The Five Things You Must Consider When Evaluating Job Offers with Equity / Stock Options
Stock options can be tricky. Here, I’ll break them down into simpler terms so you can better evaluate the opportunity in front of you.
Author’s Note
I realize this post might come at a difficult time for some readers. During a pandemic (and corresponding economic downturn), there’s really no good time to write about evaluating job opportunities; some of us would simply like to have an opportunity right now — never mind many.
I started writing this post at the beginning of March (2020) but eventually hit the pause button when the virus broke out. I just felt it would be a little tone-deaf to post about such a subject at a time when so many folks were fighting for their homes, lives, and loved ones.
As the weeks have elapsed during this downturn, I’ve slowly come to the conclusion that, while it’s still not the perfect time to publish, that perfect time might also not come for a while. As such, I wanted to get this information out there so the folks who do need it will be able to find it as soon as possible. So, with that in mind, let’s talk about startups.
What Is Equity?
So you’re thinking about joining a startup. Congrats. Whether it’s in tech, finance, professional services, or something entirely different, there’s little else that compares to working in a brand new company. The pace of change, the autonomy, and the perks can be unlike anything you’ve experienced before.
However, joining a fledgling company isn’t without uncertainty and risk. As such, in this post, I’m going to cover exactly what you need to consider when you’re presented with a job offer that provides at least some part of your compensation in equity / stock options.
But first, what exactly is equity and why should you listen to me about it?
Equity, for the purposes of our discussion, represents an opportunity to own part of the company for which you work. If you’ve heard of terms like employee stock option plans or vesting schedules, or have even just talked about owning shares in a startup before, then you’re probably familiar with this concept on some level. Either way, however, not to worry. By the time you’re done reading this post, you’ll know all about these concepts.
In general, startups offer equity to employees for two reasons. The first is they’re still figuring out how to scale their businesses and don’t have as much cash on hand as larger, more established companies do. Thus, while cash is tight, they can incentivize folks to forego some of what they could make (via salary) in exchange for a chance at a potentially larger, equity-based payout down the road.
The second reason is related to the first, and it’s that equity can get prospective employees excited. Though not every company will become the next Facebook, the idea that your early shares could eventually grow into a nest egg is a really intriguing concept. That idea can not only attract people from the get-go but also keep them working hard while they’re employed.
The reason for this is simple: when you work hard, your company is more likely to do well, and when your company does well, your equity is likely to grow in value as well.
So, that leaves one final question before we dive in fully: why should you listen to me about this subject?
Though I’m not a lawyer or financial advisor (nor do I claim to be), I’ve consulted for or worked at seven different companies where equity was involved to some degree.
And while I’m still waiting on my big, Google-IPO-esque payday, I’ve been on all sides of the equity narrative — good, bad, and indifferent. In this post, I’ll tell you a couple of those stories so you can learn how to make the right decision when it comes to your own equity-enhanced job offer(s).
So, without further ado, let’s finally get into the reasons behind why you clicked on this article in the first place — the five crucial considerations when it comes to evaluating those startup job offers.
Consideration #1: The Current Value of the Equity
Okay, it’s time to clear up a common misconception, and that’s the idea that getting equity in a company is just like someone going to E-Trade or Robinhood, buying several shares of a particular stock, and handing them to you.
For several complicated reasons, many of them tax-related, employers rarely do that. Instead, they typically offer you stock options, which represent an opportunity to buy shares of the company at a specific price. That price is what’s known as your strike price.
Your strike price, though it may seem it, is not the same thing as the current market price of the stock. Sure, the two may sometimes be, temporarily, equal in value, but they’re still different, conceptually. This applies regardless of whether or not the company’s stock is already listed for sale on a public exchange. In simpler terms, here’s what I mean by all that:
Unlike the market price of a stock, your strike price doesn’t change; the price at which you’re allowed to “buy” or “exercise” your options stays the same regardless of whether the company’s valuation goes way up, plunges way down, or stays totally flat.
In addition, depending on the stage and industry of your company, employee strike prices can sometimes be lower than current market valuations. Companies offer these lower prices, when permissible by state and federal laws, to further incentivize employees to jump on board.
