In my previous jobs with early stage startups, ESOPs were always a significant portion of my total compensation. Till a few years ago, I had no idea how to value ESOPs as part of my total salary package. Should I take a salary cut and compensate that through a higher ESOP package? I had read so many stories of startup employees striking it rich when startups went IPO or got acquired for millions of dollars, that I never bothered to understand the intricacies of valuations, ESOPs etc.
I was recently having a conversation with an ex-colleague who was struggling with something similar. He wasn’t sure whether he should settle for a lower pay and get a higher upside on ESOPs to make up for the lower pay. Here’s what I shared with him.
ESOPs in Early to Mid-Stage Startups
It’s not uncommon for founders of early-to-mid stage startups to paint a rather optimistic vision of the future to their employees. ESOPs worth a few thousand dollars today would magically turn into millions of dollars a few years later. And given this vision, founders manage to convince their employees to take a pay cut of anywhere from 20% to 50% of their market salary.
Should you take that pay cut? Absolutely not. In my opinion, you should ascribe zero value to your ESOPs as an employee of an early to mid-stage startup. At least in so far as negotiating your total compensation is concerned.
Hoping to strike it rich one day through your ESOPs is a bit like buying a lottery ticket and expecting to win the lottery. This might sound rather pessimistic but the odds are slim in both cases. If the payday happens one day, great. If it doesn’t, so be it. You shouldn’t be taking a lower salary today hoping for that pay-off many years later. There are so many people who put in years of hard work but never get there. The outcome really is the proverbial pot of gold at the end of the rainbow.
And even if you were to get to that liquidity event, how much do you really stand to make as an employee holding ESOPs? Let’s say the startup gets acquired for $100 million. Say that the founders make $50 million, investors make $40 million and the remaining amount of $10 million is for the employees holding ESOPs. As one of the earliest employees you end up making $500k. Was it really worth putting in the blood, sweat and tears over many years when the monetary outcome is outlandishly stacked in favor of the founders? You would have probably made that much money anyway by working in a large company over 2–3 years.
Of course, if the startup goes IPO or gets acquired for a few billion dollars, then everyone stands to make considerable money. But how many such success stories do we know of?
My learning has been that you should never compromise on the cash component of the salary as an employee of an early stage startup. You should strive to take 100% or more of the market pay and also get that upside of ESOPs. However, if learning is the main objective of joining an early stage startup, then it doesn’t matter whether you are compromising on the cash component or not. You’re in it for different reasons.
ESOPs in Late Stage Startups
Joining late stage startups significantly reduces the risk of not striking a payday. However, if the payday were to happen, the returns will never be as outsized as that of an employee who had joined in the early stages
Let’s say you’re joining a late stage startup and you’ve been told that the ESOPs allocated to you are worth $X today. When you’re trying to understand your total compensation i.e your salary and ESOPs, it is important to think about how much the ESOPs could be worth in a few years time. You could make 2X, 5X or even 10X in a few years time. Perhaps, for late-stage startups, it makes sense to negotiate more on getting a higher upside on ESOPs than the monthly salary.
So how do you understand the future value of these ESOPs? At the very minimum, it is important to know the valuation of the company at which you’ve got your ESOPs. Say the current valuation is $500 million. Do you see the valuation of the company increasing by 10X from $500 million to $5 billion in a few years? If yes, then it might be safe to assume that your $X of ESOPs would result in a $10X payoff someday. If not, then you should stop ascribing 10X value to your ESOPs. While it seems obvious, I’m just surprised at how it isn’t obvious to a lot of folks (including an ignorant me from a few years ago).
Of course, there are many parameters that determine the valuation of a startup. I don’t intend to discuss how valuations are done. But a simple understanding of the mechanics of valuations will go a long way in being more knowledgeable about how you can value your ESOPs. It is important to understand factors that drive valuation such as the historical and expected future growth rate of the startup, valuation of other companies in the same space and how it increased over time, whether the market being addressed is really that big that it justifies a large valuation etc. And based on this limited understanding — if you don’t see the valuation of the startup increasing by 10X, then don’t factor in the 10X value to your ESOPs. If you think a 2X or a 3X is a more likely scenario, then value your ESOPs accordingly and negotiate accordingly.
So far I’ve discussed how to ascribe a value to your ESOPs as part of your total compensation. I have ignored a number of other things you should know to understand how ESOPs work as that wasn’t the topic I wanted to address. As an employee holding ESOPs I think it’s pertinent to get familiar with terms such Outstanding Shares, Exercise Price, Fair Market Price, Current Valuation, Vesting Schedule, Cliff Period, Expiration of ESOPs, Tax Implications on Exercising ESOPs etc. All of this might sound boring but a simple 15 minute reading will place you in good stead in truly understanding how ESOPs work.
I found these two articles helpful in knowing the basics of ESOPs: Things you should know about stock options before negotiating an offer and An engineer’s guide to stock options. For a more detailed reading, check out The Holloway guide to equity compensation.