12 reasons why your stock options could be worthless
Stock options now pay off 90% less than 20 years ago
In the two decades since the dot-com era, the likelihood and magnitude of payoffs from stock options have quietly eroded.
In this model I developed comparing the payoff today vs in 2000, I estimate that the expected payoff is now 90% less than it was during the dot-com era. Here’s what happened.
Stock options were once a quick path to riches
Options became a wildly popular mode of tech startup compensation during the dot-com era. On April 4, 1994, Marc Andreesen co-founded Netscape and proceeded to IPO to spectacular fame on August 9, 1995. The IPO price rocketed from $28 to as high as $74.75 on the first day, settling at $58.25 and giving Netscape a market cap of $2.7 billion. This unprecedented event inspired dot-com startups to grant stock options widely to all employees, with glorious stories spreading like wildfire that even junior employees like company chefs (who made the free meals) became millionaires. Hundreds of startups validated this timeline and payoff. Between 1995 and 2000, there were 397 to 700 IPOs each year. That’s more than every year since that era except for 2021. A few recognizable names from that era live on today. Yahoo IPO’d in April 1996, taking 2.3 years. Amazon was “slow” when it IPO’d in May 1997, taking 2.9 years. eBay followed in September 1998, taking 3.1 years.
Everything was happening so fast, nobody questioned that IPOs would be quick. Time was called “Internet time” — it was 10x faster than usual. The standard terms of stock options — 3 or 4 year vesting with a 1 year cliff — were solidified across Silicon Valley for the next 2.5 decades by this quick IPO timeline. Any deviation from these terms made it difficult to recruit.
For many in Silicon Valley, there was even a culture of diversifying by vesting 25% and then hopping to another dot-com. After 4 years, one would have stock from four dot-coms with a good chance that at least one of them would IPO and be worth a fantastic sum. The IRS had not yet started to strictly enforce taxes on exercising options (similar to their pace in regulating cryptocurrency taxes today), so money flowed quickly and freely.
The value of stock options has gradually eroded the past 20 years
Here’s why.
1. The vast majority of startups fail
Approximately 400k startups are formed every year. Around 20 startups reach unicorn status each year. That’s a 1 in 20,000 chance of a startup becoming a unicorn, or 0.005%. The odds are similar to a high school basketball player making it into the NBA (0.004%).
Like all startups, tech startups have a pronounced failure rate, as evidenced by this steep TechCrunch graph. Obviously, there’s no payoff if the startup fails, and this remains the top reason stock options don’t pay off.
2. Startups now typically take 9–12 years to IPO
In 2022, if you Google “years from founding to IPO”, the results generally indicate 4 to 9 years, with an average of 5.7 years. The fallacy of these analyses is that they calculate a historical average, instead of a trendline.
We compiled a sampling of data on tech IPOs and graphed them by vintage, i.e. founding year. The results show a clear trend toward IPOs taking longer.
A quick glance at the IPOs in the past 10 years validates our intuition. Uber took 11 years to IPO. Airbnb took 12. Spotify 12. Palantir 17. SquareSpace 18. Square was a rare exception at 6 years, but had the benefit of a celebrity founder. International startups were no exception. Didi took 9 years. So did Grab. GoTo and Zomato took 13.
Many of these IPO’d in part due to the aberration of hyper-overvaluations in 2021. And these are the top unicorns. 2020–2021 was a gold rush for IPOs, setting a 20 year record. This means that if a startup misses this gold rush, it may have to wait many years for another boom year. Imagine the timeline of an IPO if you join an average startup in a period without a well timed bull market or bubble.
Notably, startups that were founded at the end of a bubble — i.e. 2001, 2007–2008 — had very few IPOs. This is possibly due to their founders learning poor management from unsound bubble periods and then applying them in a bear market.
Note that this chart is conservative. Data for startups founded after 2013 are not available, since there is not at least 10–12 years of historic data available. The average time to IPO may lengthen further as time passes and more historic data becomes available.
For instance, Stripe is currently the highest valued tech startup that is still private. It was founded in 2010 and will add another notable data point of at least 13 years when it finally IPOs someday.
3. The probability of reaching an IPO is less than 1%
Given this longer timeline from founding to IPO, startups must now survive more years to reach an IPO. Each additional year is an additional year of possible failure. Data bears this out. Only about 1% of VC-backed seed-stage startups reach a Series F funding round (TechCrunch). If you include a larger pool — angel-backed startups — the success rate drops more than 10x, to less than one in a thousand, or 0.1%.
Many startups now choose not to IPO. The supply of funding for startups from private markets is plentiful, unlike in decades past. Institutional investors dip into early stage startups by investing in VCs or hedge funds like Tiger Global, which raised from around 800 limited partners in each of their recent rounds.
A handful of VCs have even lengthened or started eliminating their standard fund life cycle of entering and exiting an investment within 10 years. This means that many VCs no longer pressure their startups to IPO within ten years. Sequoia’s recent announcement of an evergreen fund is part of a fundamental shift to private markets.
