So you’ve been offered a job at a startup…
Congratulations! Working at an up-and-coming company in the tech industry is an incredibly rewarding, frustrating, educational, and unique opportunity. One of the most exciting and terrifying things about working at a small startup is the fact that you will have a chance to do things simply because there’s no one else to do them. Need a new golang client for your api, but you’ve never written anything in Go? Time to look up Hello World in Go, because neither has anybody else at your company. Does a potential client want to talk to an engineer who’s familiar with the networking stack? Guess what — you’re now in sales!
For some people, this is a reason not to be at a startup. In a big company, you have a very well-defined job description, very well-defined success metrics, and room to grow in a few select directions. If you are hired to write server code at BigCorp, it is unlikely that you will be asked to demonstrate BigCorp’s new product at a conference.
But there are downsides as well. It turns out that all the employees who are not in engineering at BigCorp actually do work that matters, and you’ll find this out the second you join a company where few or none of them have been hired. And one of those things is in such a fundamental place that you’d think it wouldn’t even be needed, but… it sort of is.
You’ve got that offer sheet in your hands, and it says you can be the proud owner of 100,000 shares of NewFoo, a company that just made Foo and is going to change the world with it. So… how much is that worth?
You also have an offer from BigCorp. The salaries are easy to compare. But your Equity in BigCorp has a value that you can look up. Sometimes BigCorp is also technically a startup (BigStartCorp), but you can still look up their value (search the news for any famous startups you can think of… it’s probably out there).
Still, NewFoo just says you have shares. What are those worth? You asked the hiring manager and she wouldn’t say anything. Why is she not answering the question? Why will private BigStartCorp tell you right off the bat that you should value their RSUs at $35 a share (they might call this a “preferred price”), but NewFoo won’t?
Why all the silence
First, because of the information asymmetry, there are a lot of regulations around discussing the valuation of a company while it is private. Discussions about publicly available information are treated very differently from private information, even if it seems like a simple question: how much is the stuff you’re giving me worth?
The hiring manager at NewFoo knows more about NewFoo’s state than you do. They may have chatted with board members (not uncommon for smaller companies) or heard announcements about funding rounds. This is much more likely to be the case at small startups (< 50 employees) than it is to be at big startup companies (any unicorn you can look up in the news). And if you know material nonpublic information about a company’s financials, the restrictions on what you can say are a Big Deal.
As for the recruiter from BigStartCorp that told you how to value your RSUs? That value is based on publicly available information — stuff you can read in the news. As long as they stick to this value (and it’s a value that is publicly known), they can tell you.
Fine. So how do I think about this?
The first thing to know is that working at a startup is risky. It is potentially very lucrative, but that is specifically because most startups fail. It is also the case that the payoff to employees for a startup is typically very low (in the equity sense) if the company does not have a “home run” exit. For anything less than a unicorn exit, VCs tend to get most of the return.
Interlude — Why do VCs only want “home runs?” Are they just greedy?
The short answer is that they aren’t, at least not any more so than you could rationally expect a profitable business to be. Investors in startups don’t want the companies they invest in to be incentivized to have “okay” exits. Think about it this way: would you let your friend borrow $100 to play roulette (a straight bet) in exchange for a 50% cut of the profits if he wins? A standard American roulette wheel pays out 35:1 for single-digit guessing. The probability of winning is 2.63% and if you win, you get $3600.
The expected return for the both of you is: −$100 + $3,600 × 0.0263 = −$5.32. As you might expect from the fact that casinos are profitable businesses, you are likely to lose money here. But weren’t you only promised half of the winnings? That makes your expected return −$100 + $1,800 × 0.0263 = −$52.66. And what about your friend? Remember that he didn’t pay anything to play, so his equation looks like $1,800 × 0.0263 = $47.34. This is a great game for him.
In fact, suppose your friend got to pick how to bet. A straight bet (bet on exactly one number) pays 35:1 with 1 in 38 odds. A red/black bet (bet only on what color the ball lands on) pays 1:1 and has 48.6% probability of happening. If your friend picks a red/black bet, it makes your expected payout −$100 + $100 × 0.486 = −$51.40, and your friend’s payout becomes $100 × 0.486 = +$48.60. This is an even better game for your friend, and only a marginally better one for you.
Venture capital is sort of like this. Founders and employees don’t put up capital, though they do put in “sweat equity.” They tend to get paid all along the way via their salaries. Also, the amount of money that is “nice” for a single person is a whole lot lower than the amount that makes playing roulette feel worthwhile for a fundraising firm. Roulette isn’t a perfect metaphor, but the concept of needing a big payoff to be worth your while (also imagine you won’t get any return on your $100 for ten years, so you need to include the time value of money) and the fact that “doing okay” still exposes the VC to a lot of risk for not-so-great reward while being kind of nice for the founders is important to remember.
