Valuing startup equity

The standard answer is that you should value startup equity at \$0.

This is dumb and obviously wrong. No one values their startup equity at \$0. Here’s how to check: ask someone if they’ll give you their startup equity in exchange for \$0. If they won’t, they value their equity at more than \$0.

Maybe ask them if they’ll give it up for \$1? They still won’t, so they must value it at more than \$1. \$1,000? For most people, still no. \$1,000,000? For a lot of people, yes.

I’m being cranky; I get that the ethos behind “value startup equity at \$0” is something like “don’t expect that your equity will be worth anything” or “there’s a high, probably >50% chance that your equity will be worth \$0”.

This is true, but “value your equity at \$0” is a bad general way of phrasing this. When you’re trying to see if you can afford to buy a house this year, yes, startup equity is worth \$0. If you’re trying to decide if you’re being shafted by accepting 0.001% equity in a startup you’re set on joining, startup equity is not worth \$0.

Break-even valuations

(The rest of this post is mostly about VC-backed startups.)

In general, you value equity based on how successful you think the company will be. I try to look specifically at opportunity costs and break-even points:

For example:

On the other hand, if the company offered you:

Similarly, if they kept the equity at .01% but raised the salary to:

At \$180,000, you’ve already broke even, because at that point you have “no risk”. Of course that’s not quite true, a startup is always going to carry more risk than a stable company (i.e., that you’ll lose your job suddenly).

This model isn’t perfect, but I like it, mostly because it boils down to a single number (the break-even valuation) before having to introduce any probabilistic reasoning. It doesn’t tell you anything about how to decide if a company is actually going to be worth \$X, but at least quantifies the situation in a way that I think makes things more accessible and easier to reason about.

The break-even valuation is what people are calculating when they infer valuations based on venture capital investment. If a VC invests \$X for Y% of a company, their “valuation” of the company is \$X / Y%. A startup employee’s “valuation” in this way is almost always going to be way higher than the VC valuation (the VC is getting a better deal than employees).

One thing I skipped: usually, startups aren’t giving you shares directly but are giving you options: the option to buy a share at some set price/share \$X, the “strike price”. You should in theory factor this into your math, but the opportunity costs are usually so much higher than the strike that it doesn’t change things too much.

Dilution

Dilution unfortunately complicates things.

When a company says they’re giving you X%, what they mean is that they’re giving you an amount of shares that, as of right now, represents X% of the company. But the total number of shares can increase over time, which means the % that your shares represent goes down.

The main way new shares get created is during fundraising: the company wants money from investors, investors want shares in the company, so the company creates new shares to give to the investors.

How much you get diluted, then, has to do with:

  1. How much money the company needs/wants.
  2. How highly investors value the company.

Which are both probably related to how well the company is doing and how old it is.

My rule of thumb has been to just to assume some ~standard amount of dilution per round, and make a guess at number of rounds to exit. 20% per round is a figure I’ve heard. I once found a site that had some more concrete data on this… I’ll be sure to link to it if I ever find it again.


- alec, May 26, 2020