How much is your startup lottery ticket really worth?

And when is that IPO really happening?

It’s time to talk about timing. When people get job offers, they often are accompanied with all of these opinions about how to estimate the value of these options. You might get spreadsheets from a recruiter, you might vague answers. I recommend you educate yourself and question the opinions of the people trying to sell you. They might be earnest, for sure, but I always evaluate the quality of the data I’m receiving, and formulate my own opinions. We’ve covered basic options details and how taxes and exercising options works in previous posts. This time, we’ll discuss how to think about how much your stock is worth, and how far away that IPO really is. 

Understanding Your Stock Value Over Time

Valuations of privately-held companies work a lot differently than public companies. Publicly-held companies benefit from efficient markets where information flows freely and there is always a buyer on the other side to purchase a share offered by a seller. Public market stock prices change second-by-second, whereas private valuations and private stock prices may stay the same for months or years at a time. The most frequent reason for a price movement in a private company’s equity is due to a financing round.

Companies who want you to work for them will often be enthusiastic about the future value of their stock, offering ideas of what your stock might be worth with billion-dollar valuations. The reality is that most companies never make it that far, and the mechanics of stock values are more complex than just that.

When a company takes a round of funding, a set of investors buy stock at a particular price, and the company issues new stock to sell to those investors. This is a really important concept to understand: the company creates new stock out of thin air, and sells that new stock to the investors. This is called dilution.

Most major investors won’t invest unless they can get significant skin in the game, usually to the tune of about 20% of the company (though if your company is doing really well or really poorly, that amount can be much more or much less). This means that every time your company gets a big bump in valuation, it’s usually coming alongside a bit of dilution, so if you previously owned .1% of a $100M company, you might now own .08% of a $200M company. This is still a good thing for you. Your stock was previously worth $100,000, and now it’s worth $160,000. That said, when the value of the company doubles, it’s extremely unlikely that your stock value also doubles. You just have a smaller piece of a larger pie.

IPO is just around the corner

It’s pretty common for companies to talk about how they’re pre-IPO, but they’re growing at such a fast clip that the IPO is just around the bend. This is generally not true, and growth curves vary wildly from company to company. Oftentimes, when VCs are looking for the fastest growth companies, and the quickest path to IPO, they’ll talk about 3-3-2-2-2 (triple, triple, double, double, double).

What this is is a representation of the company’s annual recurring revenue growth each year, which produces that nice hockey-stick looking chart that VCs salivate over. By tripling twice, and doubling three times, companies will reach north of $100M in ARR within 5 years. For example, if in your first year of sales, you do $2M in ARR, next year you target $6M, then $18M, then $36M, $72M, $144M, and then you IPO (maybe). This is the growth curve taken by the best companies in the world. It is extraordinarily rare for companies to actually manage to hit this growth rate. It’s basically a lightning strike, and it’s almost certain not to happen for you if you join a company before the C round or so. Even at the C round, it’s hard to spot some of these companies, and promising companies can still falter.

Increasingly, companies are staying private longer (case in point: Airbnb took 12 years to IPO and Stripe remains a wildly-successful private company at 10 years old), so even if you get to these points, it might be a while before you see liquidity. That said, companies that see that much success often have tender offers or other mechanisms for early employees to take some money off the table, but it’s not something you can easily bet on. Getting to an IPO is a huge effort that extends beyond just hitting revenue targets — companies need to be hitting critical KPIs, show predictable growth. Frankly, luck and timing have a lot to do with it, too. We’ve already seen multiple IPOs put on pause in the past year (Roblox and Affirm both delayed), because of frothiness in the markets. No intelligent crew is going to set sail in the middle of a storm, and the IPO markets are very similar — you wait for calm waters.

The right thing to do is, when evaluating an offer, get details about the revenue for the last couple years, and ask about expected forward revenue. Depending on how badly the company wants to hire you, you may or may not get a ton of information, but if you don’t at least ask for it, you’ll never get it.

How many funding rounds will it take to get to an exit?

This is a key question to answer if you really want to understand the value of your stock. As we’ve mentioned earlier, each funding round will typically dilute the stock pool by about 20% (if your company isn’t doing well, this number may be much higher than 20%, and if you’re doing extremely well, it could be less than 20%).

Companies typically raise enough money to get themselves 18-24 months of runway. Again, not a hard and fast rule, but it’s generally on the order. So if it typically takes somewhere between 7-9 years for a company to IPO, you can imagine that companies are going to take somewhere around 4-6 rounds of funding during their lives as private companies. Some companies, like the Airbnbs, Facebooks, and Stripes of the world, stayed private for very long times, and so took even more rounds than that.

If we assume that a company will take 8 years to get to IPO, and you started at the company in year 3 of its life (probably somewhere around the B round), it means you’re likely to see 4 more rounds of funding before liquidity. So if you started with .25% of the company in year 3, by IPO you’ll probably have

.25% X .84 = ~.1% at time of IPO

But again, .1% of a big pie is still a big chunk of money, and way more than .25% of that small pie you started with.

What if you get acquired?

A ton of different things happen in situations where you get acquired. Acquisitions are also one of the arenas where that whole preferred stock versus common stock thing becomes really important.

