Startup stock options: a beginner's guide
Rationally valuing equity for startup employees
What equity offers and contracts look like
Startup employment offers typically consist of base salary plus stock options. It's also common to have a trade-off between cash and equity by giving the candidate a choice between multiple parallel offers, such as
- 3,400€/mo base + 7,000 options
- 4,200€/mo base + 4,800 options
- 5,000€/mo base + 3,200 options
Options are stock in the company that you haven't paid for yet but have the option to buy out (exercise) sometime later for a small fee (strike price). Very roughly speaking, one option is otherwise equivalent to one share of stock in a company.
(Italicized words are standard terms you can expect to see in many places and find information about on Google.)
The norm in startups is to have employees vest their options according to a vesting schedule, typically lasting 48 months with a 12-month cliff. If you chose the middle offer above (4,800 units total), you would get no options for the first 12 months of your employment, then 25% (1,200 units) at the end of the first year, and 100 units every month for the next 36 months.
You'll get 1/48 of the option package every month, except the first year is a probation period – you'll become a part-owner of the company only if you manage to stay at least one year. Why? Because the company doesn't want to give equity to underperformers or opportunists that leave in a few months. A cliff also reduces the size of the cap table (list of company owners), which reduces admin overhead and general annoying work for the company.
Remember that stock options are usually not part of the employment contract. You'll need to sign a separate contract called a Stock Option Agreement or Option Agreement.
Contract details depend on the domicile of the company. You might be joining an Estonian company that is 100% owned by a US company (Delaware C-corp) and get stock options (restricted stock units) in the latter – that is pretty typical for Estonian startups. Or you might get stock in the Estonian OÜ, in which case the contracts probably derive from these model documents.
The legal language differs even when using model documents. You should read carefully for essential clauses like conditions where the company can take back already-vested options ("Bad Leaver" clauses). But usually, regardless of the legal system, the intended outcome is what I've described above.
How much are stock options worth?
When you buy stock in a publicly-traded company, say, Procter & Gamble, you probably expect growth at about the market average of 5-10% every year. Due to economic cycles, prices may vary by a few tens of percent. The occasional company goes bust, but the default expectation is slow compounding growth.
Startup stock returns look nothing like that. For you, early-stage startup stock returns fall into two possible scenarios:
- Worth nothing – the typical outcome.
- Worth a LOT – rare but life-changing if this happens.
It's not hopeless, but I wanted to clear the wrong intuition conveyed by the overloaded word "stock" here.
You might object that a startup could exit (be sold) at a mediocre price. For example, exiting at double the total money invested into the startup after 7-8 years would mean a stock-market-like return. But that would still be considered a failure by investors for whom only the 1-in-100 successes return the money lost on the 99-in-100 failures. And for employees, mediocre outcomes often mean their options are worth nothing due to investors' liquidation preferences. The investors get their invested money back first, and sometimes multiple times the investment. The remainder is split among founders and employees – and with mediocre outcomes, the remainder is often zero.
So how do you, personally, choose how much cash to sacrifice for a given amount of options? (By the way, I encourage you to negotiate instead of just accepting whatever offer comes your way.) We need to put a dollar value on every share of stock.
The simplest way to do this is to apply the same logic as in public markets: use the price of the last transaction. In other words, take the latest valuation, divide it by the number of outstanding shares, and you'll get the price.
Let's work through an example. A startup raised 1.8M€ for 15%, so the valuation was
1.8M€ / 0.15 = 12M€. Say there are a total of 3,500,000 units of stock, so each unit is worth
12M€ / 3500000 = 3.43€ according to the last transaction. Using the middle offer from above, your monthly total compensation would be
- 4,200€ per month in cash, plus
4800 options * 3.43 €/option / 48 months= 343€ per month in options.
To calculate the above, you need some inputs: the company's last valuation and the total amount of stock currently in the cap table. If they are unwilling to share that information, assume the option package is worth nothing – and if they want to convince you otherwise, they'll have to do it with numbers. But honestly, if they won't let you calculate the value of your stock grant, that's a huge red flag.