One way to think about how scale works in founders’ favor and against VCs is to consider the following: A VC firm puts up $100 million on a risky venture, splitting the profits with a founder. Four years later, the founder sells the company for $110 million, netting the founder and the VC firm $5 million dollars in profit, plus her salary for the past four years. For the founder, this is pretty sweet — she just earned $5 million for four years of work. For the VCs, they risked $100 million just to get $5 million dollars back four years later, which is probably not even the cost of inflation over 4 years. They could have put their money in the S&P 500 and achieved much better gains. They hate this outcome.
To avert this, venture capitalists tend to structure their funding rounds in such a way that the payout for mediocre exits in equity terms for those who didn’t put up capital is close to zero. Just like that $1800 isn’t such a great incentive for you to loan out $100 with so much risk, a 10x company exit isn’t a great incentive for VCs. This is one reason (among several other important ones) why preferred shares exist and are given to founders. In the $100 million example above, a simple clause might give investors 100% of the profits until they reach a certain cliff, like double the invested money. This way the founder doesn’t have a very tempting $5 million incentive to quit as soon as she hits $110 million in value.
Suffice to say, while VCs are trying to make money, it’s not entirely fair to call being eager for home runs “greed” so much as “the only reason loaning money to startups is worthwhile.”
Back to my equity…
So, you don’t know how much NeoFoo is worth, because they haven’t told the public and they can’t tell you. How on earth can you mentally value this?
If you want to be extremely precise about it, you can’t. But that doesn’t mean you can’t even ballpark it. For companies at the very small end who have no publicly known values, you can probably guess that the total valuation from their latest round is less than $1 billion. Why? Because if they were worth more than a billion dollars, that means they’re a unicorn, and companies love to tell people about this. It’s not easy to be a unicorn, and growing a company to that size is a huge achievement.
Making big public announcements also means that they can switch over into BigStartCorp’s tactics of telling candidates that their shares have a preferred value. So let’s assume that NeoFoo is worth less than a billion. What other information do you know based on the offer letter, or what other information can you infer?
Numbers!
First, that number of shares should be translatable into an ownership percentage. Typical percentages are available in various documents, the most canonical of which is The Holloway Guide. Now that you have a rough percentage, you also can think about what a typical company at this stage is valued at. I recommend vigorous googling for up-to-date numbers depending on when you read this, but some good ballpark figures as of time of writing can be found at Investopedia. A seed round company is typically worth somewhere between $3 million and $6 million, and a series A company is typically worth somewhere between that seed value and $23 million. Series B tend to be in the $30-$60 million range, and series C companies tend to be around something like $120 million.
Let’s say NeoFoo is series B, and you like to be a medium kind of person, so you guess that the company is worth $45 million. Let’s also say that your ownership percentage is 0.1% — that would be a very good Series B staff engineer offer. Now we have numbers that we can play with!
The right now value of your 100,000 shares then is 0.1% × $45,000,000 = $45,000. Considering those shares vest over 4 years, that’s probably not impressive if you’re a staff-level software engineer. It’s almost certainly less than BigStartCorp or BigPublicCorp is offering you in equity pay.
But the good news (in an admittedly tragic way) is that you will almost never get $45,000 out of your equity. You’ll either get $0, or much, much more.
This is the time where you can start to think about your outcomes in terms of the roulette wheel, with the happy news that you’re the “friend” borrowing money — there is very little chance for you to lose money on your startup (ignoring the opportunity cost of not working at BigPublicCorp). So now you can start making spreadsheets and playing with numbers, if you are so inclined.
Equations you can actually use
I like to think of exit opportunities as “fail,” “meh,” “nice,” “Yeah!” and “Whooaaah!” Your equity value then is the result of:
(Eᶠpᶠ + Eᵐpᵐ + Eⁿpⁿ + Eᵐpᵐ+Eʸpʸ + Eʷpʷ)× Pᵒ = Cash
Note: I had to use superscripts rather than subscripts in order to make the TeX-to-unicode plugin work for Medium (instead of pasting in images). No value here is raised to any power.
