raganwald
Monday, March 21, 2005
  Are you thinking of working for a start up?
Let’s say you want to work for a start up. You aren’t one of the founders: you’re coming in after the company has raised some money: it looks like it’s serious about success.

You know that the start up route is a work hard, work harder environment. You’re going to push yourself to the end of your rope and then push yourself harder. You know the deal: work 60, 70, 80, or even 100+ hours a week in exchange for working with great people on something you believe in.

If the personal rewards matter more than any monetary consideration, you can stop reading right here. I wish you well, and nothing would please me more than to hear that the years you spent in a start up were the most thrilling years of your life to date. Go for it!

But what if you want a little more than the vibe? Everyone’s heard about the riches available to employees with stock options when their company goes public or gets bought for big money. Should you consider the working for a venture backed company to make money? Is it worth it?

I’m going to give you my perspective, based on widely disseminated anecdotes about working for start up companies in the technology sector. After you’ve read this post, you should be able to come up with a basic figure of how much money you need to make on your options to justify the long hours, hard work, and lower pay of a start up company.
Let’s say you’re a senior kind of person and you’re offered options worth 1% of the company. Not so fast! As the company grows, it takes in more investment. With every round of investment, the existing stock holders get diluted. You need to figure out how much of the company you’ll have when the company is worth M$100.
First, a disclaimer: I absolutely positively cannot value your stock options. Even if your employer is wildly successful, your ability to cash in depends entirely on the whims of your Board of Directors. If they want to screw you out of your option money, they can and will do so. If you’re an employee, the only reasons to let you cash in are to keep you from quitting and to hold you up as an example so they can motivate other people to work for them.

(Some of the time, those two reasons are good enough. This is especially true if the company has been backed by a reputable VC firm. The VC business depends on “deal flow”: a steady stream of entrepreneurs walking into the offices and offering the VCs new businesses to own. It hurts their deal flow when word gets around that they don’t share the wealth.)

So how much will you get? And is it worth the work? As I said, I don’t know how much you’ll get. I can give you a few tools for making a Wild Assed Guess.

Raganwald’s Scientific Wild-Assed Guesstimation Methodology

First, you have to convert options into your interest in the company. Don’t waste your time figuring out “if the company goes public at $100 a share, and each option has a strike price of $1, I get $99 per option, times 10,000 options is…” That doesn’t work. The thing to do is to figure out how much of the company you have a right to buy.

Let’s say you’re a senior kind of person and you’re offered options worth 1% of the company. That sounds like a lot. If your company is purchased for M$100, your options are worth a million dollars give or take. (Just so you know, lots of software companies are sold for between one and four times revenues. So unless your company is really, really hot, your company isn’t going to be worth M$100 unless you get revenues up to M$25 at the very, very least.)



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Okay, 1% is worth a million dollars. Not so fast! As the company grows, it takes in more investment. With every round of investment, the existing stock holders get diluted. That means the 1% you have now (I’m being generous: you typically have the right to buy 1% provided you don’t quit or get fired over the next four years) will actually be worth less than 1% of the company when you cash in.

So you ask the President about the dilution, and she laughs and says “yes, but that means we’ll be on track and on our way to riches, so it’s worth it.” Okay, but you can’t have it both ways: you can’t say 1% of M$100 is worth a million dollars: you need to figure out how much of the company you’ll have when the company is worth M$100.

Here’s an easy way to figure out what your 1% is worth: pretend you’re a VC. They just invested in the company, right? So… what was the post-money valuation? If the company shares this with you, they’re telling you how much the VCs thought the company was worth when they made their investment.

Let’s say you get a rough estimate of the post-money valuation. I’m going to take a really early stage company, a company that just raised M$4 on a post-money valuation of M$12. In other words, the investors just paid M$4 in exchange for 33% of the company.

Guess what? Some people with a reasonable idea of what start up companies are worth just said that 100% of the company is worth exactly M$12. So what do you think 1% of the company is worth? That’s right, 1% of M$12 is worth $120,000. No more, no less.

Another SWAG

Is that worth it to you? Maybe you want a second opinion. Or maybe you aren’t told the post money valuation. Okay, here’s the other way to calculate what your options are worth. For this, you need to figure out your share after all the dilution. Basically, you need to estimate how many times the company will raise more money and how much stock they’ll give investors to do it.

