Startup Stock Options: the Shortest Complete Guide for Employees

Answering the really important questions

To most people, myself included, stock options were a mysterious black box lottery.

I created this guide as the shortest possible explanation of stock options to answer the truly important questions from an employee perspective.

Say, a seed-stage startup has offered you 1,500 stock options. Is this a good offer? How do you cash out? Should you negotiate for more cash instead? How much money is that?

Did you know 99% of gamblers start-up employees quit right before striking big?

I am not a lawyer, VC, or founder. I am a guy who was offered stock options many times and wanted to figure it out. Consider everything written here to be guidelines on what to look up, what to ask your company about, and what to bring up with your lawyer.

Still, have some confidence: this guide has been proofread by my friend Vasily Kondyrev, ex-VC at Baring Vostok, founder of telemetree.io and substack author.

Some of this information is US-specific, but most translate to other jurisdictions. I used to work for an Italian company and everything worked as described, except with different tax brackets and other details. The core is the same.

I will illustrate some points with stories from the internet, mostly about people losing a lot of money. Please treat this as any internet writing and don’t trust it blindly.

Topics covered: basics of equity compensation, how startup exits work, possible outcomes for stock options holders, taxes, dilution, expected waiting times, and likelihood of good pay-outs.

The guide is structured in sections in the order of importance. The most important is on top and the lower you go, the more detail you get. Each section ends with a summarizing bottom line. You can read the bottom lines if you want to skim. All bottom lines are summarized at the end.

Basics of Equity Compensation

Startups offer employees equity, which is partial ownership of the company, in addition to salary.

In a liquidation event, commonly called “exit”, equity can translate into a lot of money. An exit is either: a merger, acquisition, or going public with an Initial Public Offering (IPO) to be traded on stock exchanges.

Why companies do it:

1. Saving cash.

2. Incentives. Equity motivates employees to work for the long term, keep the company alive, and push the startup to a successful exit. All for the sweet cash-out at the end.

3. Keeping employees. The more an employee works at the company, the more equity they get, which is a carrot that motivates them to stay.

Basics of Stock Options

The usual stock option grant looks like this: 2,000 stock options with a strike price of $150, a vesting period of 4 years with 1-year cliff. Let’s make sense of this.

Stock options grant a right to purchase a number of stocks at an agreed price. Wait, stock options are not stock? Yes, stock options are not equity. Stock options can be exercised by paying the strike price to convert them into shares, which is equity. You make a profit by getting stock options, exercising them to get shares, and selling the shares.

Next up: vesting. Companies don’t want you to run away with stock options immediately after they hire you. There is a vesting schedule: chunks of stock options gradually become available to you. The vesting period is a point after which all the granted stock options become yours. The cliff period is a point after which you get the first chunk of stock options. Typical vesting schedule: 25% stock options a year, paid in equal chunks each month.

Vesting example. 2,000 stock options, 4 years vesting, 1 year cliff. The first year you get nothing. After one year you get 500 stock options, 25% of the grant, as one big chunk. After this, you get a small chuck of stock options each month, specifically about 42, which is 75% of 2000 divided by 36 months. After 4 years at the company, you have 2,000 vested stock options.

Vested stock options can be exercised after an exit or before. Exercising after an exit gives you stock in case of IPO, or money in case of some acquisition scenarios. Exercising before an exit gives you private restricted stock, which is useless until an exit happens.

Unfun fact: as of 2023 as much as 72% are not exercising their equity.¹ The most likely cause is that exercising requires a lot of money upfront and it is very risky to do when there is no exit in sight. We will cover that later.

Bottom line: stock options have to be exercised by paying the strike price to get shares. Stock options become gradually available to you according to a vesting schedule while you work for the company.

Initial Public Offering

In an IPO a company goes public and starts trading on an exchange. At this point, you can exercise your stock options and sell the shares.

Simplified example. You have 2,000 stock options with a strike price of $150. The stock is trading on an exchange at $300. You want to exercise and sell. The difference between the market price and the strike price is called the spread. In this case, the spread is $150. You have to pay 2000 * $150 = $300,000 to exercise the options. Finally, you sell for $600,000 and your profit is $300,000.

This is the basic idea. In reality, the profit is smaller due to taxes, preferred versus common stock, and other things we will cover later.

You can also exercise the options and keep the stock, to collect dividends, sell later, or optimize taxes.

Note: in practice, you can’t sell immediately. There is almost always a lock-up period where you can’t sell for a year or more.

I got screwed due to the lockup period. Our company went public during the dot com boom less than 6 months before 9/11. By the time we had reached the end of the 1 year lockup period where we could finally sell the shares, 9/11 happened and the market crashed. Our shares had lost about 90% of it's peak value. […] As regular joes stock option holders, we got fucked, but the founders, large investors and friends & family all had a different class of share that could be cashed out at any time, and boy did they ever.

