https://en.wikipedia.org/wiki/Unicorn
I spent a lot of time recruiting. It’s one of the most enjoyable and energizing parts of my job. One of the key conversations I have with candidates is in the post-offer stage, where a candidate has a Qumulo offer and is contemplating whether to accept it or not. These conversations typically cover the product, engineering culture, future plans and other topics.
However, there is always one topic that is always discussed — stock options. More specifically what are they are how to value them. Before we dive into the world of options and valuations, I have to offer you a few words of wisdom
Warning: I am not a financial advisor. I am also not a tax advisor. The below is simply my own opinion.
What are Stock Options Anyways?
In finance, an option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on a specified date, depending on the form of the option. Broadly speaking there are two types of options: Calls and Puts.
Call options give their owner the option to buy an underlying asset at a predetermined price (the strike price) during the option’s lifetime. Put options on the other hand give their owner the option to sell an underlying asset at a predetermined price throughout the option’s lifetime. Call option holders are bullish about the prospects of the underlying asset, while Put option holders are bearish. Let’s walk through a very simple example that illustrates how both work.
The figure on the left shows a Call option for Apple’s stock. Apple’s stock is trading at ~$224 as I am typing this post. There are a few things to note about the option:
- Expiration date: This option will expire on 2019–01–18
- Strike Price: This is the price ($300) the owner of the option would have to pay to own Apple shares that are covered by this contract. A single options contract typically covers 100 shares.
- Option Price: This is the price ($0.42) you have to pay to buy this option contract.
The owner of this options contract is therefore hoping that the price of Apple shares will rise above $300 before the options expiration date. Assuming that sometime during that period Apple’s shares rise to $350, the option holder would stand to profit from the $50 delta between the value of the Apple stock and her strike option. Note, that the exact profit is a bit more nuanced than what I just described. I’ll spare you details about options lifetime and volatility and how they impact an option’s price. If you are keen to learn how options are priced, I suggest reading about the Black-Scholes Model.
Conversely, the chart to the left shows a Put option for Apple. This options contract is set to expire on 01–18–2019. The strike price for this option is the same as the call option we described above ($300). However, notice the difference in price between this put option and the call option from the earlier example. This options contract is priced at $93.46 whereas the call option was priced at $0.42. A holder of this option can sell Apple shares at $300 and therefore pocket ~$76 in profit by doing so. The lower Apple’s share go between now and the expiration date, the more money the option holder stands to gain. Pricing the option at $93.45 takes into this consideration the immediate profit opportunity, as well as other factors in the options price (time and volatility). Simply said, the main reason this option is priced at $93.46 is because there is no free money 🙂
Incentive Stock Options (ISO)
An incentive stock option (ISO) is a type of company stock option granted exclusively to employees. ISOs are typically granted to employees as a form of long-term compensation that allows the employee to share in the value created in the granted shares during the holding period. The value created in an ISO is typically measured by the difference in ISO strike price[1]and the fair market value of the shares a the time of sale, which is very similar to regular stock options. ISOs can confer an income tax benefit when exercised. Incentive Stock Options are also referred to as “incentive share options” or “qualified stock options.” ISOs granted to employees usually have a vesting schedule, which allows employees to earn their options as they remain employed with their company. The vesting schedule companies offer varies. However, it is not uncommon to see vesting schedules with an initial cliff following by a linear rate of vesting shares.
Let’s put all of this together in an example.
Imagine for a moment that Olarticoechea di Canio is contemplating joining Unicornia, a high flying startup. Unicornia just completed a Series-E round which valued it at $1B and has 70M outstanding shares. Unicornia offers Olarticoechea 100 options set at a strike price of $1.00. These options will fully vest over a 4 year period commencing from the date Olarticoechea starts working at Unicornia. The vesting schedule for these options includes a 1 year cliff. Olarticoechea will vest 25% of his shares at his one year employment anniversary and the remaining 75 monthly for the next 3 years.
We’ll be using this example to help answer some of the questions posed at the beginning of this post. Before we dive into my approach of valuing equity, we need to take a quick detour to discuss common shares and preferred shares, dilution and a few other topics.
Common vs Preferred Shares
Most venture backed companies have two classes of shares: common and preferred. Common shares are typically shares given to employees, while Preferred are given to investors. Preferred shares typically come with benefits which include voting rights, dividends, liquidation preference, participation rights, conversion rights and more. I’ll focus on two of these rights, as they can have substantial implications to Common shareholders.