Thus, how you make money with options goes a little like this: first, you get into a company when the valuation of said company is low, or at least lower than you think it could be. Second, you wait for an exit event (typically in the form of an acquisition or initial public offering). Third, you exercise (buy) your options at your strike price, turning them into real stock. And, finally, you sell your stock for more than you paid for it, leaving the difference in your bank account.
The important thing to stress here is that, with stock options, you don’t actually own anything until you exercise them. This misconception can often get folks into trouble. Here’s an example to show you what I mean by that:
If a company tells you they’re giving you $5,000 worth of stock, what they’re likely doing, in reality, is giving you the option to buy $5,000 worth of stock at a predefined price per share (your strike price) in the future.
And, if, at that later date, the market value of your options does not exceed what you’d have to pay in order to exercise them, then you cannot make any money on them. Thus, having confidence that the valuation of the company will go up is of the utmost importance when it comes to considering equity offers.
But let’s get back to the subject of this section — the current value of your equity. Why is this important? For starters, if that value is small — say $1,000 — it’s unlikely that it’ll ever amount to the massive payday you may be envisioning in your head. That’s not to say it’s impossible, just that the math isn’t necessarily on your side.
For example, since the money you could potentially make on each share equals what you could sell it for down the road minus your strike price, you’d need the value of the company to go up 50-fold just to make $49,000 (exercise for $1,000, sell for $50,000, net $49,000).
Of course, that’s not a bad payout, but is such a 50x increase in value likely? And is that potential sum, and the uncertainty of it coming to fruition, more appealing to you than any other offers you may have? These sorts of ideas are extremely important to consider; we’ll discuss them further in the next section.
Sure, if the company were worth $200,000 today, growing 50x to achieve a $10m valuation doesn’t sound too crazy. Especially not in tech. That said, most companies you’ll be interviewing with will be worth far more than $200,000, which can make the math more difficult.
This leads us to consideration number two — the second half of the money equation.
Consideration #2: The Current Valuation of the Company
Why is it important to know the current valuation of the company? The answer relates to what I alluded to in the previous section: you only make money when you exercise an option and sell the resulting share for more than what you paid (your strike price).
What that means, in practice, is that even if you were granted $100,000 worth of options in a $700m company, if your strike price were $100 a share (meaning you have 1,000 options), and the company sold for $101 a share next year, you’d actually only make $1,000 ($1 profit per share * 1000 shares = $1,000).
Thus, the current “value” of your options means very little if you don’t also know the current price per share of the company (I put value in quotes here because your options technically aren’t worth anything until they’re exercised). That price is something your hiring manager should be able to provide, but, just so you know, it’s calculated by taking the current valuation of the company and dividing it by the number of shares outstanding.
Of course, there are a few caveats to the example I just provided. The first is that you aren’t always forced to sell your shares for cash when your company is acquired. Though that is quite common, acquiring companies will sometimes just convert your equity into shares in their company. Thus, even after an acquisition, it may still be possible to keep your bet going, albeit on a different company’s books.
The second caveat, as I alluded to in the previous section, is that companies can sometimes offer employees lower strike prices than current market values. Again, this is not always possible or legal, but if it happens to you, great. You’ve already got a headstart on your payday. Make sure to ask about this during your negotiations. However, for the sake of simpler examples here, I’m going to assume that your strike price and the current price per share of the company are equal to one another.
On a related note, it’s also important to learn the current valuation of the company because it could signal how much growth is still possible for said organization. For example, if the company is already valued at $300m, and, historically, no other company in the industry has ever been acquired for such a price, then the odds that said valuation zooms past that point might not be totally on your side.
Of course, it’s hard to know exactly how much a company could sell for — be it today or sometime down the road. I’ll leave that complicated logic to the bankers. The main point I’m trying to make here is that you want to find a company that isn’t already worth so much that it can’t multiply its valuation and boost the value of the options it’s ready to hand to you.
The best-case scenario, though obviously difficult to find, is one where the company is not yet worth an astronomical amount, but also has a real potential to be one day. Sure, smaller companies typically pay less and are more likely to go out of business than their larger counterparts, but the upside of such smaller companies can also be much higher. To show you what I mean by that, here’s an example:
Instead of the $100,000 equity scenario I just described, let’s consider 100 options, worth a total of $10,000, in a company that’s currently worth $10m overall. If that company were to grow, and later sell for $100m, you’d have way more cash in your pocket than you would in the first scenario — $89,000 more, in fact (exercise for $10,000, sell for $100,000, net $90,000; compared to $1,000 in the previous example).