4. More funding rounds means more dilution
Successful tech startups usually do funding rounds every 20–24 months (Source: Crunchbase). With IPOs taking 9–12 years or more, this means there are typically 5 to 8 funding rounds (reaching Series E — H), plus the IPO itself. Each of these dilutes common shareholders, typically by 5–25%.
Investors will often own more than 50% of the equity within 3–5 rounds. By the time employees can sell after an IPO, their share can be diluted 3–66%, depending on the number of rounds of dilution they passed through.
To quantify this dilution, I built a model using data from over 8000 data points from Crunchbase over 2010 to 2018. This graph depicts the dilution impact to common stock held by an average tech startup founder or employee assuming an IPO exit after Series G.
Dilution exposure is substantial for founders and early employees. The average founder is diluted 63% by the time they complete 8 rounds and then IPO. The earliest employees can expect to be diluted 53%. Employees joining after the first VC round can expect 30% dilution.
Dilution tends to decrease with each subsequent round, especially after the seed and Series A. The following chart shows the equity that remains factoring in dilution from each funding round. With each round, the line flattens.
One takeaway is that if founders can bootstrap and effectively “skip” the seed and Series A or get much more favorable terms than the industry average, then they will retain a much higher percentage of the equity.
Another takeaway is that employees joining late stage startups have limited dilution exposure. An employee joining after a Series F round can expect dilution of about 7%.
Acquisitions are rarely accretive to employees
5. Acquisitions are cyclical and hard to time
Acquisitions are 3–15x more likely than IPOs. That said, they are still a statistically low result, at 2–17% of all startups (depending on what stage is included in the denominator).
However, acquisitions rarely result in a payoff for employees. Here’s why it’s so hard to get a payoff from an acquisition.
Acquisitions are cyclical. These macro cycles usually start with a new technological innovation. In Web1, it was the Internet. In Web2, a new wave was catalyzed by mobile technology, cloud computing, social networks, APIs, et. al. In order to keep up with these innovations, big tech like Google acquired users and talent, rather than build. In the social space, AOL tried but failed to beat Facebook by buying Beebo for $850 million. Facebook feared its own demise when it acquired Instagram in 2012 for $1B, just two years after Instagram was founded.
2022 is a consolidation business cycle, after the recent bull market (over)funded so many startups who were vying in the same competitive spaces. So, more acquisitions are happening now.
In the e-commerce deals space, Groupon faced 400 copycats around the world. So, they went on a 5 year acquisition spree after their 2011 IPO to try to stay ahead. Groupon spent up to tens of millions on each acquisition.
If the timing works out, this can result in an early and profitable exit for holders of stock options. However, it is difficult to time a startup, especially when runways are usually only 18–24 months.
Nowadays, big tech are more likely to build than buy, partly because the track record of getting acquisitions to work is so poor. Take short form videos. 10 years ago, Twitter bought Vine — the original short form video platform that Twitter shut down in 2018. TikTok took advantage of this failure to launch and quickly gain 1 billion users. To compete with TikTok’s onslaught, big tech built rather than bought. Google launched its copycat, Youtube Shorts. Facebook upgraded Instagram with Reels. In late 2021, Twitter started pushing their in-house TikTok copycat. The lesson is that from a startup perspective, acquisitions are more about timing than anything else. That’s a large part of why VCs hate it when they hear a startup pitch that they plan to get acquired. The other reason is the low payoff.
6. Acquisitions usually have a low payoff, if any at all
If 10 startups were funded and one became the leader, it may acquire a small handful of companies to extend its lead. However, it is acquiring the less successful startups, so the price paid is not usually high. More often than not, it is a firesale of a struggling startup that ran out of cash and cannot raise another round.
When a startup is not a runaway success but is still attractive enough to be acquired, employees and founders usually do not usually get a big payoff, if any at all. Common shares are always last in line. To illustrate, let’s say a startup that raised $2M is acquired for $5M. There is not $5M to split amongst shareholders. It depends on how much was raised and the terms of the liquidation preference. If there is a “1x, non-participating liquidation preference” — the most favorable term for founders and employees — then $3M is available to share amongst all shareholders. If the investors negotiated a 2x preference multiple instead of 1x, they get the first $4M (2 x $2M), leaving only $1M to share. It can get worse. If the investors negotiated “participating preferred,” then they get BOTH a multiple of their investment ($4M) AND their proportion of the remaining equity (40% x $1M, or $400k) for a total payoff of $4.4M to the investors. This leaves only $600k for the founders and employees.
If a senior employee has 1% of the $600k and is fully vested (or fully accelerates), the payoff from this acquisition is only $6k. This payoff only applies if the employee is 100% vested. If they have worked 2 years and are 50% vested, they would get half that, or $3k.
If the employee has a “single trigger” clause in their Employee Stock Option Plan (ESOP), their vesting will accelerate upon acquisition, typically by 25–50%. For some employees, they may have a double trigger, which is worse. It means the startup must be acquired and the employee must be terminated in order for the vesting to accelerate. If both do not happen, then the employee simply continues to vest their options in the acquiring company.
7. Acquisitions often fail long term
Finally, many startups are acquired for equity, not cash. If the acquiring company is not public or the options are not otherwise cashed out, employees have not exited, but simply transferred their equity from one firm to another.