- Anonymous internet guy complaining.

Bottom line: in an IPO a company starts trading publicly, you can exercise your options to get shares and sell the shares after the required lock-up period.

Acquisition

Most start-ups are acquired by other companies. What happens in this case?

The core is the same: you exercise options to get equity and sell it to get money. The details are very different. It can get complicated because companies do not always get bought for cash. They could be bought for cash, stock, mix of cash and stock. All these cases have slightly different rules.

My first "successful" startup was acquired for $2M in stock in the acquirer (stock which ended up being worthless, except to the IRS). When we were acquired, the company was about a year old with some IP and market traction but no revenue […] The next one was acquired for about $30M in cash many years after I left […]The next one was a $400M cash acquisition by a huge (Fortune 25) company. At that point we were about six years old and at a gross-rev run rate of ~$90-100M. We had raised about $20M in outside capital.

- Internet guy on his acquisition experiences

Each acquisition deal is unique and a lot and depends on the specific agreement. Let’s try to cover the core ideas.

Example. You own 100 stock options that, if exercised, grant you ownership of 1% of the company UpStart. The company is sold to BitCorpo for $100M. Big win. What happens to your stock options? What if you exercised the options and have shares?

One important term is the acquisition share price. It’s the sale price divided by the total number of shares. In the example above, the acquisition price is $100M divided by 10,000 and equals $10,000.

Let’s see what happens to exercised options, vested and unvested options.

Exercised shares scenarios:

1. Cash payout. You get paid for each share in cash. You theoretically get 1% of the $100M, but practically less because of the preferred stock of investors, more on that later.

2. Conversion. Your shares are converted into shares of the acquiring company at some conversion rate. If the conversion rate is 0.5, your 100 shares turn into 50 shares of BigCorpo. Your profit depends on this conversion rate. You have no way to affect it. It’s just part of the acquisition deal. But it will depend on the acquisition price, so in a good sale you should make a profit.

Vested options scenarios:

1. Cash payout. BigCorpo buys the options from you for the spread: the difference between the acquisition price and the strike price. If the acquisition price is $100 per share and the strike price is $50, the spread is $50. For 100 vested options, you will receive $5,000.

2. Conversion. The options are exchanged into options of BigCorpo at some conversion ratio. If you own 100 stock options and the conversion ratio is 0.5, you receive 50 options of BigCorpo with a new strike price. The difference between this and the above case is that you get options, not shares. The new strike price is based on the old strike price and the conversion ratio. Usually, the cost of exercising the options will remain the same, but the upside will be better because BigCorpo stock is worth more.

3. Exercise and sell. BigCorpo allows you to exercise the options and sell the shares to them. In that case, you need to quickly provide the cash to exercise the options or they are gone.

Unvested options scenarios:

1. Accelerated vesting. Some of your options, maybe all, vest immediately. Then one of the above cases happens.

2. Conversion. Your options are converted into BigCorpo stock options at a conversion ratio with a new strike price and a new vesting schedule. The new strike price is based on the old one. The vesting schedule usually does not change, but it can.

3. Pro Rata Cash-out. BigCorpo pays you cash based on the spread between the acquisition price and the strike price, adjusted for the portion of the vesting period completed. You get more money for options that are almost vested and less money for options far away from vesting.

4. Cancellation. Too bad, your stock options turn to dust.

That’s not all. Acquisition comes with conditions.

BigCorpo doesn’t want to buy and see every employee cash out and leave. They will often require you to work for them for a year or more. Your equity disappears if you leave before.

BigCorpo also doesn’t want to buy a startup only to find out it was all hype and borderline fraud. This is why there is usually a holdback or escrow. In a holdback arrangement, a portion of the purchase price is withheld at the time of the acquisition. Escrow is similar, but the frozen amount is held by a third party. Either way, the withheld amount is released once conditions or milestones are met.

Example. You own 1% of UpStart. UpStart is acquired for $100M by BigCorpo with a simple cash buy-out: they just buy your shares. But there is a holdback of 10% and a condition: the company must reach $1B monthly recurring revenue within one year.

Initially, you are paid for 90% of your shares. Since you own 1% of $100M, you get $900 000.

If the milestone is met within a year, you get the remaining 10%: $100,000.

If the milestone is not met? Too bad, you lose the withheld 10% part.

Bottom line: in the case of acquisition there are many more variables and conditions compared to IPO, and you have no control over them. The core idea is the same, though: you can exercise options, and get either cash for your shares or stock of the acquiring company.

