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The Myth of The Start-Up Millionaire

Published: January 13, 2008

Author: David Rodnitzky

When I came to Silicon Valley way back in 1999, I landed my first dot com job at a start-up called Rentals.com. Rentals was funded by Sequoia Capital and Softbank Venture Capital – VCs who funded Google and Yahoo, among many other impressive companies. I was employee #25, and as part of my employment package, I was granted 10,000 stock options. I was pumped.

Upon accepting the employment offer, I immediately started to dream big. I conservatively estimated that Rentals.com stock would quickly hit at least $100 a share, and fantasized about multiple stock splits and share values in the several hundred dollars. After all, this was 1999, and new billion dollar companies were celebrating their IPOs weekly.

Suffice to say, the millions I envisioned never materialized – not even close. By the time Rentals.com was sold (in what was basically a fire sale) in 2001, my 10,000 shares were worth around $.18 each. Of course my purchase price was $.37 each, so had I bought any shares, I would have gotten a tax write-off and nothing more.

Since Rentals.com, I’ve accepted stock from three companies and I’m sad to say that I’ve yet to see a penny for any of my options. You could say I’ve been unlucky, or you could say that I’ve just chosen the wrong companies. To some extent, I suppose that is true. I have, after all, rejected offers at companies that have in fact gone on to have stock that was worth something.

But I actually think that my story very accurately represents the true value of stock options – next to nothing. Once you understand the realities of stock options, it’s hard not to be cynical when someone tries to woo you to their company by promising you that you’ll be sharing in a billion dollar valuation.

There are basically seven reasons why you should be very hesitant about choosing a company based on the stock options:

1. Big Numbers of Options, Little Value. Let’s take a look at that 10,000 option package I was offered at Rentals.com. It sounds like a lot of stock. Certainly, if I had 10,000 shares of Google stock today, that would be worth $7 million, not too shabby. But when you are looking at stock from a start-up, you shouldn’t dream of the potential value of each share; instead, you should consider what percentage of the company you are getting.

For example, let’s say that Rentals.com issued 100 million shares (which is not uncommon for a start-up). My 10,000 shares would be exactly 1/100th of a percent of the company. So if Rentals.com had miraculously sold for $1 billion, my shares would be worth $100,000. If the company sold for a much more likely $100,000, suddenly my shares are worth $10,000. I’m not saying that getting $100,000 or even $10,000 of free money is a bad thing, but I suspect that most young start up employees are fooled by big numbers of stock options into thinking that their potential windfall is a lot greater than it actually will be.

2. High Company Valuation. I joined one company with a decent amount of stock, but with the company’s existing valuation at $200 million. What does this mean? Basically, when I joined the company, my stock was priced on the assumption that the company was already worth $200 million. So if the company sold for $300 million, my return was based on the sales price minus the existing valuation – $300 million minus $200 million equals $100 million of gain.

If you are the founder of a company, you get your stock at the initial issue price – usually something like one or two million dollars. So when you sell for $300 million, your shares gain $298 million dollars. If you own 50% of the company, you would have an extra $149 million in the bank.

Now compare that to the lowly employee who came in with 10,000 stock options work 1/100th of a percent of the company. Since this guy’s stock was priced at a $200 million company valuation, he only gets $100 million of gain. That means that he ends up with 1/100th of $100 million, or $10,000. That’s a long way from the $149 million the founder is taking home!

3. Likelihood of positive outcome. No one purposely joins a company that is going to fail or even stagnant, but the fact is that most Silicon Valley start-ups do not become Google, Facebook, or YouTube. Venture capitalists invest in ten companies and hope that just one of them has a big pay day. Part of their model is assuming that most of their investments won’t produce much profit for anyone involved.

What this means is that when you join a start-up, you need to factor in a “discount rate” for your stock options. Discount rate basically means that you need to factor in the potential likelihood of value for your stock and then use that to discount the value of your shares today.

Think of this like buying a lottery ticket. What’s the value of a lottery ticket? Well, obviously, if you win $200 million, the value would be $200 million (less taxes, but we’ll get to that!). But since you know that the odds of that ticket actually being worth $200 million are very low, you would value that ticket at a much lower price. In fact, if I walked up to you today and tried to sell you 10 lottery tickets for tomorrow’s drawing, the most you would be willing to pay for these tickets would be $1 each, right? In reality, since you know that the state is going to make money on the lottery, the real value of the lottery ticket is probably around $.80.

The same analysis needs to be applied to stock options. What are the chances of your current company ever being sold for $1 billion? How about $100 million? How about $5 million? The higher the number, the lower the chances that this will actually happen.

The analysis is different for every company. For example, if you are working at a company that is already pulling in $50 million of profit a year, the discount rate is going to be much lower than a company that just incorporated yesterday.

