Joining a Start-up? Use this Formula to Determine How Many Stock Options You Should Get

You’re thinking of joining a startup and a component of your compensation is in the form of stock options. How do you know what’s fair?

Most people will want to talk in terms of percentage ownership .1%, .25%, 1% etc. - but that isn't the best approach. Every company is at a different stage and valued differently. Fair percentage ownership is going to look very different if you are joining a seed-stage start-up valued at $10 million vs. a Series D start-up valued at $50 billion.  

I’ve developed a simple methodology that normalizes these variables to come up with an Annual Cash Equivalent (ACE). The idea is to determine what the value of the stock options would be worth if they were sold in the open market to an external investor. Once you know the cash value you can divide it by the number of years the stock options are vested over to determine the annual cash equivalent.

To determine the cash value of the stock options, use a stock option valuation calculator. Here is one I frequently use (pictured below).  Enter these five variables:

1.Stock Price

What is the stock currently worth as a price per share? You'll need to ask what the price per share was of the last financing round and then make your own determination as to whether the stock has appreciated in value since then. If the company is planning a new financing round in the near future, ask what the expected price per share will be - and then discount it a bit because it hasn't happened yet.

If you’re pretty certain it’s going to happen very soon then discount it 10%. If it seems less certain, but you believe it will happen, then maybe use 20%. 

Compare it to the previous financing round to assess how believable the expected financing price really is. If the last round closed in the last six months, I would just use the last round price per share.

2. Exercise Price 

The exercise price—also known as the strike price—is the price per share you would need to pay to buy the stock in the future. It will usually be at a significant discount to the stock price of the most recent financing, especially for early-stage companies. Typically, the more mature a company gets the smaller the discount is.

3. Time to Maturity

This is the number of years before the option expires. It’s often 10 years. For the purpose of the valuation, I would just use the vesting period as the Time to Maturity. In most cases this will be 4 years, but you should confirm with the company.

For the last 2, you will need to make some assumptions of your own:

4. Annual Risk-Free Interest Rate

The interest rate has a very minimal impact on the calculation - just use 2.5%.

5. Annualized Volatility

The volatility you use will have the biggest impact on the calculation and is correlated to the stage of the company. A big stable company with predictable cash flows, like Walmart, might have an annual volatility of 20%, while a riskier company like Sears might be more like 75% or higher. You'll have to use some judgement, but here is a good rule of thumb.

For a very early stage company that has only done a seed round, I would use 125%. For a company that has done its Series A and has good momentum, use 100%. After the Series B, use 80%. For later rounds when a company is doing well, 60%. 

You might need to interpolate depending on the risk and the stage. Just keep in mind that the volatility in this case is a proxy for risk, which is correlated with upside. You could always use two different volatilities to give yourself a range of values.

Once you get the price of the option from the calculator (that is for a single stock option), multiply it by the number of stock options you are being offered. Your number is the total cash market value of your potential options. If they vest over 4 years (most do), then divide this value by four to get the annual cash value equivalent.

Now you have a way of comparing an offer that is made up of cash and stock options to a cash only offer. Don't be tempted by what the stock could be worth. The stock options have a real value today. Also, note that this methodology does not consider your ownership percentage. That is irrelevant if you know what the true market value of your options are worth.

This ACE methodology can also be used by companies trying to determine how many stock options to offer new employees. I have had success using this methodology in the past. It is very helpful in keeping compensation consistent across similar people that join at very different stages of the company's life. Other methods are widely discussed on the internet and business circles and I would certainly encourage you to do your due diligence and bounce things off an experienced accountant.

Good luck! I would love to hear any questions you have regarding the methodology or any problems you encounter as you try to implement it in practice. 

An alternate version of this article was originally posted to Inc.com on February 8.