What ifs

Let’s cover some potential outcomes of the risky bet that is stock options.

What happens if the company goes bust?

You lose it all, and your stock options and exercised shares become worthless.

What happens if you stay in the company and do not exercise the options for a long time?

Stock options have an expiration date. Usually, it’s 10 years after the grant. You have to exercise your options before that.

What happens if you leave or get fired before an exit?

You keep the vested stock options and lose the rest.

After leaving you have a limited time window, called the "Post-Termination Exercise window" (PTE), to exercise your options. If you don’t exercise options in this window they are gone. Traditionally PTE is 90 days, but it can be whatever the company wants it to be. You can negotiate for a longer PTE window. No guarantee you will get it, but it costs nothing to the company.

There is a chance the company will buy back from you. The company employee stock options plan (ESOP) might include a buy-back clause. The company needs stock to give away to other employees, to investors, or to keep for the founders, so they might be willing to exchange some cash for your stock options. In that case, you can get some money right away but don’t expect crazy returns.

What if I can’t pay for exercising?

Exercising might require putting down tens of thousands if not hundreds of thousands for a mere chance of profit later. At the same time, it’s painful to let go of earned shares. If you don’t exercise in time it’s all gone.

In the case of post-exit, this is not an issue, because the money will be taken from the sale profits.

Before an exit, it’s harder: you can exercise the shares, but you can’t get a profit.

Sometimes, companies will offer an exchange: you sell some of your options to them to exercise the rest of the options.

Finally, you can take a loan. Traditional loans would add crazy risk on top of your crazy risk.

There are companies that offer non-recourse financing: they pay for your exercise, but in case of exit you need to repay the cost of exercising plus a fee. Basically, it’s like a loan, but you don’t lose anything if there is no exit. Typical rates are around 5%.

What if you exercised options, but no exit happens for a long time?

All you can do is wait. You can exercise the options to get shares, which will be worthless until an exit, or keep the stock options if your PTE allows it. The good news is that investors typically push startups to exit. Still, no guarantees.

There is a "startup" in my area that has been around for now 21 years. I actually got an offer there last year. They are still giving options with their offers. They say they plan to go public soon, but according to past employees I've talked to, they've been saying that for over a decade.

- Another anonymous guy

What if the company has an exit, but you have unvested stock options?

Depends on the employee stock options plan. Can vary from immediate vesting to losing all unvested stock options. Ask the company about it.

What if you leave, exercise the options and the company dies later?

Too bad. You paid a lot of money to exercise the options and paid tax, but the stock you have is worthless.

Can you sell stock options?

You can’t sell stock options, but you might be able to sell exercised stock options also known as private restricted stock. Sometimes, the stock options plan forbids this practice, but sometimes not. There are “secondary markets” for private stock and brokers that connect sellers with buyers. Expect terrible prices and brokerage fees to be around 5%.

An investor might want to buy your private shares. They will inform the founders, and if they agree, they will reach out to you with an offer. You will be offered a share price based on the company valuation before the investment round, the so-called pre-money valuation. If you work for a $10M start-up and an investor is willing to invest $30M, this would bump the valuation to at least $40M. But you will get a price based on $10M. Often this is not a bad deal: the alternative is waiting many years for an exit that might not happen.

Can a company just not give me the promised stock options?

If you signed a contract granting you stock options then no, a company can not do this legally.

However, a certain thing can happen. Imagine you negotiated for some stock options and accepted the company’s offer. You sign the employment contract and relax. But stay alert: your employment contract is not related to a stock options grant.

To give you stock options the company collects a batch of requests from multiple employees and presents them all to the board of directors as a suggestion. The board reviews the request. This can take months. Finally, if all is well, the company will get back to you to sign the actual stock options grant. Nothing prevents the board from denying the request. You might end up in a situation where you were promised stock options, but they never came. This is not a typical situation, but it’s good to keep in mind and watch out for it.

Ouch, taxes!

The purpose of this section is to give you a general idea. The disclaimer about none of this being professional advice goes double for this section. Taxes depend on your jurisdiction, tax brackets, tax benefits and so much more. Mentally add “it depends on your situation“ to every line. I will assume US taxes with a select tax bracket for demonstration purposes.

Stock options are taxed at two points in time: when they are exercised and when they are sold.

Taxes on exercising stock options

Reminder: exercising is when you pay money to convert your stock option into shares.

Wait, you have to pay tax before you earn a dime? Of course!

How much you pay depends on the spread: the difference between your strike price and the current fair market value (FMV) of the stock.

If a company is public, fair market value is how much the stock is worth on an exchange. If it’s not public you still have to pay tax. Here’s what happens. First, you exercise your stock options by paying the company. The company files a form at the end of the tax year, where they will include an FMV. They obtain it by either getting a 3rd-party to appraise them or by self-declaring it. You will use this FMV when you file and pay your taxes.

