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Stock Options

February 5th, 2016
money, stock  [html]
When I was joining Adverplex (now CogoLabs) in 2010 they offered me a combination of salary and stock options. After I decided I should be risk-neutral with donation money I decided to ask for less salary in exchange for more stock. How did this work out?

Not so well. Overall I lost ~$12k in salary and ~$2k in stock, and the outcome was one I hadn't even considered in trying to figure out how to value the options.

When I was considering asking for less salary in exchange for more options I needed to decide on a valuation for the stock options so I could compare them. The CTO had told me his "target valuation is $1B," his "personal guess is $500M," and he "would be surprised if it did not come out to at least $100M". I drew up a table of possible company valuations:

  10%:  company fails, options worthless
   5%:  company sells for ~50M
  10%:  company sells for ~100M
  15%:  company sells for ~250M
  25%:  company sells for ~500M
  20%:  company sells for ~750M
  15%:  company sells for ~1B

   EV: $498M

This seemed too optimistic, so I pulled it down to:

  50%:  company fails, options worthless
   5%:  company sells for ~50M
  10%:  company sells for ~100M
  25%:  company sells for 100M-500M
  10%:  company sells for ~1B

   EV: $175M

I sent this to some friends, they convinced me this was still too optimistic, so I updated down again:

  34%:  company fails, options worthless
  10%:  company doesn't grow, options worthless
  10%:  company sells for ~$25M
  25%:  company sells for ~$50M
  15%:  company sells for ~$100M
   5%:  company sells for ~$300M
   1%:  company sells for ~$1B

   EV: $55M
I went back to the company, we negotiated back and forth, and I agreed to give up $7k/year for options I valued risk-neutrally at $9k/year. (Options for an additional 1/6,400th of the company annually.)

I started at the company, things were good, but several years later I decided to leave for Google. I had vested options for 0.06% of the company, and I had a choice: I could exercise, paying the strike price of $2,820 to turn the options into stock, or I could give up the options. My estimate of the company's valuation had gone up since I had done the initial calculation, so I decided to exercise.

Over the years I watched the company as it grew its business and brought on more employees. A small project I had worked on the beginnings of grew into a company big enough to move across the street, and the main company outgrew the area I remembered, expanding into an additional 10k sqft on the floor above. It looked like the company was doing well, and I was content to wait until it went public, was acquired, or folded.

I was surprised, however, when they sent me a letter that they were doing a reverse stock split, 90k:1. This means that for every 90,000 old shares you had, you would get one new one. They weren't allowing fractional shares, and I had far less than 90k, which meant I was forced to sell. Worse, their current valuation (~1.2M) was lower than it was when my shares were issued (~4.7M), which meant that after paying $2,820 to exercise I would be getting back just $734.

So, what went wrong? Now, I knew this was a risky option, and something I was only willing to do because I was being risk neutral, but the way it ended up not working out wasn't actually something I had considered. Looking back over the emails I sent to friends at the time asking advice, here's what I would do differently in the future when evaluating options. Not all of these are things that went wrong in this case, but knowing more they're things I would take into account:

  • When I thought about the different things that might happen to the company, they all involved it either failing or selling. But a company could stay private for a long time, with options/stock you can't sell. I wasn't applying any time discounting, where $10k received in 2010 is worth something like 1.6x what it would be worth if received in 2020. And given that this was money intended for donating, a higher discount rate than "I could have gotten a 5% real return in the stock market" might be appropriate.

  • Dilution from needing to take on additional funding isn't ideal from a shareholder point of view, but it's pretty reasonable. If the company is worth $X and takes on an additional $X in funding, then you're going to have half as many shares but they're worth twice as much. But my model didn't account for this at all, since the CTO wrote:

    Taking on an investment of capital is the likely place where dilution can occur. Our plan is to fund our growth by the sale of businesses currently under incubation, so we hope to not seek outside funding. But if this were to happen, there could be dilution. Adverplex employees are all quite aware of what dilution means to them so it's not something the company can really sneak by the employees. The most likely scenario would be that additional grants would be made to employees to bring their equity positions up and reduce the impact of dilution.
    But notice that this doesn't say anything about the handling of ex-employees. If the company took on additional funding it would need to keep current employees happy, but former employees are pretty much just people who happen to hold a small amount of stock. I should have been considering this case, discounting the value of the options accordingly. Further, the CTO wasn't committing to make additional grants, and I should have considered that they might not.
  • Very small shareholders don't have much negotiating power. I wasn't very keen on this reverse split, it didn't seem at all in my interest, but what was I going to do?

  • Valuations are pretty arbitrary, and the company has a lot of latitude to adjust based on their needs. This is especially true when the company isn't taking on external funding and instead is self-financing through revenue.

  • Since I was negotiating with people who knew much more about how this would work than I did, I should have accounted for this information mismatch by valuing salary more and stock less. Salary is simple, stock is complicated, and the more complex something is the more of an advantage experts have. Plus they knew more about the company's prospects than I did.

  • I anchored on the CTOs initial valuation numbers, and while I did update down substantially I don't think I updated down far enough given how little I knew at the time.

I feel pretty bad about this, all in all. I gave up thousands of dollars in passed up salary and exercising options, and if I had gone with salary instead that would have been money that could have done a lot of good via an effective charity.

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