Now, the startup might try to convince you the options are worth more. The main argument goes along the lines of
In five years, we'll be worth so much more! So you should calculate with the valuation we'll have then, not our current valuation.
Ignore that. In the last investment round, the potential growth – and risk of failure – were already priced in. In a way, you're delegating your due diligence to the investors of the last funding round and anchoring to the price they paid, which is entirely reasonable, especially since you have much less access to the company's internals.
There's a similar argument that is more credible:
Look, we know our last-round valuation is $X, but that round closed 18 months ago. We've made tons of progress meanwhile and are closing the next round in three weeks, with a significantly higher valuation of $Y. So in calculating the size of your grant we used a number between X and Y.
I might be willing to buy this if
- I generally trust the founders,
- terms of the upcoming fundraising are clear, and closing time is near
- revenue has grown significantly compared to the last round.
The financial model above, if you can call it that, is pretty rough. You probably shouldn't care much about being wrong by 20-30%. You're trying to figure out the order of magnitude and compare offers, including different trade-offs from the same company.
A more precise model would also consider the following factors that reduce option value.
- You have worse terms than investors do – usually because of liquidation preferences.
- Time value of money – you get the last 1/48 of your grant in four years.
- Relatedly, your stock will be illiquid for years – you might be rich on paper but poor in the bank for years after vesting is completed.
- Taxes ranging from 20% to 40-50% depending on jurisdiction.
On the other hand, you get preferred access. Most of the top startups in recent years have to turn away investors (the rounds are oversubscribed), but you get access to upside in the company as an employee.
All the above helps calculate the expected value of your options, considering both the potential risk and upside. But the future will take one particular trajectory. What could that look like?
The favorable scenario for your stock is that the startup grows revenue, raises a few more funding rounds, and eventually goes public (like Wise) or is acquired (like Pipedrive). So you might find yourself thinking along the lines of:
I own 0.2% of the company now... so if our company eventually sells for a billion euros, I will have [*quick mental math*] 2 million euros in my bank account.
That's probably the correct order of magnitude, but your actual cashout will be strictly less than that. Why? Dilution. About 10-20% of the company is sold to venture capitalists in every funding round. But the new investors' cut doesn't appear from thin air. It is squeezed in at the expense of existing stockholders who now hold a smaller percentage of a larger pie.
So if you have 0.2% today, and tomorrow some investors buy 15% of the company, you'll have
0.2% * (100% - 15%) / 100% = 0.17%. Two more funding rounds like that, and your share is 0.12%. If the company now exits for a billion euros, you'll have 1.2 million in your bank account – less, but the same order of magnitude.
HOWEVER: you, today, calculating your compensation, should be considering the average outcome, not the best possible one. If you bet $50 on "heads" in a coin toss, the best result is to come out with $100, but the average outcome is still
50% * $100 + 50% * $0 = $50. Similarly, your option value estimate should roll up both the futures where the startup fails and futures where it wins big. And the easiest way to do that is to use the number that the investors of the last round used – they had more data, more time to consider, and more money at stake.
How much stock to expect
Equity compensation, like cash, varies with role and experience, among other factors. I only have a few data points from myself and my friends, so please take these numbers with a grain of salt.
If you join before the startup has raised significant money, percentages are the best guide because dollar amounts are tiny:
- First employee (engineer): up to a few percent of the company.
- <10th employee (engineer): 0.1-1.0% of the company.
Later, there tends to be some formula involved and exceptions negotiated individually. Grants are then probably calculated as a percentage of salary, kind of like a bonus. The company:
- takes your salary offer – say 4,000€;
- calculates the target grant size in cash – if offering +20% of equity on top of cash compensation, vesting over 4 years, then
48 months * 4000€ / month * 20% = 38400€;
- converts that into the amount of stock, hopefully using the last-round valuation – if the valuation is 4.52€ per unit of stock, your grant will consist of
38400€ / 4.52€ = 8496units of stock that vest over four years.
Offers of 10-30% equity on top of cash are common for engineers. Of course, top performers and critical employees can get more, and vice versa. As for concrete data, the high-stock/low-salary offers I've received have come in at 10%, 24%, 50%, and 53%. Writing this, I also asked a founder about offers in their seed-stage ~10-person startup. Mid-level engineers there can expect 75-100% equity on top of cash and senior engineers 100-150%, though the startup is also smaller than most companies I've considered.