Exercising is taxed as ordinary income according to your tax bracket.

There are differences based on the stock type: ISO or NSO. We will talk about it in a bit. For now, let’s assume the stock is NSO: the most common type with no bells and whistles.

Example. 2000 stock options, strike price $150. The stock is NSO. IPO happens, the market price is $300, and you immediately exercise and sell. The spread is $150, so the government thinks you gained a profit of $150 and you have to pay ordinary income tax on that. The total spread is $300,000. Plugging the value of the spread plus some example info into an income tax calculator I get a 24% effective income tax rate. Definitely plug in your own values to get a realistic estimate. The tax amounts to about $72,047.

You haven’t earned anything, but already owe someone’s yearly salary. Isn’t it great?

Taxes on selling shares

You must pay capital gains tax when you get money in an exit event.

When you sell stock you pay capital gains tax on the profits. If you exercise the options and keep the stock then it behaves like every other stock, which means you don’t pay capital gains until you sell, but have to pay tax on the dividends.

For capital gains, the details depend on how long you hold the shares. There are two types:

1. Long-term capital gains tax: 0% - 20%.

2. Short-term capital gains tax: 10% - 37%.

You pay the higher short-term capital gains tax if you sell the stock within one year. You pay long-term capital gains if you hold the stock for more than one year.

Again, there are differences based on the stock type, ISO, or NSO, but we will talk about it in the next section.

Example. As above, 2000 stock options, strike price $150, the stock is NSO, IPO happens, the market price is $300. You exercised your shares by paying $300,000 plus $72,047 tax. You immediately sell and your profit is $300,000. You pay short-term capital gains tax, which is, given an effective tax rate of %13.1: $39,365.

Your profit after all the trouble? $300,000 - $72,047 - $39,365 = $188,588

In this example, the real return is about 63%. Assuming you worked at the company for four years, it’s as if you were paid a $47,147 yearly bonus and didn’t invest any of it.

ISO vs NSO

In the case of the US, there is a distinction based on what type of stock options you have:

1. Incentive Stock Options (ISO) do not require you to pay income tax when exercising (but you might need to pay AMT²). ISO qualifies for better capital gains tax treatment if you hold the stock for at least one year after exercising and at least two years after the grant.

2. Non-qualified Stock Options (NSO) do not provide any tax benefits. NSOs are the most common you see in start-ups.

Ask the company and read the contract to find out the type you are offered.

Worst case scenario

The worst situation: taxes you can not pay.

Imagine you joined a company early. The value of your stake went up to the moon. Your stake costs $10k to exercise, but you can sell it for $1 000 000. Time to get rich! Except you need to pay income tax on the spread. The spread is $990,000. The income tax, assuming calculations above, is $237,600. This is a ton of money before any profit.

If the company has IPOd already, then you just take this money from the profits.

The situation is worse if the company has not exited yet. Leaving the company you have a short PTE, usually 3 months, to exercise your options. You could end up in a situation where you exercised your options, and paid a ton of taxes, but the company never exits and you can’t sell your shares.

I'm planning to leave the company I joined about 7 years ago as one of the first dozen or so employees. I have some options that are worth $X,000,000 as of the last tender offer, and would cost $X0,000 to buy. Exercising them isn't a problem, but I doubt I could handle the taxes. The company itself was valued in the $500M-$1B range in the last funding round. I'd hate to leave the options behind, but even if I could afford them, that's a ton of money to put at risk.

- Another anonymus internet guy

Taxes: bottom line

Stock options are taxed when exercised and when you sell shares. Exercising is taxed as regular income. Selling shares is taxed as capital gains. Details vary a lot depending on your situation.

You should be most careful when exercising stock options before an exit.

What is the hell is valuation anyway?

How do I know, or at least estimate, the post-IPO market price?

You don’t.

Here’s what you really want to know: will your shares be worth more than the strike price? Nobody can ever know, of course. However, startups estimate that to the best of their ability using valuation.

Valuation

Valuation is how much a company is worth in total. “Worth” is very fuzzy here. It’s not just the book value: the cash, desks, paper clips, and other physical assets. Valuation also accounts for cash flow, potential cash flow, future growth, competitive advantage, geography and a billion other factors. In short, the valuation of a company is like the price of a house. There is no “objective” valuation, there is only how much somebody is willing to pay for it. Estimating valuation is dark magic and doing it yourself is futile.

