Considering Stock Options in Employee Compensation

Stock options have been a part of the startup world for decades. We’ve all read how the receptionist and chef at Google became millionaires from their stock options that multiplied in value 100s of times by the IPO. Unfortunately, there’s a problem: most employees of startups over-value stock options in their compensation.

I know of a startup in town that asked everyone on the team to take a serious pay cut when times were tough in exchange for many more stock options. Well, stock options are not well understood by most people and for the options to be in the money at this startup (e.g. worth more than the strike price), the startup needed to be valued at 15x the revenue. That’s right, the strike price was ridiculous. Most companies are valued at a multiple of profits (e.g. 4x-6x) or in the software business usually 2x-5x revenue. Thus the bar was crazy high and the employees were focused on the number of options as opposed to the percent ownership of the company. Having 100,000 options in one company could be less ownership than having 1,000 options in another company as it depends on how many total shares the company has and how many of those shares have been issued.

For my company we generally don’t do stock options and instead focus on having our average compensation across all employees be in the 75th percentile as well as providing exceptional benefits (health, dental, 401k, disability, food, drinks, etc). People understand the value of a salary and benefits. Now, many startups would disagree with this approach but it has worked well for our culture.

If you are an employee considering stock options as part of compensation I would ask the following questions:

• How many total shares are there and how many outstanding? What percentage ownership of the company does this represent?
• If the company sells for $5MM, $10MM, $25MM, or $50MM how much money would I get? Liquidity preferences of preferred shareholders can significantly affect how much money you take home e.g. even though you own 1% of the company you don’t get 1% of the proceeds.
• What is the likelihood of raising more money and what would the dilution of shareholders look like?

Stock options, or more commonly restricted stock now, represent a part of the startup world. My recommendation is to really understand them when considering overall compensation.

What else? What other tips do you have when considering stock options as part of compensation?