Let’s go back to the hapless recent law school grad joining Rentals.com in 1999 and getting 10,000 options. Rentals.com was a brand new company, without a product, without any revenue, and without a single customer. Granted, the addressable market for the company (apartment rentals) was huge, but the chances of Rentals.com dominating that market were very low. In other words, you would need to apply a very high discount rate to the likelihood of Rentals.com stock being worth anything more than the paper on which it was printed.

I was chatting with a friend of mine in the venture capital world last week, and I asked him how many Internet companies since 2000 were valued at over $1 billion. He estimated it to be around 20. I then asked him how many made it over $100 million and he estimated it to be somewhere around 1000. Now factor in the total number of start-ups that have graced Silicon Valley since 2000 – it’s got to be at least 50,000 or more.

If my math is correct, that means that you have a 1/50 shot at joining a company with a valuation of over $100 million. So if you join a company with current valuation of $20 million, the chances that you’ll actually get to $100 million in company valuation is about 2%. Perhaps at $50 million it goes up to 5%, and maybe at $20 million it is 25%. The bottom line is that when you factor
in the odds of your stock ever being worth anything, you quickly realize how little your options are actually worth.

4. Death by Dilution. Let’s say that Rentals.com actually started to bring in some money and customers. Things are looking good for the company and our budding millionaire employee. But despite the flow of revenue, the company is still not cash-flow positive. It often takes many years for a company to turn their first month of profit. As a result, most start-ups need to go back to their investors and ask for more financing. I recently had dinner with a founder who had to take seven rounds of financing – more than $200 million of investment.

The problem with multiple rounds of investment is that it often dilutes the value of existing stockholders’ stock. Let’s say that there are 100 million shares of Rentals.com and each is valued at $.20. That means that the company is currently worth $20 million. To raise more money, however, Rentals.com decides to issue another 20 million shares, which they sell for $.30 each. Now, instead of 100 million shares worth $20 million, there are 120 million shares worth $26 million.

By issuing more shares, each individual share now owns a smaller percentage of the company. If you owned 1% of the company before the 2nd round of investment, your shares would now only account for .83% of the company. After a few rounds of funding, your percentage of the company can shrink considerably. As a result, when the company finally does sell, your take is a lot smaller than what it first seemed.

5. Send in the Lawyers. As an employee of a company, you generally have little say in how the company deals with investors, rounds of funding, and the eventual sale of the company. Not so, however, if you are an investor. Venture capitalists are very smart folks, and they generally hire very smart lawyers to represent their interests. As a result, many venture capitalists insist on putting clauses into their funding deals that guarantee a certain level of return to the VC. For example, the VC may invest $10 million in a company and give the company a valuation of $40 million, but then insist that they get a guaranteed 5X return on their investment before anyone else gets paid.

So let’s say the company sells for $70 million. The VC is guarantee five times $10 million ($50 million) before anyone else gets a dime. That leaves $20 million for everyone else to split.

In some cases, you may also run into founders who – despite claims that they want to make all their employees wealthy – have inserted clauses into legal documents to ensure that they get paid first. For example, the founders could create two classes of shares (preferred and common), and set up rules that give the preferred shareholders (the founders) a pay out first before any common stockholders (employees) get anything.

6. Four More Years. It’s standard for any stock option agreement to be based on a four year vesting schedule. This means that you basically get 25% of your stock every year – if you leave after one year, you are only entitled to 1/4th of your stock. So if you think that you have stock with $100,000, remember that you are basically getting paid this over four years, so that gives you a value of $25,000 a year.

7. Don’t Forget Uncle Sam. The IRS loves it when you make money because they get more money. Stock options are no different. If you cash out $100,000 of stock, remember that you’ll pay a big chunk of this (perhaps up to 40%) in taxes.

So let’s recap. When you join a company, you are almost guaranteed to receive 1% or less of the company in stock (1% if you are an executive, that is), unless you are a founder of the company. You don’t make a penny until your company exceeds it’s current valuation. Most companies fail and very few exceed $100 million of valuation. Subsequent rounds of funding will dilute the value of your stock. Founders and investors may insert clauses to protect their interests over yours. You have to work for four years to get the full value. And the IRS will be sure to take a big chunk of your money if you ever do make anything.

Add all of this up and this leads me to conclude that you should negotiate every other part of your employment package first, before you even talk about your stock options. You should work at companies where you are having fun and learning, but you shouldn’t feel like you have ‘golden handcuffs’ to stick around and wait for your stock to vest.

If you really want to make money of stock options, you should either found your own company or become a venture capitalist!

Addendum: Apparently my knowledge of financial terms is not as strong as I thought. Here’s the scoop via my Brother:

“You’ve got a few terms mixed up. Discount rate applies to finding the net present value of a cash flow by discounting it at the prevailing rate of interest, compounded by the number of years you expect to hold that investment.

What you are talking about is more like a binomial distribution, a real option calculation, where you use weighted probabilities to find the future value of a current asset. That is found by summing together the complete set of probabilities times their expected monetary outcome to find the expected value of the cash flow.

Your financially savvy brother.”

My response: what he said.

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