What do you mean by, "The company is valued at $50 million"? Every company has multiple valuations floating around: (1) the valuation from the most-recent round of funding (if any), typically described as a post-money valuation or a funding round; (2) the valuation of the company you can derive from a 409a valuation on common stock; (3) the valuation of the company that lives in a founder's head.

- Internet guy complaining about valuation, for good reason

Some people know valuation as closely as possible: the investors. How much stock they buy for how much money depends on valuation. This is the best you can do: ask your company for the valuation at which they expect to attract the next round. Then check this number against Crunchbase.

Valuation divided by the number of shares is what you want: the share price. To estimate the share price we need two components: valuation and the total number of shares in circulation.

The total number of shares is much harder. Say, they offer you 1,000 stock options. You can ask how many shares are in circulation and they tell you it’s 100,000, so your offer is 1% of the company. That doesn’t tell you much though because of dilution: a company can issue as many shares as it wants and the percentage you own can change arbitrarily, which we will cover in the next section. Also, you get common stock, investors get preferred stock, and that changes your payout, which is also covered in a later section.

Even if you can somehow estimate the post-IPO price, typically you are bound by a clause that prevents selling for a year. You certainly can not predict the price in a year.

Keep in mind that valuation is not always fair. Imagine you work for a company that makes AI on blockchain for pet names. You are employee number 1, the company is worth $1M, and you have 1 share out of 100. The company raises a new round of $10M and issues 25 new shares. Now you own 1/125 of $11 mil, which is $88,000. Over 10X profit! But then the hype fades and people realize that AI, blockchain, and pets are not quite the next Facebook. Valuation drops to $250,000. Now you own 1/125 worth $ 2,000. 0.25X profit! Such a company will also have trouble raising money again and have a higher risk of dying.

This is why sane companies avoid inflating their valuation. And you should avoid the insane companies.

Fair market value (FMV) does not equal market value. FMV is calculated usually by a 3rd party valuation firm in order to set an accounting value on the price. When the firm sells shares it’s actually the preferred price which can be much higher than FMV. So I would actually ask for how much investors paid per share (preferred) on the last funding round to get a sense of per share value. Then you can do the math once you get shares outstanding to figure out value. Also this information is sometimes available online if you search your company on Crunchbase.

- Helpful internet guy

Bottom line: the best you can do is to ask your company for the investor’s price per share in the last round, and compare it to the strike price. If your strike price is much lower than the investor’s price per share then it might be a good gamble to exercise your options. Before an exit, it’s still a risky attempt to time the market.

How does dilution work and should I be worried?

Remember how in The Social Network drama an early employee finds his stake in the company reduced to nearly nothing? This is dilution.

Say, a founder owns 100% of the company via 100 shares. The company is valued at $1M and raises an additional $500,000. The company issues 50 new shares to the investor. The total pool of shares increased to 150, but each share now represents a smaller percentage of the company ownership. The stock pool was diluted.

The founder’s ownership stake is now 2/3 of the company. Still, since the company is now valued at $1.5M, the founder’s stake is worth $500,000 as before. But typically the company raises more money, say $10M, and in that case the stake worth increases to $7,333,334.

You are just like a founder, except you own much less stock. Usually less than a percent.

As long as the company keeps raising money your shares are getting diluted, but, ideally, they should retain the same value or grow. Practically speaking, is the new stake guaranteed to be the same value? Absolutely not!

A company can issue shares at any point, for example, to give out to new employees. You were employee number 1, the company is worth $1M, and you have 1 share out of 100. Your stake is worth $10,000. The founder decides to issue 25 new shares to hire new employees. Now you own 1 out of 125, which is worth $8,000. You lost money and the founders also lost money. Usually, companies try to avoid this and tend to give you refreshers: additional shares as you stay with them, during annual reviews or otherwise. Dilution is a fact of life and you can’t do anything about it.

There can be truly silly situations. When institutional investors invest money they often require the founders to give employees more shares, in a so-called top-up, to keep the talent in. The founder’s stake may get diluted so much that senior early employees end up with more equity.

This Carta data shows that it’s common to see 10% - 30% dilution at every investment round.

Important part: your shares, as an employee, can be subject to different dilution rules than what founders and investors get. You should be worried, and you should ask the company for all the details about how dilution works in their stock options plan.

Bottom line: your stake in the company can be decreased by dilution, especially if the company raises money at a poor valuation, and you should ask companies about their dilution rules.

How much stock can I expect?

Typically a company allocates a fraction of the equity pool for employees. Usually about 10%. Each employee gets a bit of that depending on their seniority and importance to the company. Earlier employees get more stock since they take more risk.

My company sold for about $30m and our founders made approximately $15m, $9m, and $3m, respectively. The remaining $3m went to the early hire pool. No external funding.