Where Eⁿ is the valuation of the company in a “nice” exit, and pⁿ is the probability of a “nice” exit, and Pᵒ is your ownership percentage. Note that the value of the company in the “fail” and “meh” cases are pretty close to zero for you (because of the reasons covered above with you lending a friend money to play roulette), and if you want to simplify your spreadsheet, you can just merge those two cases and add their probabilities. The real question is, what are the valuations and probabilities for the different exits?
There’s actually a ton of data on this that is publicly available. You can see the likelihood of a company surviving to certain stages at this nice chart from TechCrunch. If you want information about possible exit values, it’s worth asking the company you’re applying to what their goal is. Most of them will tell you that they want to IPO. If a company does make it to that stage, they are usually ending up in the “Yeah!” and “Whooaaah!” valuations.
Let’s take a look on Crunchbase at a few recent IPOs:
- Affirm — valuation at IPO of $11.9 billion
- Poshmark — $3 billion
- Playtika — $11 billion
- Qualtrics — $15 billion
- Bumble — $8.2 billion
- Oscar Health — $7.9 billion
- Coupang — $60 billion
- DigitalOcean — $5 billion
The median of those eight (who are in no way random nor representative) is $9.2 billion. For your 0.1% of initial equity, that would mean a payout of $9.2 million. Unfortunately, it’s rarely quite as simple as multiplying the two values out.
Unless NeoFoo goes public after its series B round (extremely rare), your ownership stake will be diluted over the rounds as the company increases in value. You will also probably get refreshers at each round from the options pool. It’s difficult to say what percentage you’d have at IPO. Let’s estimate that — if you stick with the company the whole time — you own 0.05% of the final equity. For a $9.2 billion IPO, that means your payout (usually after a holding period) is $4.6 million. That’s not a bad haul for 4 years’ worth of work—though you would receive the bulk of that at the time of liquidity, not at the end of four years. Companies typically take between 8–10 years to go public.
Of course, there’s a (strong) chance that NeoFoo never gets there. Very rough ballpark numbers from that 1 out of 20 (ish) series B companies survives to series H. Let’s use that as a guesstimate of “makes it public at a median value.”
In that case, your expected median IPO value would be 0.05% × $9,600,000,000 × (1/20) = $240,000. If you also think that there’s a 1/100 chance of NeoFoo being a Coupang, then you should include that value too: 0.05% × $60,000,000,000 × (1/100) = $300,000.
You could add in a “meh” IPO at $1,000,000,000 at 1/10 odds to get an expected value of that outcome at $50,000, for a total expected value of $50,000 + $300,000 + $240,000 = $590,000, which is a reasonable cash out (in expected value) over a 4-year period.
Remember that you’re getting paid in actual cash this whole time as a salary. For a staff engineer in a major market, that’s probably something in the $180,000–$225,000 range (staff is a very high level engineering position). Let’s say your cash take-home is $200,000 (again, let’s be “middling”). So your total expected value over four years is 4 × $200,000 + $590,000 = $1.39M, with an annual rate of $347,500 (assuming you never get a raise).
There are a few things worth pointing out about this calculation. The first is that I may have been far too generous with my likelihood of getting to an IPO at all. You can include in these the possibility of an exit by purchase at other values. It’s also worth noting that the amount of dilution per round varies wildly by company and by round. And the amount of refreshers given out of the options pool also varies considerably among companies and within a company.
If this valuation sounds too good to be true, then perhaps you’re not as bullish on the future of NeoFoo as you thought, and you should adjust those percentages downward. The goal here isn’t to give you a hard number that you can sell the shares for; it is so that you can have a fleeting grasp of how to even think about a value on equity for a company that is a long way from having that value be liquid. People who have taken a couple of finance classes may even want to discount the returned amount for the time value of money (and assign expected values to the number of years away they think an IPO is), but that’s more Excel acrobatics than I’m willing to write out in an article.
Whatever your personal inclination towards a Foo on every desk in the US and EMEA is, you can pull all sorts of values from the linked TechCrunch article and tons of other sources around the web to come up with a way to value your sweet, sweet shares of NeoFoo.
The details here are all highly variable. Are you joining a Seed round company? A Series A, B, or C? How senior are you? How long do you intend to stay? Do some research on what typically happens at each stage, and then ask yourself: do I think the company I’m joining can be bigger than this public, comparable company in the same space? Do I think I’m in it for the long haul? If not, you should plan on your shares to end up more diluted than if you stick around.
Set up your spreadsheet, set up your percentages based on what the average company does, and then adjust them as you like. If you’re conservative, add weight to the small outcomes. If you’re willing to bet heavily, then turn the knobs closer to a Coupang IPO and see what your shares would be worth.
Happy mathing, startup warrior.