In a best case scenario, an acquirer comes by, says you look like a nice company, I think I’ll buy you, and offers a price that is much larger than what your company is worth today. In this case, they may offer to buy the company with stock, or cash, or some combination of the two. What happens in each situation is slightly different:

• All Cash: This is pretty simple. The acquirer pays some amount of money per share, and all of your owned stock, and vested options automatically get exercised and sold off for the predetermined price. Any unvested options will typically convert at some ratio to acquirer’s stock, and you’ll continue vesting. Congratulations!

• All Stock: In this situation, the acquirer determines a conversion ratio of their stock for yours. If the ratio is 2:1, you’ll likely get one share of the acquirer’s stock for every two shares of yours (or two of theirs for one of yours, depending on how the ratio is written). This applies to all exercised shares, vested but unexercised options, and unvested options (which continue vesting). Congratulations again!

• Part Cash, Part Stock: Unsurprisingly, this is a combination of the two above. Some percentage of your shares get sold for cash, some percentage convert. Still congratulations!

If the company has not done well, you might run into situations where the price being paid is very close to the current value of the company, or possibly even less than the current value. This where a particular detail of preferred stock comes into play. Oftentimes preferred stock comes with a contractual feature called liquidation preference. This is typically defined as some multiple of the price you have paid for the stock (1x, 2x, etc.), and the company basically says: we’ll pay you out up to your liquidation preference multiple before we pay out proceeds to any of the common stockholders in an acquisition. Usually, preferred stockholders have to make a decision: they can either receive proceeds up to their liquidation preference, and then nothing more, or they can convert their shares to common stock, and receive the same per-share price as common stockholders for all their shares. If the stock has highly-appreciated, preferred stockholders will usually convert to common shares, because they make more money that way. But if the company does poorly, or they have a really high liquidation preference multiple, they may choose to get paid out first, because they get made whole on a poor investment before any of the employees do. 

As an example, let’s say a company is worth $10M, an investor owns 20% of the company (purchased for $2M) at 2x liquidation preference, and the company gets sold for $15M. The 20% of the $15M company is worth $3M if the investor converts to common shares (and the employees share the remaining $12M), but if they retain their liquidation preference, they’ll actually get paid out $4M, and the employees share the remaining $11M. If the company had sold for $20M (or anything over $20M), however, the investor’s liquidation preference would result in a return equal to or more than what they would get if they converted to common stock (the breakeven is at $4M), so it’s in the investor’s best interest at that point to convert.

This is precisely why investors pay a much higher price for preferred shares, and why that FMV is often so much lower than the preferred price after a round. Tough noogies, employees. 

What is the company actually worth?

Ok, so here’s the hard part. If you know how the future value of the company, calculating your payout is a little work, but far from infeasible. However the the real question is: how much is this thing actually going to be worth? That’s a super hard question to answer, and I’ll suggest some approaches you could use, but all of this is an inexact science.

Ignore private market valuations (for the moment): The private markets are extremely frothy right now. Valuations are crazy high, even at seed stages, and those valuations often won’t align well with what companies can actually fetch in an acquisition or on the public markets. They’re useful guiding numbers, because VCs are saying they think that these companies will be worth this much in the future, but companies typically have to grow into their valuations. Ask yourself: have other companies actually realized these valuations? (I’m using realized in the financial sense: has a acquisition or an IPO happened at valuations like the ones in your market)

Look at comparables: Comparables are a finance term for “stuff that looks like this thing.” Oftentimes when you see stock analysts talking about a particular stock’s potential value, they’ll point out other companies in the same sector, or even selling very similar products, and compare their metrics to one another, to get a sense for “how does this scale?” Comparing to other private companies is difficult, since most of their metrics will not be public, but if you have close private competitors, look at what kinds of valuations they got in their fundraising (the secret here to always finding a valuation is to have a VC friend who has access to Pitchbook). If there are public companies doing what you do, look at their PE (price/equity) or price/sales ratios, which can help you figure out a multiple that you can apply to your own company. Often times a sane range for a price/sales ratio is in the 10–20 range (for software, at least…other sectors can be wildly different). 

Assuming a 10x price/sales multiple, if your company is doing $20M in ARR (annual recurring revenue), your company is probably worth about $200M–$400M in a sale, depending on continuing growth trajectory. That said, to my previous point on private market valuations, you’ll probably see funding rounds with much higher valuations attached. Take them with a grain of salt.

That said, it’s probably not in your best interest to go out seeking a “fairly” valued company to work for. The VCs make big bets on the ones they think have the highest likelihood of reaching escape velocity, so to speak. They’ll overpay for the companies with the best metrics and growth, so sometimes you just have to accept that you’re going to get on the ride with a company that is overvalued, in order to take advantage of their successes later on. It’s all a balancing act of risk and reward in the end.

Thinking Holistically

With any luck, this information will give you some of the tools necessary to really understand the value of your stock today, and what it might be worth tomorrow. The reality is that stock options are a much more complex financial instrument than most startup employees realize, but in the best of circumstances, it can generate huge wealth for startup employees.

That said, it’s important to recognize that startup equity is, in many cases, a lottery ticket, and a lot of those lottery tickets come up short. A software engineer at a Series C company may get a $150,000 salary and another $150,000 in stock options, but the total compensation per year may never amount to more than $187,500, and even that would be a better outcome than many startup employees will see. Startups aren’t for everyone, and if you’re just in it to make a lot of money, you may be better off at a FAANG with a much more guaranteed outcome.