- Internet guy’s story with exactly 10% equity for employees

Here’s a cool guide on expected employee equity ranges for series A startups:³

• Chief executive officer (CEO): 5–10%

• Chief operating officer (COO): 2–5%

• Vice president (VP): 1–2%

• Independent board member: 1%

• Director: 0.4–1.25%

• Lead engineer 0.5–1%

• Senior engineer: 0.33–0.66%

• Manager or junior engineer: 0.2–0.33%

It depends on the series too. Pre-seed you can see engineers getting over 1%. In series B you will never see anything like it.

It’s a huge red flag if a company offers you more than usual, say, 5% for an engineer, because the founders don’t know what they are doing with equity.

As others have stated, 5% each is absurd. A 5-10% ESOP pool would be standard post-seed. This would mean you’d get 1.5% as a VP level hire and 0.15% as a junior. This is the range. The nuance within this range then depends. For context, our engineering lead is on 0.7% after our Series A. Prior to our A round he was on ~1%.

Of course, these numbers aren’t absolute, but they’re a reasonably fair benchmark based upon my own startup and the other startups I’m close to.

- One more internet guy

Bottom line: as a regular employee, expect 0.1% - 1% up until series A, much less if joining later.

Preferred shares vs common shares?

This section is about shares you get after exercising stock options. In short, the shares you get are common stock, but investors get preferred stock. In case of an exit, you can get less than 1% of the company value even if you own 1% of the company. Basically, in case of a bad sale, don’t expect to get much.

Not all stock is created equal. Shares come in classes offering different rights and privilleges to owners. In your contract these can be named Class-A, Class-B and so forth shares, or something else.

For example: GOOGL is Alphabet’s Class A common stock, GOOG is Class C preferred stock.

The important distinction is between common stock and preferred stock.

As an employee, you get common stock. Founders also, typically, get common stock. Investors typically get preferred stock.

The difference is:

• In case of liquidation preferred stockholders get paid first.

• In case of dividends preferred stockholders get paid first.

• Preferred stock doesn’t give voting rights, common stock does.

• Preferred stock can be protected for dilution. Your shares get diluted, theirs maybe don’t.

Here’s the important part. In case of a liquidation event holders of different shares get paid in a certain order. To spoil the fun part: you with common stock are at the bottom of this order. If there is not enough money for everyone, for example when selling at a loss, nothing might trickle down to you.

We need one more notion: liquidation preference. It’s a multiple like 1x, 2x, etc. An investor with a 1x liquidation preference gets paid back their full investment amount. With 2x they get paid double. 1x preference is the most common. Liquidation preference is only applicable to preferred stock.

There are also participating liquidation preferences and non-participating liquidation preferences. They change how the payout is calculated in a liquidation event:

• Participating liquidation preference: The shareholder receives both liquidation preference (e.g. the invested money, or 2x the invested money) and a certain share of the remaining funds (e.g. 20% of what’s left for the founder and employees).

• Non-participating: The shareholder gets either a liquidation preference or a share of the remaining funds, but not both.

What happens in a bad sale?

An investor invests $1M in a company at a $4M valuation, bumping the valuation to $5M. He now owns 20% of the company. The investor received preferred shares in return, with a 2x liquidation preference. Sometime later, the company fails and has to be sold for only $3M.

Let’s calculate the payout for participating liquidation preferences. You can do your own calculation for non-participating if this is what you like to do in your free time, for some reason.

The total proceeds of the investor are liquidation preference plus a percentage share of the remaining proceeds. Liquidation preference is 2x, so the investor gets $2M first.

Remaining proceeds: $3M - $2M = $1M.

The investor gets the remaining proceeds times his ownership percentage: 20% times $1M = $0.2M.

Total: $2.2M

The founders and employees divide $0.8M, about 27% of the sale price, between them according to their shares, despite owning 80% of the company. If you owned 1% of the company you actually get 1% of the 27% of the company.

What happens in a good sale?

An investor invests $1M in a company at a $4M valuation, bumping the valuation to $5M. He now owns 20% of the company. The investor received preferred shares in return, with a 2x liquidation preference. The company does well and is sold for $100M.

The total proceeds of the investor are liquidation preference + percentage share of the remaining proceeds.

Liquidation preference is 2 times 1$M, 2$M.

Remaining proceeds: $100M - $2M = $98M.

The investor gets the remaining proceeds times his ownership percentage: 20% times $98M = $19.6M.

Total: $21.6M.

The founders and employees divide the remaining $78.4M. If you owned 1% of the company you get 1% of $78.4M which is not bad at all.

Bottom line: work for unicorns and don’t work for failing startups, it’s that easy. In all seriousness, expect to get less money if things go bad, and don’t worry about the percentage of ownership too much.