Thus, while the overall valuation of the company is an important piece of information to gather, what’s even more important is understanding where that valuation could eventually go. This stems back to the fact that you only make money on the difference between what you sell your shares for and what you pay for them.
In your case, this means that a larger (initial) company valuation does not necessarily represent a greater chance to make money. In fact, I’d argue that the opposite is usually true. Small companies typically grow faster than large ones. Sure, they’re also far riskier, but that doesn’t change the fact that larger-sum payouts are more common at startups than they are at established organizations.
This is because high valuations eventually close in upon a bit of a ceiling. At $10m, there’s plenty of room for growth; a company can expand its business and, if all goes smoothly, get to $100m fairly quickly (though not necessarily easily).
At $1b, however, it becomes much harder for a company to grow by the same percentage (and achieve a $10b valuation). That’s not to say it’s impossible, just that it can take far longer, as the company may have to establish brand new business lines if it’s already saturated its current market(s).
So, since the amount you stand to make depends upon the percentage by which the company grows its valuation, don’t let yourself get distracted by an organization that’s already worth a great sum. Again, the current “value” of your options doesn’t matter all that much, all things considered. All that does is that you can grow that value significantly and net yourself a greater spread between sale and strike price down the road.
Consideration #3: Desired Exit Strategies for the Company
After you’ve figured out what your potential options are “worth” and what the current valuation of the company is, you’ll want to inquire upon the desired exit strategies for the company. Though asking this many questions could earn you some strange looks from hiring managers, remember, this is your financial future we’re talking about — not theirs.
This leads me to a quick, related story.
Several years ago, I was on the fence as to whether or not I should join this new tech company. Ultimately, their vision and passion won me over; I was excited about their dream of becoming a $1b company. As such, I made sure to negotiate some equity in my contract.
Now, did I think such a valuation was a lofty goal? Absolutely. Did I think it was actually going to happen? Not exactly. But, as they say, shoot for the moon, and, even if you miss, you’ll still probably land amongst the stars. Corny? Yes. But still, not a bad place to be.
Fast forward a few years. The company gets acquired. Not for $1b. Not even for 5% of that. Sure, not a measly acquisition by any means, just not the “moon,” exactly. Heck, not even really “the stars,” if I’m being honest. Disappointing, but that’s part of the risk you take.
In the acquisition, my equity converts, and I make some money. Just not all that much more than what I’d recently received as a holiday bonus. As such, I was a little upset.
Yet, regardless of my frustration, I now see that I made two tactical errors during the process. While hindsight is 20–20, if I had addressed these things before joining the company, I might have found myself in a better place come acquisition day. So, what were those two errors? Let’s discuss them.
First, the company didn’t have a formal valuation or strike price when I joined. This is somewhat common at startups. Valuations can be expensive to perform, so, often, companies will kick the can and say, “Don’t worry, we’ll figure it out later.” Unfortunately for me, I was too attached to the dream of making money down the road that I didn’t push back hard enough on that. This prevented me from evaluating my prospects as well as I probably should’ve been able to.
Second, a very large chunk of the company was owned by two first-time entrepreneurs, and I didn’t know that. This meant a couple of things. First, those two people, alone, could decide the fate of the company. Second, if a multi-million dollar offer were put in front of them, they’d both be pretty incentivized to pull the trigger, regardless of what their publicly proclaimed acquisition price was.
Thus, when evaluating an equity offer, remember to ask for the numbers we’ve already discussed here (strike price, company valuation, etc) as well as some clarity on how much of the company is owned by its largest shareholders.
Though said shareholders may claim they won’t sell the company below a certain price, things can change quickly when life-altering offers start coming in. That’s no knock on said shareholders — I’d do the same exact thing if I were them. It’s just that such decisions could vastly impact your equity, so you need to get this information before you can make an informed decision on your offer.
If the company sells shortly after you join, without adding much to its valuation, sadly, you won’t make a lot of money on your equity. As such, see if you can find a company that has its sights set high, but isn’t owned by just one or two people. The more any one person stands to make in a sale, the more he or she will likely want to sell when those tempting offers start rolling in.
