Is it common to value startup equity on future expected valuations?

Question

Disclaimer: The numbers are made up, but reflect the real proportions.

I was offered a job at a startup, which just closed a financing round with $10M valuation and has 10M outstanding shares. The offer included 25k options vesting over 4 years (25% vest per year, 1-year cliff). The strike price is $0.1.

According to the startup equity calculator and taking the current $10M valuation as expected exit value, these options should be worth $24k in total.

However, my potential future boss has told me that the offer is the equivalent of $10k per year flowing into stock options and are thus worth $40k in total. His calculation was as follows: The next 2 years, the valuation is $10M and and a fictive $20k flow into stock options, making up 20k of options. In 2 years, there will be the next financing round at about $40k valuation. Then another $20k flow into stock options, adding another 5k of options. Thus over 4 years, a total of fictive $10k per year have flown into options, thus this salary component has a value of $10k per year.

My question is now: Which of the two calculation options reflects the value of the stock options better? Is it common/good practice to evaluate the stock option offer not based on the current valuation but some future valuations in a next financing round?

My question differs from the following one because I am offering 2 potential evaluation methods: What are the questions to ask a pre-seed start-up in order to understand the value of the offered equity?.

Answer 1

Options in a startup are a lottery ticket, and should be treated as such. You'll either hit it big, or make literally nothing. There is some in between, but it will be a small bonus at most if you don't hit a home run. I evaluate them as worth 0, then decide whether the extras I get for working at a startup (freedom to do things the way I want, being more important to the success of the company, working on more interesting things, etc) are worth the money I'd miss working at a big corp. And that answer can change depending on where you are in life. Right now I'm cashing out for a few years, but I could see myself returning to startup land when I've socked away some more money.

Please note that there are a LOT of games that can be played on stock options. THe biggest one out there right now if investors getting a multiplies (they put in say 5M but get 10M back on sale BEFORE calculating everyone's percentage based on shares). My last startup has I think around 20M invested but needed to sell for 40M to give any of our options even a penny. So don't assume even if you own .1% of the stock (a common offer to a senior engineer at a series B or C company) that it will get you .1% of the sale price. You'll make less.

Also don't assume the number of shares you find is accurate. Investors may have put in convertible notes, which convert to shares, which means there's a bigger pool then you know

Answer 2

In 2 years, there will be the next financing round at about $40k valuation.

Your "this is my potential boss's argument" section is rather confusing, and I'm not sure how much of that is inherent to his argument and how is in you trying to recreate it. I take it you mean "the next financing round will be such that the stock I have options to will be value at $40k"?

Outside investors clearly aren't convinced that the company will be valued at $40m; if they were, they wouldn't have been able to buy it at a $10m valuation, as they would have been outbid by investors buying in at a $40m valuation. Now, your potential boss may be in a better position to evaluate the company's value, but he also is more subject to cognitive biases such as confirmation bias, and has a strong interest in the company being valued as high as possible.

So, there's a relatively objective evaluation of the company at $10m, and a highly self-serving evaluation at $40m. Is it standard/good practice to allow companies to set their own valuations? No. Also, keep in mind that even that the $10m is based on a highly diversified portfolio. Unless you have a large net worth, the combined risk of having both your job and your stock options relying on the same company is going to make this a large, undiversified part of your portfolio. Gabe Sechan compared them to lottery tickets in their answer and concluded that they should be treated as being worth zero, but I wouldn't go that far. Everyone has a different risk discount rate, but most people don't have a 100% discount rate (and the $10m valuation is after the investors have applied their own risk discount rate).