Startup Lottery Tickets

TL;DR - You are not going to get rich at your startup. Well, you might, but the odds are about as good as winning the lottery. (So don’t make THAT the reason you go work at a startup)

Edit: If you want to skip this most and learn more about how startup equity works - check out this awesome Github repo: https://github.com/jlevy/og-equity-compensation

This whole thing started when I saw a blog post titled “Advice to Grads: Join A Winning Startup”. It’s not a bad blog post, but I was immediately turned off by the title, “Join a Winning Startup”. So simple right? Just go pick a company that is going to be a huge success, and go work there, make millions on your stock options and retire by the time you’re 40.

Luckily in another post the author tells you how to analyze and pick one of these winners.

Now that you have your target domain, geography and stage, focus on picking out a few winners - the hot companies that everyone thinks has great momentum and potential. After all, why would you want to work for anyone other than the absolute hottest company in a given category? How does an outsider figure out who the winners are in a given domain, market and stage? Ask a handful of insiders. Find the top 3 VCs, angels, tech lawyers and headhunters in your target geographical market and ask them for the two or three hottest companies that match the domain and stage you are interested in. Compile this list, pressure test it, and see what patterns you find. The firms who get the most mentions with the most compelling underlying evidence will naturally rise to the top.

Again, this isn’t bad advice, but the problem lies in the fact that all the people you are supposed to ask about the HOTTEST STARTUP are likely going to be wrong. The VC returns over the past 10 years shows how incredibly hard it is for the experts at Venture Capital firms to pick winners. According to Cambridge Associates, the 10 year VC return is about 10%, compared to the S&P 500 at about 7.5%. That 2.5% might look good to some, but I don’t think that comes even close to compensating the LP’s (Limited Partners a.k.a “The Money”) for the added risk that comes with investing in early stage businesses.

So - let’s say you follow the very rational advice given above to pick your startup. You need an amazing run of positive events to occur in order for you to have “a huge win” on your stock options. Let’s take a look at a recent example of one (extreme) scenario where those hard earned options could go bust.

Spotify Raises $1 Billion in Debt Financing

The fact that a large “startup” is taking a huge fundraising round should not be new to anyone who’s been paying attention. We’ve seen many other large companies raising huge private rounds. Even the fact that they are taking a debt round shouldn’t be shocking. Companies are going to go where the money is at, and for Spotify the best terms they were able to get on additional fundraising was clearly using this convertible debt option. The reason this news has been making the rounds in various tech publications is because of some painful terms in the deal.

In addition, TPG and Dragoneer are permitted to cash out their shares as soon as 90 days after an IPO, instead of the 180-day period “lockup” employees and other shareholders are forced to wait before selling shares, the people said

Take the scenario that you are an employee at a startup who has vested stock options. In this simplified example, when the company goes public you are unable to exercise your stock options (sell them on the open market), until a 180-day period of time called a “lockup”. If there are more sellers than buyers to a stock, then the price will go down. If someone has the ability to offload lots of shares before you, its likely (but not guaranteed) that the share price will be pushed down as a result.

So - those stock options that you have been coveting for years and hoping they turn into millions? By the time there is a market for you to sell them in, and the lockup expires, the share price could be down dramatically. So instead of ending up a Dot-Com Millionaire, you’ll end up a Dot-Com Thousandaire (maybe). In the case of Gilt Groupe you could just end up with nothing, or worse a tax bill for exercised options that now have no value.

So, stock options are bullshit?

No - definitely not. There are lots of ways you can make money on them, the problem is that there are MANY MANY MORE ways that you can get screwed on them, things that are 100% out of your control.

Here are a couple examples of things that 100% definitely did not happen to me or my stock options at any point in the past. Any usage of “I” or “Me” is for storytelling purposes only.

Fake Scenario 1: Start at a company where I have a stock option grant of 0.75%, this was calculated based on the number of shares granted divided against all outstanding shares (numbers your CEO or CFO should be able to tell you). The company works hard to bring on big customers and partners who are using the product. The CEO makes a mis-step on the timing for the B round fundraise, we reach the end of the month and on Friday are literally out of money. We go to our existing investors with our hat in hand. Needless to say the worst time to ask for money is when you’re locking the doors if you don’t get it.

End Result: Massive dilution in the option pool. Meaning (simply), many more shares have been created/issued, yet the value of the company value did not increase. We had to get sold for a few hundred million dollars for anyone to make money on their options (they didn’t).

Fake Scenario 2: Work at a company for a while, living thru the ups and downs normal of startup land. Inevitably we reach the point where its time to fundraise again. Yet the company hasn’t increased their revenue enough to justify the valuation for the amount of money they want to raise. So in this scenario the venture firm does a ‘participating preferred multiple’ as part of their investment. There are people smarter than me who give great descriptions about what “participating preferred” is, so I’d recommend you read their posts. The very simple definition is the money that comes off the top in the case of an exit. For example: if I invest 20mm at a 1x multiple, and the company gets sold for 100mm, I take 20mm of the top then I split the 80mm with the other shareholders.

End Result: Company takes large investment at a 4x participating multiple. Would need to get sold for about 500mm for common stock to have any value at all (They didn’t).

So what does this all mean?

Don’t go work at a startup because you think you are going to get rich (you won’t). Don’t go work at a startup making significantly less than market rate salary just to get stock options.

Go work at a startup because you like to learn more than just a single part of your job.

Go work at a startup because you like the speed at which things can change day by day.

Go work at a startup to have an incredible amount of impact on the success of your organization.

Go work at a startup to have the chance to build something from nothing.

Go work at a startup because the amount of experience you can gain during just a few years will be FAR MORE than a the same time working at BigCorp.

Just don’t go under the impression that you will “strike it rich”, the odds are stacked against you in far too many ways.