How long do I have to wait until exit?

Let’s see how long successful start-ups exist between founding and exit.

Blossom Ventures ⁴ provides estimates for IPOd companies:

• B2B SAAS median exit: 10 years.

• Consumer product median exit: 7 years.

The error bars seem large with some companies taking only 5 years, others 15 years, and some extreme outliers on both sides.

This source ⁵ lists benchmark median exit years for various industries and most of the numbers are in the 7 to 15 years range.

Carta’s end-of-2023 data ⁶ shows that the median time between rounds is about two years. Start-ups typically exit at round C or later. That makes typical exit times over 6 years.

Bottom line: hope for 5 years, plan for about 10 years, and be ready for 15 years or more.

How likely am I to make money?

Assume you are about to join a seed stage start-up, you are offered 1,000 stock options that would grant you ownership of 1% if exercised, the strike price is $100, so the total cost of exercising is $100,000, and you want to get at least $1,000,000. What is the probability of that?

Let’s fetch some statistics to get us in the ballpark, just to align the expectations.

I will do the calculations for the example above, but you can plug in the values of your offer. For simplicity, I will disregard dilution, taxes, preferred stock, and other details.

For you to earn $1M or more, the start-up has to reach exit and your stake should be worth at least $1.1M. The valuation at sale must be at least $110M. Our question becomes: what is the probability the start-up has an exit with a valuation of $110M or more?

You would think this information would be freely available, given how much money there is in predicting start-up outcomes, but no.

This Carta data from 2023 shows that $100M+ valuations start from Series C.

Now we can decompose our question:

1. How likely is reaching series C or further?

2. How likely to exit after reaching series C?

Some more Carta data gives an idea about the acquisition funnel:

This Dealroom data too:⁷

Finally, there are also some outdated statistics from 2010 by CB Insights: ⁸

The probability of reaching series C:

1. Carta data: 5.8%.

2. Dealroom: 15%.

3. CB Insights: 14%.

We don’t know which is more accurate, so let’s average this: 11.6%. Averaging typically yields a better estimate.

We also need the probability of exiting at Series C or after. Some companies will die or never exit even after Series C, we need to account for that.

According to CB Insights, if a start-up reaches Series C, the probability of exiting is 32%. Let’s combine this with the previously computed probability of reaching series C: 32% of 11.6% is 3.7%. This is one estimate of the chance of post-Series C exit.

Another estimate is readily available in the CB Insights statistics: the probability for a seed start-up to exit post-Series C is about 5%.

We have two estimates of the chance of exit, 5% and 3.7%. Let’s average them. Then our probability for a seed start-up to have a series C exit is 4.35%. Series C exit doesn’t guarantee $110M+ valuation, but it’s close enough, so let’s use this value.

CB Insights data also has a direct estimate of the chance to exit with $100M+: 2.1%. Again, this is not quite what we want, since we need $110M, but it’s close enough.

Let’s average the two estimates to get the final answer: (4.35% + 2.1%)/2 = 3.2%.

Given the starting conditions above, the chance to earn at least $1M is 3.2%.

The probability of exit will be better if you join the start-up in later stages, but you will also get less equity. Also, the survival funnels differ between industries. Plug your own numbers into the calculations above to get more accurate estimates.

Remember that in reality, you will get less money due to dilution, preferred stock, the possibility of stock tanking in case of IPO, and taxes. To account for this without crazy statistics you can plug a 50% higher target value, e.g. $1.5M instead of $1M, hoping that the extra money would cover unaccounted losses.

Bottom line: the chances of a good payout are low, specifically 3.2% for a seed-stage start-up to exit with $100M or more. This is a rule of thumb. For a better estimate plug in the numbers from your offer and details of your situation.

How do I factor in my confidence?

This will get a little bit mathy, but don’t worry, the math is not as important as the idea. You can just scroll to the conclusion if you have a headache.

Not all start-ups are alike. Let’s say you truly believe in this one. Should this affect your expectations much?

Probability theory provides us with a tool to adjust the probability of the desired exit, which is 3.2%, according to your confidence about a specific start-up. Bayes Formula.

In the frequentist framework probability is just how often something occurred previously. In the Bayesian framework probability is a subjective estimate of how likely it is for a thing to happen. In the absence of extra information, the best estimate is the prior we computed from statistics: 3.2%, in which case both frameworks agree. The Bayesian way allows us to factor in more information though, like the fact that we believe this start-up will succeed, to adjust our expectations.

Let E be the event that the start-up has a successful exit. And let’s stay -E is the event of no exit. Let A be your belief that this start-up will exit. What we want is P(E|A): how likely is the start-up to exit if you believe it will? The formula is:

\(P(E|A) = \frac{P(A|E)P(E)}{P(A)}\)

Here:

• P(E) = 0.032; the probability of exit if we know nothing about this specific start-up.

