When you start a company, on day one the stock is basically worthless. There are some exceptions to this rule such as a spinoff company where Newco is getting some valuable assets day one. However in the vast majority of cases, the value of a startup on day one is zero.One of the objectives of an entrepreneur is to steadily increase the value of the business and the stock price.
At some point, the Company will generate revenues and earnings and can be valued using traditional valuation metrics like discounted cash flow and earnings multiples. But early on in the life of a startup it is trickier to value the stock.
Fortunately we have a marketplace for startup equity. It is called the venture capital business. Every time a startup raises capital, there is a competition between investors and a negotiation beetween the Company and the investors. Those two processes provide a mechanism to determine stock price.
There is a growing trend to finance the ‘seed stage’ of a startup’s life with debt, specifically convertible debt. One of the reasons I am not fond of convertible debt is that it obfuscates the equity pricing process. But that’s a digression.
So between the formation time when the stock price is most likely $0.01 per share (ie zero) and the time of exit at hopefully $100/share or more, there is a progression of price appreciation along the way marked by the progress of the business, financing events, and eventually revenues and earnings which lead to financial analysis.
If you are an entrepreneur or an employee in a startup who has equity as part of your compensation, it behooves you to understand the appreciation in the value if your equity.
One thing that you need to know is that the price doesn’t always rise. There can be setbacks in the business that lead to price declines. There can be setbacks in the capital markets that make all businesses less valuable including startups.
And if course your Company could fail in which case all of the employee equity will be worthless.
In the case of a startup that becomes a successful business, the price will appreciate over time. There can be price declines or long periods of price stagnation, but if you are patient and the business succeeds, the employee equity will appreciate over the long run.
There are some specific issues that require a deeper dive, including the impact of liquidation preferences and the role of a 409a valuation. I will tackle those issues in the comings weeks.
I’ve been through this a bunch of times and had people really happy and really upset.
I now tell people this: The equity portion of your compensation is purely setup so if we hit it out of the ballpark you get a taste of the upside. That’s it period.
Don’t come if that’s the only thing you focus on. Focus in on the experience. You are going to learn, you are going to grow, you are going to have a much better time being a part of the experience, rather than being a cog in a giant machine. If I do my job right worst case is you have a great time, grow professionally and are in a position to advance in our company or outside at another company.
I try to pay fair, maybe just maybe you could make more at BigCo, but one day a consultant might come in fresh out of an Ivy League school and declare your department non-core and out you go. If we grow of course you’ll get paid more.
Come work because you want to work here not because of the options.
That being said I think its ridiculous to give out options without just saying number of shares, percent of company, total company valuation. If you don’t give out those you’ might as well say “just trust me” which never works. I haven’t though ever given out the company has to be worth X to get past the current liquidation preferences.
This article was originally written by Fred Wilson on October 11, 2010 here.