Liquidation preferences grant the Preferred stockholders the right to be paid a specific amount of sale proceeds in priority and preference to other classes and series of stock, even if that guaranteed payout is greater than the Preferred stocks percentage ownership in the company. Participation rights grant the Preferred stockholder the right to “participate” in the allocation of proceeds granted to other classes and/or series of stock.
Sounds like legal mumbo jumbo so far. Let’s walk through an example to see how this works.
An investor buys 5 million shares of preferred stock for $10 per share for a total of $50 million. After the financing, there are 20 million shares of common stock and 5 million shares of preferred stock outstanding. The company is then acquired for $150 million. If all the outstanding shares were Common stock, each stockholder would receive $6.00 per share. That’s $150 million / 25 million shares. A hypothetical employee who held .1% of the company, or 25,000 shares, would receive $150,000 (that’s .1% of $150 million).
If the preferred stockholders had a 1x liquidation preference they would receive 1x their investment ($50 million) before any common stock is paid in an acquisition. Under this scenario, Preferred would receive the first $50 million of the acquisition price, and the remaining $100 million would be divided among the 20 million shares of common stock outstanding ($100 million / 20 million shares of common stock). Each common stockholder would be paid $5 per share, and hypothetical employee who held 1% of the company would receive $125,000 vs $150,000 above.
In the above scenario, if the liquidation preference was 3x, then the prefered shareholder would get the entire $150M. Our hypothetical employee who held .1% of the company would get $0.00. Liquidation preferences can destroy common shareholders.
Most startups do not disclose their liquidation preferences to prospective employees. You should absolutely ask about those before accepting an offer from a startup. That 1% ownership that you think you have, might after all be 0%.
Participation Rights enable an investor to participate in any remaining upside beyond what they recouped from their Liquidation Preference. Without Participation Rights, Preferred stockholders must choose to either receive their Liquidation Preference or participate as a Common stockholder in the division of the full acquisition price among the all Common shares (the upside).
If the Preferred Stock also had Participation Rights, they would receive their Liquidation Preference and have the right to participate in the distribution of the remaining proceeds. In our example with a 1x Liquidation Preference but adding a 1:1 Preferred to Common Participation Right, the Participating Preferred Stock would receive their $50 million Liquidation Preference and 20% (5 million shares/25 million shares = 20%) or $20 million of the remaining $100 million of the acquisition price equal to their % ownership in the company. As this example shows the Preferred stockholders who only owns 5 million of the 25 million total outstanding shares would receive $70 million in proceeds; 47% of the total proceeds.
Non-Participating Preferred typically receives an amount equal to or greater than the Preferred stockholders initial investment upon a liquidation event; the Liquidation Preference. Holders of Common stock then receive the remaining assets. If holders of Common stock would receive more per share than holders of Preferred stock upon a sale or liquidation, then holders of Preferred stock should convert their shares into Common stock and give up their Liquidation Preference in exchange for the right to share pro rata in the total liquidation proceeds.
Non-Participating preferred stock is favored by holders of Common stock because the Liquidation Preference will become meaningless after reaching a transaction value where Common stock value exceeds the value of the Preferred stock. Non-Participation is what you want as a Common shareholder.
The table below shows the outcome of various scenarios for the fictitious company mentioned earlier (5M preferred shares and 20M common shares). These outcomes are based on various acquisition prices and preferred privileges.
The cleanest terms and ones that are fairest to Common Shareholders are ones where Preferred have Non-Participation Rights along with a 1x Liquidation Preference. This means that Preferred Shareholder either get to exercise their Liquidation Preference (think of this as the floor) or convert their shares to common and give up their Liquidation Preference in exchange for the right to share pro rata.
Make sure you ask about Preferred rights before you accept an offer. I highly recommend you read more about this topic here.
Valuation
We now get to the heart of this note, which is valuation, or how big do I think Unicornia can become. When I think of valuation I look at four main attributes: industry, margins, growth and total number of shares outstanding (i.e dilution). The first three try to estimate the size of the pie, while the last one estimates the total slices in the pie.
Location, location, location!
Industry is what location is to real estate. It matters. A lot.
The picture to the left shows what $500K can buy you house-wise in Nashville vs Seattle. There’s a stark difference between both! The industry a firm competes in is incredibly important for its overall success and valuation. A commoditized and low margin industry (e.g. airlines) won’t be as rewarding as one with fewer competitors and rich margins (e.g. software). Let’s look at a more concrete example.
The table below compares the valuation — based on September 14th 2018 prices — of various publicly traded companies in different industries.
First a few definitions.
