Thread by @epaley

Stock options are a key lure of working at a startup. But explaining them, and particularly their value, is a challenge for a few reasons:

🤩 Expectations management

🎲 Valuing risk is hard

💱 Financial complexity

Here are some thoughts on communicating options.

/1

🤩 Expectations Management

Telling a bright MIT grad that they’re getting options that equal 0.1% of the current value of the company doesn’t sound compelling,

So a large number of startups tout the number of shares they’re offering instead.

/2

This frame may solve the perception problem. A typical grant of 10,000 shares sounds better than 0.1%. The employee looks at recent tech IPOs, makes a note of the potential upside, and they begin to imagine the possibilities their shares hold! But it’s totally misleading.

/3

The employee is happier with this because they feel like there’s more potential value.

The founder is even happier because they’re able to use the employee’s optimism as a form of currency, but the company is misleading the employee and taking advantage of naiveté.

/4

Absent an understanding of the *total* number of shares outstanding, even a large sounding grant — say a million shares — could be tiny if there are a trillion shares outstanding. Those numbers are an absurd example, but this is a common game some unscrupulous founders play.

/5

We recommend companies explain stock options in the context of the “preferred equivalent value” of the startup at its current valuation. For instance, “Investors most recently would have paid $100K to purchase these shares and they invested hoping for multiples in return.”

/6

Explaining options this way will ground the employee’s expectations in reality with a clear view of upside optimism. It also requires the founder to make a case for why they expect those options to increase in value — hopefully in spectacular fashion. That said...

/7

🎲 Valuing risk is hard

It’s easy to feed employee’s expectations in a deceiving manner. Many seeded founders can tell a compelling story about how they’ll turn a $10M valuation to a $1B ambition without really examining the risks along the way. Don’t be this founder.

/8

Early-stage “strike prices” tend to be in the tens of cents and in upside scenarios are a negligible cost. The belief is that those shares could be worth tens of dollars. Stock options, especially at the early stages, offer geometric financial upside and almost no downside.

/9

It’s worth pausing on the concept of "strike price," which is the amount of money an employee has to pay to exercise their stock options. Since 2004, strike prices have been determined by what's called a 409a valuation that sets a fair market value.

inc.com/larry-kim/7-th…

/10

At the later stages, strike prices tend to increase, driven by the startup’s larger valuation. In cases like WeWork’s, where the valuation later decreases, some options are underwater, in that they are worth less on the market than what they cost to strike.

/11

Thankfully, this is a rare occurrence. The more typical challenge is trying to decide whether an option with a current strike price of fifty cents will be worth $5, or $50, in 5-10 year’s time. This is where it’s easy for founders/employees to become overly optimistic.

/12

One of our portfolio companies gives each employee an options calculator spreadsheet that shows the value of the grant but allows them to plug in what they think a likely exit value might be, and the value of their stock at that price. It also backs out the strike price.

/13

The company might command a $100M valuation at present, but the employee may believe it could be worth 5X as much in an M&A scenario and this tool makes it easy to model the critical risks and opportunities.

/14

💱 Financial Complexity

The final challenge in talking about stock options is venture math. Founders obsess over dilution, but most employees don’t think about it much. Nor should they: In an up round, % dilution is ultimately a sign of value appreciation.

/15

It’s important to note the differences between common and preferred stock when explaining options. Flat rounds, small markups, convertible notes, and even the dreaded down round can complicate the picture and undermine the employee’s perception of their option value.

/16

The preference stack is a landmine for employees. Founders are usually keenly aware of it, but many employees don’t realize that there are scenarios in which the company sells for a high-dollar value, but because of the amount of money raised, they walk away with nothing.

/17

You don’t need to remind your team about what the stack means constantly, but it is worth discussing with new hires and keeping the team aware as you raise funds. If nothing else, it may help them understand how capital efficiency ultimately benefits them.

/18

At the end of all this, it’s worth stepping back and appreciating how amazing stock options are. You likely buy them for under a dollar, and they can appreciate to be worth 10X, 50X, or more, while the downside is most often zero.

/19

There’s been a bit of a turn against tech as an industry over the last few years, but it’s worth remembering that almost no other industry gives employees a similar benefit. 401K matches are great, but near-infinite upside can be transformative.

/End