Following up with the post New Car, New House, or New Life Concept for Employee Equity Value, the reality is that almost all employee stock options in startups end up being worthless. Why? Well, 99% of tech startups never hit $1 million in revenue in a calendar year such that there’s no value in the business to begin with. Even then, there a number of reasons why startup stock options are usually worthless. Here are four:
- Few Exits – Compared to the number of startups out there, and even the number that get funded, there are very few exits. Then, if you look at the exits in the Bay Area vs outside the Bay Area, the number drops even more.
- More Capital Raised than Exit Price – Even when a company is acquired, if it isn’t acquired for a price substantially more than the amount of capital raised, the stock options are worthless. Investors structure their investment to get their money back first before anyone else in the event of a sale that’s less than the amount of money raised.
- Leave Before Exit – Most stock option plans require the options be exercised (turned into actual equity) within 30 days of the leaving the company. Only, it costs money to exercise the options (the number of options times the strike price) such that most people don’t do it because they’ll be paying money for something that could very well have no value.
- Down Round – When a startup raises money at a valuation lower than their last valuation it’s known as a down round. When this happens, common stockholders (e.g. employees, advisors, etc.) are often wiped out (diluted to where there’s really no chance of value).
Stock options, in most cases, should be viewed as icing on the cake. The salary compensation, experiences gained, and general journey should be the core value with stock options as a nice addition.
What else? What are some more reasons why stock options are usually worthless?
2 thoughts on “4 Reasons Why Startup Stock Options are Usually Worthless”
I believe that conventional valuation models systematically over-value employee stock options. The main reasons being a) Black-Scholes was never intended to value employee stock options, especially startup options because empirically, B-S breaks down as volatility exceeds 30% and the time horizon exceeds 6-12 months and b) the “current price” used to seed the model is almost always too high, and the gap between strike and current price is too low, thereby inflating the value of the option.
To be fair, these reasons all reduce down to “most stock options are worthless because most startups fail” (with the reasons being varying degrees of ‘failure’).
And that’s certainly true. But it doesn’t mean that startups shouldn’t issue stock options, or that employees shouldn’t value them.
No one joins a startup expecting it to fail, and no one working at a startup works every day for it to fail. If you tell employees that “we don’t offer stock options because they are most likely to be worthless” you are sending the wrong message. Stock options are a way to help spread out the risk/reward inherent in joining a startup. Even if a startup pays aggressive market salaries and benefits, there is still risk (of failure), and options provide some balance to that.
Now, there are a TON of ways that options and option terms are abused by companies, leading to very misleading expectations and mismatched outcomes. Employees getting options can’t have blinders on about either the likelihood of getting a great outcome (small), or the risk of getting options with bad terms… but that would be a different blog post!