This often ends poorly because 70–90% of acquisitions fail. Groupon ultimately ran out of gas after their acquisition spree and failed to piece them into a globally competitive business. They are now valued at 98% less than the day of their IPO. Alibaba tried to expand outside China by buying local e-commerce marketplace leaders, but later entrants like Shopee that built rather than bought have overtaken Alibaba.
Employees actually risk losing money from stock options
Exercising requires that employees spend their own money, which brings us to our last four points.
Rather than earn money, employees can actually lose money from options.
8. Options now frequently expire prior to an exit event, creating an “option trap”
Options now typically expire 10 years after the stock option grant date. 10 years is the maximum that US law allows for incentive stock options (ISO) to qualify for lower tax treatment, so it has become the new standard.
With IPOs now taking longer or not happening at all, many employees are put in a bind and face an “option trap” — the dilemma of whether to exercise their options in year 9.
Many of Stripe’s early employees are now facing this options trap, since they were founded 12 years ago and have yet to IPO. To mitigate backlash, I’ve heard that Stripe has been offering buyouts to some. Your startup may not be so kind.
In years past, startups often set options to expire 90 days after an employee leaves a company, reasoning that this helps lock employees into the company. However, employees increasingly understand this is likely to put them in an option trap. Some, especially anyone on the fence of quitting, assume their stock options are probably worthless due to this trap and actually quit earlier. Startups also understand that using the options expiration date to artificially keep an employee in the company longer than they otherwise would is in fact a recipe for keeping a potentially unproductive and disgruntled team member around longer. So setting a 90 day options expiration can actually backfire. Regardless of the timing, facing an options expiration date is either a “bad or worse” situation.
9. High valuations
To earn money from options, employees must exercise them and then hold common shares. This carries risks:
In many countries including the US, regulations require that the option strike price always be set to the market share price, even if the company is private. If an employee joins a late stage startup — especially after a high valuation funding round from the likes of SoftBank or Tiger Global — then the strike price can be inflated.
If the market softens and valuations dip — as happened in early 2022 with stock prices dipping 70–90% for many tech firms that recently IPO — then the options go underwater with an unpredictable chance of being worth anything again. This applies even to private companies that do not have publicly traded shares. In the US, this re-valuation is called a 409A valuation. Stripe did this during the bear market of 2022.
Employees can’t predict when and if the market will fall, so there is always a risk to exercising prior to just before a liquidity event.
10. Tax may be owed right away
If an employee joins a startup early and the strike price is in the pennies, then the amount they pay to exercise is often only a few hundred or a few thousand dollars. However, in many jurisdictions like the US, exercising options is a taxable event. In some countries it can be worse, e.g. Singapore has a “deemed exercise rule” that taxes non-citizens who move out of the country even if they do not exercise options. In the US and many other countries, the tax liability is based on the fair market value of the shares at the time of the exercise, which can be inflated during bull runs like 2021. To avoid paying tax right away, the IRS allows for US employees to file paperwork (Section 83b), but these must be sent to the IRS within 30 days of the initial stock option grant. Many employees miss this filing since they are busy starting a new job, though a responsible HR team or vesting platform should help catch this.
11. No liquidity
Prior to an IPO, employees can try to sell their options on the secondary market. However, this really only applies to hot startups that are in high demand. Plus, the hassle factor and transaction fees are high, as someone needs to be paid to find a private buyer of the shares. There are secondary market platforms like Forge Global, EquityZen, and Zanbato.
Even if there is an IPO, founders, employees, and VCs are usually locked from being able to sell for 6 months after the IPO. This results in selling pressure at the start of the 7th month. Historical data shows that the median stock price is actually below the IPO price both the month before (in anticipation) and the month after the lock up expires.
This is a risky period of time to be holding publicly tradeable shares. The volatility of tech stocks during their first year is approximately 3 times higher than the market. There is a settling period the first year after an IPO. The market is watching carefully to see the company’s first quarterly results as a public company. Management are often rookies to the myriad of challenges of being a newly public company. Many fail this difficult test, especially when the original founders are still in charge and do not relinquish enough control to experienced management.
12. The share price is likely to drop
Common tech lore is that prices pop upon an IPO. That is true. In this study of tech IPOs from 2010–2018, 80% of tech IPOs rose on day 1, with a median pop of 21%.
But remember, it’s not the day 1 pop that matters. What matters is that when shares are finally sold, the final selling price must be greater than the exercise price plus any taxes already paid.
In the same study, the median share price one year after an IPO is down 19% relative to the broader tech sector.
Many shareholders wait one year after getting their common shares to take advantage of potentially lower capital gains taxes. This additional delay further increases the odds that the share price drops below the cash paid. The market anticipates this selling pressure at the 12 month point, impacting the price.
Don’t lose hope
Despite the pitfalls of stock options, this is not a story of doom and gloom. Employees can still find a path to quick riches. They just need to be smart about it. I will offer up crucial tips in my upcoming articles:
- Tokens are up to 7x better than stock options. Here’s why.
- Critical questions to ask an employer about vesting
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, financial, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction.