- TTM stands for trailing 12 months i.e. the preceding 12 months.
- P/TTM is a valuation metric, much like the dreaded and utterly useless P/E. This ratio looks at the price per share relative to the sales generated over the trailing 12 months (on a per share basis).
- Gross margin for the TTM period. The industry definitions are as per the GICS
The first industry is “Technology Hardware, Storage & Peripherals”. Companies in this space make most of their money by building and selling hardware appliances. The other industry covers the “Software” and “Internet Software & Services industries”. All of the companies below make most of their revenue by selling their products to the same segment: large enterprises. They likely share the same customers, however their valuations are quite different.
You will notice a few things. First, the P/TTM is much higher in the “Software” and “Internet Software & Services industries” vs the “Technology Hardware, Storage & Peripherals”. Ditto for the gross margins. A manifestation of this is that every $1B in sales generated by Pure results in ~$6.7B more in market cap vs $12.6B for Splunk. The market is rewarding these companies differently due to many factors, one of which is the industry they compete in. A highly competitive industry like hardware peripherals commands lower premiums than the enterprise software industry.
Knowing the industry of the company you are considering joining allows you to evaluate how the market rewards some of its peers. This would be similar to you looking at houses next to the one you want to buy for comps. However, much like adjacent homes are not created equal so are companies in the same industry. For example, Nutanix and Pure are in same industry, yet Nutanix’s valuation metrics are higher than Pure’s.
What this market data will give you is a range for market cap at a successful outcome.
Growth and Business Health
Here you are trying to get a baseline on the health of the business. You should get a decent understanding of the product(s) the company sells, who buys them, why they do and who do they compete with. Try and get a good understanding (and data) about the company’s revenue and margin trends over the past year. What sort of projections does the company have over the next 12–24 months. This will give you a sense of growth and health of the company’s business.
A word of caution though. It is not unusual for startups to have a very volatile and choppy ride. Not all startups have an “up and to the right.” Don’t believe me. Take a look at the chart above which shows the highly cyclical profitability trend for a well known public company. Would you have joined this company in in 2006?
You better have. Amazon went to do quite well since then!
Projecting Future Outstanding Shares
The last piece of the puzzle is trying to estimate the total number of shares outstanding at the time of a liquidity event (IPO or acquisition).
Everytime a company raises money it does so by exchanging the money it raised from investors with shares (typically Preferred). Effectively companies print new shares and exchange those for money from investors. The introduction of these new shares results in dilution to existing shareholders.
For example, let’s assume that BubbleMania has 100 outstanding shares, each valued at $1 and that one of its employees owns 1% of the company. BubbleMania raises a $20 round by offering its investors 10 shares bringing the total outstanding shares to 110. As a result of this new funding round, our fictitious employee no longer owns 1% of BubbleMania. His share is now ~0.9%. In this particular scenario, having his percent ownership drop from 1% to 0.9% isn’t necessarily a bad outcome to our employee. He has seen the value of his shares go from $10 to $20. The value of his shares doubled even though his percent ownership dropped by ~10%.
Try doing that exercise with a slightly different scenario: BubbleMania raises $20 by offering investors 200 shares bringing the total outstanding shares to 300. Ouch.
When trying to project the total number of outstanding shares, you are effectively trying to assess how much more capital the company will need to raise and at what cost (dilution). That’s a very difficult problem as it depends on so many factors: cash burn, rate of growth, margins, operating model and so on. My advice is to start by looking at how much capital the company has raised lifetime to date and the dilution per round. Then you will have to make some reasonable assumption on how much capital the company will need and the implied dilution per round. You could look at comparable companies that went public. For example, if the company’s main competitor raised $250M before going public and the company you want to join has raised $100, then perhaps they might do one more round.
Let’s go back to our friend Olarticoechea.
He did his due diligence and decides that he will create a simple NxM matrix like the one shown below that models various valuation and outstanding share outcomes. The x-axis in this model shows valuations for Unicronia ranging from $2B to $10B. I am feeling bullish about Unicronia and am already assuming that it will be at least a $2B company. Similarly, the y-axis tracks a range for the total number of Unicronia’s outstanding shares starting from the present figure of 70M up to 100M shares. Each cell in the matrix represents a per share price for a particular scenario. The juiciest outcome would be $10B at 70M shares or $143/share. The least favorable of the scenarios below would be $2B at 100M shares which nets at $20/share.
Olarticoechea’s offer of 100 Unicronia shares would range from $2000 at the low end to a cool $14,300 at the upper end of his model.
Putting it all together
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