Last, but not least, make sure there’s a path to a potential exit event for the company. Without going too deep into it, in order to make money on your exercised options / shares, you’ll need someone else to buy them off you. Luckily, if your company gets acquired or goes public, you’ll have plenty of folks to sell to.
However, if the company plans to keep things the way they are and never shoot for an acquisition or initial public offering, you may be left without a buyer for those options. Selling shares outside of an acquisition or IPO is tricky business at best. Don’t get caught in an illiquidity trap — make sure the company is interested in and motivated toward an exit event.
Consideration #4: The Vesting Schedule of Your Options
Almost all equity options are tied to something called a vesting schedule. These schedules control when you can exercise your options, all else being equal. Here’s a decent way to conceptualize this sort of thing:
Let’s say you hired someone and gave them 10% of your company on day one (with no strings attached). Then, let’s say that, on day two, that same person left the company, taking that 10% with them. As you could probably imagine, you wouldn’t be all too happy about that. And, if you had investors, they probably wouldn’t be, either.
This is why we need vesting schedules. These helpful tools allow companies to hold onto options for determined periods of time before turning them over to employees. They’re a way to effectively say, “We’re not just giving these shares away; you actually have to earn them by staying with us and working hard.”
For those unfamiliar to the world of equity, vesting schedules can be unexpected and frustrating. Here’s an example of what I mean by that:
Let’s say that, in your negotiations, you ask for salary X, but the company says they can only offer X minus 10. To make up the difference, however, they’ll compensate you with an equal amount of company stock. Depending on how they position it, this can be slightly misleading for a few reasons.
The first is you can’t turn around and sell that stock tomorrow to actually “fill the gap” between your initially desired salary and what the company ended up offering. In fact, as we’ve already seen, that stock, since it will more than likely come in the form of options, isn’t actually worth anything to you until the company grows.
Moreover, that “filling of the salary gap” only applies to year one. Sure, you might get a raise in your second year with the company, but the starting point for that raise will be X minus 10 — not X minus 10 plus a second helping of the equity you got before you joined.
Lastly, and most importantly, you won’t have access to all of that year-one equity until the vesting schedule for those shares ends, meaning the value the company claims they’re providing you today can’t even be unlocked, in full, for quite some time. All of this can make you feel cheated or blindsided if you’ve never been through it before.
Now, with that said, we shouldn’t just assume that all companies are “out to get us.” Often, they’ve just been through this process so many times that they assume you know exactly how it works. Luckily, now you do!
This is why understanding vesting schedules and learning what yours is, upfront, is so important. They, alone, determine when you’ll actually have access to the equity the company says they’re offering you today.
A fairly common schedule in the tech sector is what’s known as “four year vesting with a one year cliff.”
What this means is that, outside of an exit event, you won’t earn the right to exercise any of your options for one year (hence “the cliff”). However, on the first day of your second year at the company, you’ll have earned the right to exercise 25% of your options (obtaining this “right” is what’s referred to as vesting).
In addition, in each subsequent month after your first year, even more of your options will vest.* That is, as long as you stay at the company.
*Specifically, in the case of “four year vesting, one year cliff,” with each additional month, you’ll see another 2.083% of your options vest (100% - 25% = 75%; 75% / 36 months = 2.083% vested per month).
That leads me to another related story.
Shortly after college, I joined a fast-growing startup and was given about $10,000 in stock options. Not knowing much about equity at the time, I was thrilled. $10k?! At 22, a lump sum of that size honestly could’ve changed my life. As such, I fixated on that number without thinking much about the details.
Fast forward nine months later. We’d built a bunch of products half-way but hadn’t released any of them. Moreover, the role I’d originally been hired for virtually disappeared, leaving me with a different job title altogether. Not the worst thing in the world, of course, but still, not exactly what I’d signed up for, either.
Not really having the passion for this new role as I did the one I was hired for, I stopped putting in the work, and, as a result, my output suffered. It didn’t help that we’d been spinning the wheels for so long either. I couldn’t see things getting better any time soon, and, as a result, I decided my effort wouldn’t make a difference.