You’re going to have to do some research on comparables to get a good estimate. I’ll take the example I’ve used above and hypothesize a company that’s just raised M$4 on a post money of M$12. This is their second round: the founders started with credit cards and sweat, then management and an “angel” investor put another M$1 to really get things going.

I would expect a company like this to raise at least two more rounds of capital if they’re going to do something big. They’ll probably give away another 50% of the company to do so. So the 1% you have today is going to be worth .5% when the company scores a big win. What’s that worth?
A VC is having a good year when one in five investments hits a home run. If you honestly can do a better job of picking winners, drop your day job and go into venture capital. You’ll make way more money investing in start ups than working for them!
Well, you can always say “.5% of M$100 is half a million dollars.” And that sounds great, much better than $120,000. Where did the $380,000 come from? Well, the first calculation measured what investors think of the company. That takes risk into account. The second calculation doesn’t take risk into account. What’s the chance that the company will be a big success?

Making book

I know, I know. It’s a sure thing. If you didn’t think so, you wouldn’t go to work there. And the President is awfully confident. She ought to be, she’s put her career and possibly her retirement savings on the line. But don’t forget, everyone is that confident, and most VC investments tank. By most, I don’t mean 51%. I mean 80% or more go right down the toilet.

The bottom line is, you ought to ignore your gut and the pedigree of the management team. The VCs take that into account when they invest, and the best they can do is about 20%. Yup, a VC is having a good year when one in five investments hits a home run.

If you honestly can do a better job of picking winners, drop your day job and go into venture capital. You’ll make way more money investing in start ups than working for them!

So back to 20%. That’s the number I’d pick when figuring out the odds of a spectacular success. Oh, I don’t mean that there’s an 80% chance of mass layoffs and/or bankruptcy. Many VC backed start ups eke out a living and make a little money. But the option are worthless unless the company does really, really well and can go public or get bought for major money. And that only seems to happen about 20% of the time.

So… What does that do to the $500,000 we get if the company is sold for M$100? You guessed it, that means that the value of those options is really only about $100,000. Not $120,000 by this calculation, but close enough. And it should be: the investors use pretty much the same reasoning when they decide on the post money valuation.

So is that a lot of money or not?

Okay, final calculation: what’s $120,000 worth to you? I mean, is $120,000 a good return on your investment?

To figure that out, you need to know how much you’re investing by working for this company. You need to calculate your opportunity cost, the money you could have made elsewhere. Let’s start with your salary: if you could make more money somewhere else, calculate how much salary you forgo.

For example, let’s say you can get another $5,000 a year working somewhere else with little or no risk. Over the four years your options need to vest, that’s $20,000 you’ve just invested to get $120,000 when everything works out. Okay, not bad.

But wait: how hard will you work? If the other job is only 45 hours a week and the start up is 60 hours a week, you’re investing 15 hours a week. What’s that worth? You can take the other job and work out the hourly rate, but I prefer to calculate what I could make by the hour consulting. If you can work 60 or more hours in a start up, you can work a night job programming for other people.

Let’s say it’s $30 an hour. $30 by 15 hours is obviously $450 a week. You’re probably going to work 200 weeks over four years, so you’re investing another $90,000 over four years. Add that to the $20,000 and you’ve just put $110,000 into the company to get $120,000 out.

For me, that’s breaking even. It’s not terrible, but it’s no short cut to riches. If you can get a substantially better stake in the company, you’re on track to do much better. But if you’re such a hot shot, you can probably do very well seeking out a job or contract that pays well. So you probably end up in the same place.

Coda

Of course, there are other ways to get rich in a start up. The best is to be one of the founders rather than an employee. In this capitalistic world of ours, entrepreneurs are higher on the food chain than employees. Below investors, but higher than employees.

p.s. Here's Paul Graham's take on starting a company. Jerry Colonna has some reasons why you should be self-funding. And the Anti-Venture Capital web site gives an excellent example of why you'll make less money using venture capital to grow than you would staying small and profitable.

