Startup Equity is a Scam (And That's Okay)

Welcome to Catching the Biggest Fish. I have 10+ years experience in software engineering at a variety of companies from “Big N" to startups. I write a biweekly blog post discussing various topics about working as a software engineer, running a company, and ideas on tech. It’s completely free to subscribe, so please do so if you find this content interesting.

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You’ve made it through your interviews, and got the happy news. The startup you’re considering wants to make you an offer. They’re giving you some amount in salary, that’s straightforward. But then there’s the equity components, almost always in the form of options. If you’re getting multiple offers you might want to be able to compare them to decide which one you prefer, and comparing the equity is going to be an important part of that. (By the way, if you want to learn more about how options work, there are many other articles, such as this one, so I’ll assume you know the basics at least.)

Some cynical types might suggest that startup options are worth $0, and you should consider them an irrelevant part of your offer. The company of course is going to give you some rosy projections that they will “definitely grow 10-100x” and so you’ll be a millionaire pretty quickly. Unfortunately the truth is closer to the first part, as there are a number of reasons that startup options aren’t as good as they seem:

1. You have to pay to exercise your options when you leave. If the company hasn’t had an exit, this is money you have to come up with yourself, often being some amount that exceeds your salary. As a result, many options are left on the table when employees leave. There is typically a short expiration period (90 days) after you leave in which you have to decide, so you don’t really have full information as to whether it’s a good deal or not.
   
   Even if you don’t leave, options expire after 10 years. So if you stay at a startup a long time and they don’t have an exit, you’ll have to decide to exercise or else lose them all. Admittedly most employees don’t stick around that long any more, but it’s something to be aware of.

2. Your options will be common shares, rather than preferred shares that investors get. In an acquisition, preferred shares will be sold first, and there might not be any money left to pay common shareholders. Investors are the ones deciding whether to accept an acquisition offer and they surely don’t care about common shareholders when making those decisions.

3. Over time there will be dilution. Each funding round the company will issue new shares to sell to investors (usually in the range of 20%). If you get in early (say, Series A), there could be 3-5 more funding rounds before an exit, and so your options will be worth something like 25-50% of what they were originally. Of course the total value should still be higher (a typical increase in valuation is 100% at each stage), but they probably didn’t mention this in their rosy projections.

4. There’s a high chance the startup has no exit at all. One study found only a 10-20% chance of exit for early stage (Series A-C) startups (and it didn’t improve much more for later stages). That means you have something like an 80+% chance of not making any money from equity at all (actually you may end up losing money because of exercise costs, see #1). Of course, in the case of an exit it’s likely your options are worth a lot more (although see #2/#3 for caveats).

The interesting thing is that if you combine the data, you get that startup equity is roughly valued accurately at each funding stage. This is because, empirically we find: 

(Chance of Raising Round) x (Increase in Valuation) x Dilution ≈ 1

What that means is that when a startup offers you equity you should ignore their predictions of possible futures and just treat it as the actual dollar value, as that’s the fairest value for it. Of course this shouldn’t be surprising at all, as although private equity markets are hardly totally efficient, it would be unlikely for them to be off by an order of magnitude. This does ignore the issues of exercise costs, so you may need to adjust it down based on your estimates of how long you will stay. If you tend to job hop a lot then it makes sense to value startup equity a lot less, since you won’t be as informed when deciding whether to exercise or not. 

And this has the huge caveat that this compensation has insane variance. You probably have someone you know that won big at a startup, and you’re perhaps in this situation exactly because you want to be just like them. That’s fine, but you have to accept that at this point you’re gambling. It would be roughly the same to work at Google, take your entire equity compensation, and bet it at a casino (with a decent RTP).

Nevertheless, most startups will offer you a much lower dollar amount of equity than public companies. So does that mean that startup equity is basically a scam? Well, yes, in that they try to trick you into thinking it’s worth much more than it is. But, no, not in the sense that the amount they actually offer you is probably worth roughly that amount. And let’s be honest, public companies often mislead prospective job seekers as well. Their compensation is more honest, but they might promise you a “quick promotion” (hint: recruiters have no power to achieve this), to work on a specific team (but then you find you’re assigned to some boring project instead), or specific perks that get taken away. 

And compensation is only one factor anyway, there’s lots of other reasons to be interested in a job. Perhaps you find it more fun, or you are going to learn more, or the location is better, or you care about the mission, or any of a number of other factors. Often we become too reductionist in our thinking, and end up using only that data which is easy to acquire. So if you have a great startup you are excited about, but you’re worried the equity compensation is low, well, you’re probably right. But if you’re fine with that, then go for it anyway.

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If you liked this post you might also like my earlier posts comparing impact and flexibility at startups vs. big tech.