Employee Options and Grant Size
Brad and Jason have a great post up over on Ask The VC regarding the often asked first-time entrepreneur question How many shares should I create for my new company?. This is directly related to a couple of questions I've gotten lately from employees considering offers from startups that go like this (i'm combining a couple different lines of questioning into one set here):
I'm considering joining a startup that completed an A round financing. They have offered me options, and I'd like to understand the relative size of the options offer, so I've asked them about their pre and post-money valuation on the A round (which will tell me how much of of the company is owned by the investors already), and expected dilution in my equity as a result of a next round of financing. The company has not wanted to answer any of the questions in quantitative specifics, but responds qualitatively with "a good valuation" and "not much dilution". Is this reasonable? I will know the current valuation if I knew the exercise price and multiply it by total outstanding stock,right?
There are a bunch of things to say here. First, go read Brad and Jason's response to the "how many shares" question. Back already? Such a fast reader you are. Ok, let's dive into this set of questions in not necessarily any particular order.
The first question you really want answered when you're receiving an offer like this from a private company, and it's a question the company should be prepared to answer, is "what is the total number of authorized shares". If you are offered 100 options in the company, it doesn't really matter whether the company's valuation is 5 or 500 million dollars (if the company's public, all this is moot obviously. There are loads of mechanisms for valuing options in publicly traded companies). You don't really know anything about the size of your grant unless you know the total number of authorized shares, and they should be willing to let you know that information so you can determine the relative size of the grant. Without that information, the offer only amounts to "some options".
The valuation numbers are probably not going to be answered by a private company (they have multiple reasons not to go around touting the financed value of the company, not the least of which is employees claiming two years later that 'you told me the company was worth 50 million dollars'), but again, the answers to the valuation questions are secondary in my mind to the size of your grant. The first thing you really want to know is "what percent of the total authorized shares am I being offered".
In any case, you will not know the current valuation by multiplying the exercise price by the total outstanding shares. The options you are being offered are almost definitely options to purchase common stock. The investors on an institutional A round financing almost certainly have purchased preferred stock. Since the preferred stock is paid out in preference to the common stock on any liquidity event, the common stock is probably valued at a significant discount to the preferred stock. So that calculation isn't going to help you.
Once you know the percentage of authorized shares you've been offered, and you know the company's executed a 5 million dollar A round financing, how do you calculate the probable value of your options? The short answer is "you don't" or "the current value is around zero, subject to change", take your pick. The long answer is that your options aren't worth what a VC was willing to pay for their equivalent number in preferred stock. Your options are only going to be worth what somebody is ultimately willing to pay for common stock at some point in the future, and that price is only going to be determined on an IPO or sale of the company. Just like the founders, you need to decide whether you think your percentage of shares is going to be worth some potentially meaningful amount if the company is successful in the market. The only thing you can try to know with certainty is your percentage interest in the company against which you might guestimate reasonable comparable exits in the market and calculate your percentage interest in that exit, but even here, you are subject to unknown and potentially unknowable amounts of future dilution, preference multiples (in which the investors get 2x or 3x or more their investment back before any remainder is distributed to common), etc. A question you might ask the company vis-a-vis your percentage interest is whether the existing investors have any preference multiples (because this has the potential effect of reducing the common's interest in the company on a liquidity event), but again, even if the company answers this question with total transparency, it could be very challenging for you to understand or measure the implications to any reasonable degree.
The follow-on financing dilution question is important. Too few people understand the implications of follow-on equity financings, which is that everybody (probably including the existing investors if they don't invest in this round) gets diluted on any further equity financing. The trouble with specifics around this line of questioning is that the company isn't likely to have very concrete answers as to what future financings might mean for equity dilution, even if the market's supply/demand continues to function exactly the same as the present environment. One way of at least getting a sense of the magnitude/timing of potential dilution is to ask questions that help you understand how long the current financing is expected to last.
The bottom line for potential employees is that future dilution is going to be very hard to gauge, you just need to understand that the closer you are to startup mode, the more likelihood there is of significant dilution, for you and the founders and everybody else. The company should be willing to help you understand your current percentage interest in the company and some qualitative measure of the likelihood of future dilution. Beyond that, you're in the "leap of faith" pool with everybody else. If the company is unwilling to let you know what 100 shares equates to in terms of percentage interest in the company, I'd say that's a warning sign and you should ask lots more questions.