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Comments on “Are you thinking of working for a start up?:
There's another reaon why working for a start-up can be attractive (in addition to delusions of great wealth):

In general start-ups tend to work on somewhat more interesting things. I've found that most start-ups are creating some new technology as opposed to just using technology to create another stupid web-site (not that there's anything wrong with stupid web-sites if that's what interests you).
 
You've ignored the tax implications, which are non-trivial. Note that my comment are from a Canadian tax perspective.

The income is taxed at a marginal rate of around 50% as it's on top of you regular job. So you only get half that money.

The capital gain of stock options is taxes as, obviously, a capital gain, which is only (in Canada) 50% of your normal tax. So it's about 25% of the amount you bring in. However, there are some expemtions, like the capital gains exemption that still exists on CCPC share sales if you structure your deal that way. Or, in some cases, the whole thing is tax-free if you move the money from one CCPC into another.

So, in the simplest case, the stock option route lets you keep 50% more money. If you're really smart, you may end up keeping 100% of the money and not pay any tax at all.
 
A few years ago, this post would have elicited a flame war ;> Post bubble - anyone that's been through a start-up (or two), has most likely worked through the math much as you have.

Everyone thinking about joining a start-up should think carefully about what they are trying to get out of it personally.... be it money, interesting work, adventure or other.
 
I got an offer from company with a competitive pay and stock option....29,000 common shares on hire vestable in 4 years time with each 25% vestable every year. The company has 110 employees and they told me they will be profitable in 2 quarters. Is this a good company to work for? Note, I'll be getting a very competitive salary. However, I could end up working 60 hrs a week...which I would not mind if the stock options will provide me some money in the future.
 
Dude... did you read the post?

Do the math.
 
Here's an explanation of how it's possible for a company to do reasonably well, but somehow, mysteriously, the employee stock opions are worthless: Participating or Preferred.
 
If whether you'll get $100,000 or $200,000 when you cash out is the principal deciding factor, you shouldn't be working for a startup.

Like any job, it's worth it if it's a good fit for your temperament and skills, and the money is sufficient. A job that makes you miserable, but which pays fantastically well, will still make you miserable in the end; and a job that you love, even if your options are worthless, will still make you happy in the end.
 
I think the better a company manages its working capital the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that will generate suitable returns for investors.

But i dont think all companies are the same
Some companies are inherently better placed than others. Insurance companies, for instance, receive premium payments up front before having to make any payments; however, insurance companies do have unpredictable outgoings as claims come in.
 
Well more risks more rewards! important thing is that before getting yourself into something.. better do the calculations so there'll be no regrets after...

There's always a downside in every company whether start ups or not so you decide!
 
Reg,

Ugh, the most wasteful of the last 3-4 articles I read by you.

Here are a few thoughts.
1. Wrong math
>So… What does that do to the $500,000 we get if the company is sold for M$100? You guessed it, that means that the value of those options is really only about $100,000.
The above is incorrect, one stands to make half a million, the probability is one out of five. The half million is not divided among five people in different startups by the employee who made it.

2. Wrong expectation
It does not take away from from say one in 30 (or even 50) company like Google, Cisco, even medium ones like NetApp where even later employees made U$ 50+ million for 4 years of work.
The people who did not join these probably thought, Google was at it's high at 300 and ebay at 100 and so on.

3. There are lots of factors including luck and that is life.

Amit C
 
1. Wrong math
>So… What does that do to the $500,000 we get if the company is sold for M$100? You guessed it, that means that the value of those options is really only about $100,000.
The above is incorrect, one stands to make half a million, the probability is one out of five. The half million is not divided among five people in different startups by the employee who made it.


Amit, perhaps there was a communication gap. If a stock has a one in five chance of being worth $500 and a four in five chance of being worth $0, at some date in the future, you're right, the stock is worth $500 to one person in five.

However, an option to buy that stock for a few pennies today is worth approximately $100 today.

If your options were liquid, that's what you could sell them for to people who don't share your boundless enthusiasm for this particular start up.

That's how we price options and other derivatives, by discounting for risk. There are other discounts for things like the future value of money and so forth, but in this simplified calculation they are meaningless.

So, if there's a one in five chance of getting $500 for each of 1,000 shares, your option is worth $100,000.

And did I read you as saying that one in thirty start ups turn something where employees (not founders, employees) are making M$50?
 




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