to recover three years of compensation elsewhere. After investing that into the stock market at a 10% return, those 3 years of $265,000 will accrue a total value of $0.9 million! Multiplying this value by its probability of 85% yields an additional $0.7 million of value to your start-up offer!
So yes, 0.4% can equal $265,000 per year of value.
The start-up clearly incurs greater risk, but it also offers proportionally greater return, which nets out to an equivalent expected value.
Calculate the full value of your equity by making educated guesses about the future.
You can calculate the full value of your employee equity grant, including Vesting Schedule Optionality, if you make an educated guess about the following unknowns:
- How long the company will take to exit
- How much dilution / funding the company will take before exit
- The value at which the company would successful exit
- The overall probability of a successful exit
I recommend a simple process:
- Make an educated guess about all the unknowns
- Iteratively adjust them until they imply a reasonable present day “investor” valuation of the company
- Calculate the value of your equity from there
Step #1a — Guess the time to exit.
VC-backed companies typically take about 5–6 years from founding to exit:
However, successful exits probably take longer than unsuccessful exits (like acqui-hires), so you may want to buffer this figure for good measure.
Additionally, the company’s target market will have a significant influence: among companies founded circa 2008, B2B companies generally took 5 years to reach a $1 billion valuation, compared to 3 years for B2C companies.
Lastly, you should consider circumstances like the ambitions of the controlling interests. Do the founders want liquidity, or are they already wealthy? Did the VC’s invest early or late in the lifecycle of their fund? Are there a lot of strategic acquirers or will the company need to time the IPO market?
Step #1b — Guess the dilution prior to exit.
As a rule of thumb, your start-up will probably take 20% dilution every 1.5 years remaining before exit. Adjust this based on the stage of the company, its growth trajectory, and its line of sight to profitability.
Step #1c — Guess the value of the company in a successful exit.
Breakouts like Uber might create billion-dollar industries out of thin air, but most companies earn their lunch competing in researchable, established markets.
Figure out the total market capitalization of all businesses engaged in your target market. Then estimate your potential market share in light of the market’s current level of fragmentation and how truly differentiated your company’s approach will be.
Step #1d — Guess the probability of a successful exit.
28% of start-ups founded about 8 years ago have exited, but many of those exits were not successful for employees or VC’s. For instance, only 3% of the exits exceeded a valuation of $500 million.
Hopefully you’re joining a start-up that you believe is better than average. Moreover, if you’re joining at a senior level and the company’s greatest risks are in your wheelhouse (e.g. the biggest question is whether the product can be built, and you know for certain that you can build it), then make sure to factor your own contribution into the equation.
Step #2 — Iterate your guesses toward a coherent story.
You’re not the only one making guesses about the company’s future prospects. Investors do this as well, and they probably have a lot more information and expertise than you do.
The good news is that you can easily calculate the “investor valuation” that your assumptions imply for the company, and you can ensure this number matches the valuation actually used in recent or comparable investments .
To figure the “investor valuation” you will need to make an assumption about the kinds of returns those investors expect, but thankfully these expectations are well understood for venture backed start-ups.
With some simple math, which I’ve taken care of for you in my calculator, you can make sure that your assumptions don’t radically diverge from other people’s perspectives on the company… or at least you will know by how much they do.
One quick note: there are a million ways that companies can juice up their most recent valuation when they raise a round, so make sure to ask if anything non-standard happened, or you might rely on an inflated valuation.
Step #3 — Calculate the expected value of your equity grant.
This comes down to figuring out what level of additional salary would get you the same expected value as your equity grant.
The math gets tricky and uses some advanced Excel functions, so for the benefit of the internet, I’ve created a calculator in Google Sheets that anyone can copy and use:
In Summary
Prospective employees often undervalue the opportunity to join speculative start-ups. The biggest mistake is to forget that if things go badly quickly, they can leave the company and recycle their energies elsewhere. This option to leave can amplify the value of an equity grant by 5x for a Series A company, and even more for an earlier-stage company. The best way to figure out the value of an equity grant in a speculative company is to make some educated assumptions about the company’s prospects and then use the Start-Up Equity Grant Value Calculator to determine the equivalent value of salary.
Coming Up
In future articles we might review what impact the Alternative Minimum Tax has on employees, how Vesting Schedule Optionality specifically varies between companies at different stages, and how you should think about risk-reward trade-offs in compensation beyond mere expected value.
For Reference
The only article on the internet that references Vesting Schedule Optionality is Robert Heaton’s, in which he calls it “I Quit Appreciation.” He doesn’t go into nearly as much detail about how to evaluate the value quantitatively. However, he does point out a number of additional considerations around equity compensation, which you might factor into your decision.
Daniel is now the Founder and CEO of Trellis. He wrote this article as Co-Founder and Chief Product Officer at States Title. Prior, he led Product Management at Earnest from Seed through Series B. He is an alumnus of Google’s Associate Product Manager program and holds a bachelor’s degree in Computer Science from Harvard University. He also loves flying airplanes.
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