• P(-E) = 1 - P(E); probability of no exit.

• P(A|E) = 0.9; probability you would believe in a successful start-up.

• P(A); probability you will believe in a random start-up.

P(A|E) can be confusing. We have to assume some number here. This is how often you believe start-ups that really do exit will exit. It’s a measure of your skill.

We don’t know P(A) and it’s even more confusing. What does it even mean? It’s basically how often you think a start-up would succeed, combining all the times when you believed and were right and when you were wrong. We can calculate it:

\(P(A) = P(A|E)P(E) + P(A|-E)P(-E) \)

Here we only don’t know P(A|-E). This is how likely you are to believe in a failing start-up. We can think about it as your skill of identifying bad start-ups. P(A|-E) = 0.1 would mean that for 10 start-ups you trust only 1 will fail. That would make you the best VC in the world. A more realistic value would be P(A|-E) = 0.8. This would mean you can believe in a lot of start-ups, but many of them would fail. Still, even that is very generous: the collective hivemind of VCs is wrong 96.8% time, how could you be better? But let’s stick with 0.8.

\(P(A) =0.9 \cdot 0.032 + 0.8 \cdot (1-0.032) \approx 0.8\)

Finally, let’s plug in all the numbers and calculate P(E|A):

\(P(E|A) = \frac{P(A|E)P(E)}{P(A)} = \frac{0.9 \cdot 0.032}{0.8} = 0.036\)

The adjusted chance of successful exit is 3.6%, a tiny improvement over 3.2%.

The results could be different if you had extreme insider knowledge, the ability to change the situation, or are ridiculously good at evaluating start-ups. Plug in your values, adjust the model, play around with it.

It’s good to understand what risk you are facing, what risk you are ready to take, and what it would take for the risk to be lower.

Bottom line: your confidence in a start-up is less important than you might think. Especially so if you are a regular employee looking at a startup from the outside. The statistics of start-ups are just too brutal. Too many ways for it to go wrong, regardless of how good the pitch is. Beware of trusting your hunch: monkey brains are not made to handle tiny probabilities and high-risk bets.

The guide summarized

• Basics of Equity Compensation: Equity compensation is a high-risk, high-reward scenario that motivates employees by offering them a potential share in the company's future success.

• Basics of Stock Options: Stock options must be exercised by paying the strike price to get shares and become gradually available according to a vesting schedule.

• Initial Public Offering: In an IPO, a company starts trading publicly, you can exercise your options to get shares and sell the shares after the required lock-up period.

• Acquisition: In the case of an acquisition, there are many more variables and conditions compared to an IPO, and you have no control over them. The core idea remains the same: you can exercise options, and get either cash for your shares or stock of the acquiring company.

• What ifs: Various scenarios can significantly affect the value and utility of stock options, from company bankruptcy to unexercised options expiring.

• Taxes: Stock options are taxed when exercised and when you sell shares. Exercising is taxed as regular income. Selling shares is taxed as capital gains.

• Valuation: To know the potential earnings the best you can do is ask your company for the investor’s price per share in the last round and compare it to the strike price.

• Dilution: Your stake in the company can be decreased by dilution, especially if the company raises money at a poor valuation, and you should ask companies about their dilution rules.

• How much stock to expect: As a regular employee, expect 0.1% - 1% up until series A, much less if joining later.

• How long you will have to wait until exit: Hope for 5 years, plan for about 10 years, and be ready for 15 years or more.

• How likely are you to make decent money: The chances of a good payout are low, specifically 3.2% for a seed-stage start-up to exit with $100M or more. This is a rule of thumb. For a better estimate, plug in the numbers from your offer and details of your situation.

• What if you truly believe in a startup: Beware of trusting your hunch. While the risk is up to you, your confidence in a start-up is less important than you might think. The statistics of start-ups are just too brutal.

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1. https://www.benchmarkit.ai/_files/ugd/2a084b_5c36d96639974beeb610f2eeec1b060c.pdf

2. https://www.investopedia.com/terms/a/alternativeminimumtax.asp

3. https://venturehacks.com/option-pool-shuffle

4. https://blossomstreetventures.medium.com/how-long-tech-exits-actually-take-4e0de66b9443

5. https://eqvista.com/exit-timing-startups-by-industry/

6. https://carta.com/blog/state-of-private-markets-q4-2023/

7. https://dealroom.co/uploaded/2022/11/Dealroom-Global-Ecosystem-Benchmarking-2022.pdf

8. https://www.cbinsights.com/research/venture-capital-funnel-2/