What are those stock options really worth?

You've just been hired as a project manager at ABC Start-up, a new media company. Because it's a start-up, you're given a relatively low salary in addition to stock options (the right to purchase stock at an agreed-upon price at some future date) that look promising because the founder says she's expecting to complete an IPO in the next 3 years on a valuation of at least $500 million. That's exciting! Before you get too excited, however, (Wow, that means my 1% of the company will be worth $5 million in three years and I can retire at the ripe old age of 26), you might want to consider some red flags and a little item called "dilution."

The first red flag is that anyone who thinks they can predict with any degree of accuracy exactly when their company will be in a position to do an initial public offering is simply naive, or worse, disingenuous. Timing of an IPO is a function of a lot of factors, most of which are not in the founder's control. So, don't count on 3 years to IPO. It could be longer or even not happen.

The second red flag is the prediction of a certain valuation. More than one company has experienced a lukewarm reception by investors somewhere down the road and it often results in what is called a "down round." Simply put, the investors pay less than previous investors for a bigger stake in the company. The bottom line is valuation is a fluid thing; there are no sure bets.

And then there's the issue of dilution. To make it simple, let's say your founder owns 100% of the issued and outstanding shares of the company: 600,000 shares priced nominally at $1/share. She raises Series A funding (first round) from an investor in the amount of $400,000 for 400,000 new shares of stock to acquire 40% of the company. That means that there are now 1 million shares outstanding; the founder owns 60% and the investor owns 40%. The company, post money, is now worth $1 million. That's great.

But, start-ups are hungry beasts, so eventually the company will need more money. Let's say your founder has managed to raise a Series B round from another investor in the amount of $2 million for 50% of the company. Since there are 1 million shares outstanding and the new investor will want 50% of the company, you need to issue another 1 million shares at $2/share ($2 million/1 million shares). So now the founder's 50% ownership has sunk to 30% but her original $500,000 worth of ownership has now increased to $1,200,000! (see the table)

Series B Round	Investment	Price per share	Shares	Percentage	Post-Money
Entrepreneur			600,000	30%	1,200,000
Investor 1	$400,000		400,000	20%	800,000
Investor 2	$2,000,000	$2	1,000,000	50%	$2,000,000
Subtotal Investors			1,400,000	70%	$2,800,000
Total			2,000,000	100%	$4,000,000

This doesn't look so bad. If the founder continues to raise more capital, however, her percentage of ownership will decline--be diluted, but that's OK as long as the valuation of the company continues to rise. Right? Unfortunately, lots of external (and internal) factors can cause the valuation of a company to decline. Remember the down round? Investors can be fickle and they have lots of ways to protect themselves against dilution and down rounds while the founders and employee stakeholders often get to take the hit. What this means to you is that getting stock options when you're hired on as a new employee is simply a future promise that may or may not be realized. It's a very real risk that you need to factor into your decision to take the job. It should never be the only reason to take the position.

If you're a founder, be prepared to give up majority ownership in your company if you want it to grow quickly. At the end of the day, you will probably not earn as much as your investors.Therefore, your ability to maintain the attractiveness of your company as an investment is critical to insure an increasing valuation so that when your company does IPO or get acquired, your relatively small percentage of the company is still worth a significant amount.

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The Venture Edge

What are those stock options really worth?