The last step is to roll everything into total compensation by summing cash and equity. That should roughly align with your current market salary, within 10-30%. The missing chunk might be compensated by soft value: great team, mission, remote work, perks, or anything else that especially floats your boat.
Of course, there are situations where the company's offer is half of what you expect, and there is no room for negotiation. That's fine! If your market value is €8,000 and you get an offer of €3,000 cash plus €400 in stock, something is off. Most likely, the position is more junior or less critical to the company than you thought. Either way, there's a more profound mismatch than just compensation.
Making a choice
You can now compare offers! But making the actual trade-off is pretty personal. Here are a few things to consider.
- Salaries usually increase over time, especially if you take more responsibility and if the company is doing well. Equity compensation rarely increases. You might get a refresh grant a year or more into your tenure, but a) these are usually at least 2x smaller than the initial grant, and b) they vest for four years from the granting moment, which you might not want to be stuck waiting for.
- Consider your minimum living expenses, desired saving amount, and likely changes in the next year or two. Once those are covered, consider the alternatives – would you put the extra money into S&P500? Actively invest? Into a zero-interest savings account? Or would you rather invest in the same startup, which many investors are likely unsuccessfully trying to access?
- Taking more options and less cash implies betting on your success, especially as a key engineer or executive. Do you want to make that bet?
- Stock in late-stage companies, already valued at billions, offers lower risk and lower reward. On the other hand, I've heard that joining shortly before the IPO can be a good return in a few years.
As for myself, I have always been so lucky that the lowest salary/highest stock offer is enough to cover my foreseeable living costs. So I've gone for maximum equity for mainly two reasons: I don't have good alternatives for investment (I don't consider myself a great money manager), and I want to bet on my success.
Here are a few mistakes I've seen people make.
Assigning zero value to options
If you don't know how to calculate the value of an option package, I can kind of understand assigning zero value to them or thinking of options as a vague future bonus. But ignoring the value of part of your compensation is strictly irrational? I can understand sometimes choosing maximum cash – everyone needs liquidity. But doing that as a policy is just bad financial sense.
Not agreeing on grant size upfront
I've mentioned this before, but this is so important it bears repeating. As an employee, you have maximum leverage when joining because the (perceived) cost of switching jobs goes up over time. So, as part of your salary negotiation, agree on grant size in writing (an email should be enough) so that you don't have to start discussing this 18 months after joining, from a precarious position.
Related: not signing papers soon after joining
Sometimes stock option contracts might take a month or two to get signed for legal or logistical reasons. But 4-5 months is already a red flag, and more than 12 months (the typical cliff) is terrible. If you still haven't signed your option contract within two years of joining, you are in a challenging position should you want to quit. If you leave before signing the option contract, you will get no equity at all, even if some should have vested already.
Lest you think this is a theoretical issue, I know of a prominent Estonian startup where precisely that happened. I believe the one person worked there two and a half years without a stock contract. In the end, this resolved well for most employees.
But there's another startup in Estonia, slightly less known, where two separate people I trust worked for over two years. They'd been promised stock but never received a contract. In this case, unfortunately, neither person got any. It was technically legal, but the founders completely burned their reputation.
Fringe benefit taxes
This mistake is specific to Estonia: if you exercise your stock options within three years of signing, you must pay more taxes (link in Estonian). Since some contracts also have a clause where you have to exercise within three months of leaving, you might be stuck with a tax bill of thousands, or in the worst cases tens of thousands, on an asset that is still illiquid. Many Estonian contracts explicitly protect the employee against this, but be aware and ask about the tax burden should you leave before three years.
Filling in the below is a helpful way to think through the value of a stock grant.
- The grant consists of ____ options.
- The grant vests over ____ months with a ___-month cliff.
- The total value of the option grant is ____€ over the vesting period of ____ months, i.e., ____€ per month.
- The cash salary is ____€ per month.
- So my total compensation is ____ (cash) + ____ (equity) = ____€ per month.