My managers could sense it. Shortly thereafter, they fired me — rightfully so. On the way out, the founders told me that since I hadn’t reached my one year cliff, none of my equity had vested. Yup. All of it was gone. Or, to put it properly, I never technically “had” any of it, so I left with just as much as I had accrued (nothing).
Though I wasn’t all that disappointed to lose the job, I was upset about the equity. All those long nights trying to get products out the door, all those weekend hours we logged, in hopes of a nice payout down the road — gone. That day, my equity had converted — into nothing. Sure, I hadn’t been the best employee and I knew it, but still, I was not too pleased.
Please don’t get me wrong here. I don’t tell that story to garner sympathy. I simply tell it to inform you.
So please, for your own sake, take this vesting schedule stuff seriously. Moreover, ask how long you see yourself at this prospective employer, and factor that into your decision. I don’t want you getting caught off-guard the way I was. Luckily, with these considerations, you won’t.
Consideration #5: Your Passion for the Work / Role
Equity is undoubtedly confusing and messy. More often than not, it only further complicates an already difficult decision. We’ve talked about that messiness at length here already. Now, let’s close this post out by talking about one final, less perplexing subject.
That subject is passion.
We’ll get to the importance of passion in startups in just a second, but for now, ask yourself, “Do I feel called to the work I’m about to do at this company? Am I excited about the role and fired up about the opportunity?”
If you answered no to any of those questions, then none of what you’ve read up to this point really even matters, and here’s why.
Life in a startup can be grueling. Sure, the media can sometimes glamorize the whole process, but there’s a lot that goes on in the trenches that’s overlooked and anything but sexy. Behind your company’s glamorous PR features lies a lot of hard work, long nights, and sacrifice.
Sure, that hard work sometimes leads to success. But sometimes it doesn’t. So, without getting too pessimistic, the question you have to ask yourself is, “Am I willing to put up with all the challenges of this job even if the equity never actually amounts to anything?” If you are, then I think you’re ready to move forward. However, if you’re not, I’d argue, you might only be setting yourself up for disappointment.
That’s not to say your equity can’t or won’t ever amount to something substantial. If that were the case, no one would ever join a startup or build a company themselves. It’s just to say that what’s really going to get you through the challenging times in such an environment is a desire to do the work itself — to go after your target market, serve your customers, and solve engaging problems at the office, every day.
If all you’re after is a payday down the road, then the long nights and inevitable periods of bleakness will eventually wear you down and make you realize that this isn’t the right role for you after all. Either way is totally fine, but if you have any inclination, today, that you don’t have the excitement needed to get the job done, then I’d consider saving yourself the effort and looking at what other offers you might have.
Conclusion
Phew. That was a long one. I’m glad you stuck with me until the end.
As we’ve seen throughout this post, deciding whether or not to accept your equity-juiced job offer is, undoubtedly, quite difficult. However, I hope that, with the help of the five considerations we covered today, you’re now much better equipped to make the right decision for you, personally.
As with any venture, there’s no knowing where the startup you join will inevitably end up. It could go out of business quickly. It could also sell before you have a chance to make all that much money. Or, it could skyrocket in valuation ahead of an eventual sale, leaving you with a handsome payday.
Though the risks at a fledgling company are certainly high, the rewards are equally tempting. For example, there’s no better place to try out multiple roles than at a startup. There’s also no better place to take initiative on a special task or carve out your own path. And, most importantly, there’s no better place to turn something small into something big.
For, even though many startups die out or fail to reach great heights like Facebook or Google, some of them actually do get quite far, if not all the way there. After all, those urban legends of wealthy early employees have to come from somewhere, rare as they may be.
As you ponder this important decision in front of you, I implore you to consider all the variables we discussed today: the good, the bad, and the ugly. But, more than anything else, I implore you to ask yourself what you truly want to do. For, a desire to actually do the work in a startup will get you farther than almost anything else will, and, trust me, there will be no shortage of work to do here.
So, no matter what your decision, I wish you the best of luck on this next step in your career. Once you make that decision, come back here and leave a comment. Let us know where you joined and what the deciding factors were. And, if you have any questions, feel free to drop a line as well. This is no easy decision, but hopefully, with the content we’ve discussed here, the answer just became a bit clearer for you.
