By Peter Schmidt-Nielsen

Against “you should treat equity as worthless”

A common refrain I hear when folks talk about evaluating offers from start-ups is “you have to treat the equity as worthless”, and also to treat equity in larger companies as being basically volatile (i.e. worse) cash. In this post I’ll argue that not only is $1 of equity1 in a job offer worth more than $1 of cash, but often by quite a lot, due to hidden optionality. Further, I’ll argue that this holds at large public companies too – if Google lets you pick between $x cash and $x stock compensation (with a number of shares fixed up front), the stock package is worth noticeably more in expectation.

The high-level tl;dr is that when you’re given a job offer that says “you vest $400k of equity over 4 years” that structure is actually a call option on the company’s stock, struck in your time – you “exercise” this option by choosing to stay at the company if it’s going well (buying stock with your time at the pre-agreed strike price), vs quitting if the company is going poorly. The optionality part of a call option always has non-negative value, so this hidden option can potentially add quite a lot of value to your comp package.

Toy model

Here’s a toy model to demonstrate the point. Imagine there are three kinds of companies: immature companies, mature good companies whose stock is worth $3/share, and mature bad companies whose stock is worth $1/share. An immature company turns into a mature company after one year, with a 50:50 chance of being bad or good. Thus, the market price for an immature company’s stock ends up at $2/share. (I will neglect a lot of time discounting in this discussion, because it just complicates the math without affecting the conclusions, but you can add it back in if you want.)

You are about to join an immature company, and you are offered either:

  • $200k/yr of cash and no stock, or
  • no cash, but $200k/yr of stock (as 400k shares vesting over four years).

Which package do you take? We’ve stipulated that the stock is rationally priced at $2/share, so assuredly these offers have the same EV. And in fact you probably have diminishing marginal utility in dollars, so the lower variance comp package should be higher expected utility, right? Wrong, because the stock package is a call option which has additional value! It’s literally higher EV in dollars!

To extract that wealth, let’s examine two strategies for the next four years of your career:

  • You take the all-cash package, and work for four years. You make $800k.
  • You take the all-stock package, and:
    • if the company becomes a bad mature company in one year, you quit, go get a different $200k/yr job, and work it for the remaining three years, making a total of $100k + $200k + $200k + $200k = $700k.
    • if it becomes a good mature company, you stick it out all four years, and make $300k + $300k + $300k + $300k = $1.2M.

The “stick it out only if the company ends up good” strategy makes $950k in expectation over four years, so the option value of the stock package lets you squeeze out another $37.5k in expected comp per year – and the above is just the naive strategy! The strategy of “keep restarting at immature companies until you land a hit, then stay there” actually has an EV of $253k/yr over just the above four-year horizon.

In short, this extra $53k/yr of EV is coming from the option value of the hidden call option you are being given.

Practical consequences

The consequences of this are quite dramatic. If you’re joining a large publicly traded company and they’re willing to let you pick between stock and cash on an equal basis you should basically always push the slider as hard as you can in the stock direction. If you model this out based on real volatilities of typical mid- to large-cap companies, maxing out stock and then quitting if the company goes poorly adds something like 10% to 30% to your expected comp, vs the baseline of always taking all cash. In practice the difference is even bigger than this naive model, because often when your grant runs out you can press for refreshers, or just use your current comp for negotiating the next job, so the increase in your comp can often get “locked in” more than just a 4-year grant would imply.

I had one friend who joined a publicly traded mid-cap for $x/yr. Then the stock more than doubled in the first year or so, bumping him up to making about $2x/yr. Then after a few years of that he was in a position of great strength, so he negotiated a $3x/yr offer with a new place, based on being able to truthfully say “look, it’ll take more than that to poach me, as I’m making $2x/yr right now”. He was certainly happy that he pushed the slider in the stock direction, as the comp increases ended up basically locking in long term, rather than just expiring at the end of 4 years.

In fact, all of the above analysis neglects yet another source of value2 here: quitting is a form of legal insider trading. It is not illegal to see that your company is doing poorly based on material non-public information, and quit as a consequence – that is, stop trading time for equity in the company about which you have MNPI, and start trading your time for other comp at a different company. If you work at Magic Beans, Inc. it is not legal for you to trade your Magic Beans equity for dollars based on MNPI, but it is legal for you to quit Magic Beans, Inc. based on MNPI and go work at Google for cash instead. But note that the latter story has the same final portfolio as continuing to work at Magic Beans, Inc. while selling your equity for cash. In short, quitting and working somewhere else is “statically replicating” insider trading.

But what of start-ups?

Let’s specifically address “you have to treat start-up equity as worthless”. If anything, start-ups exemplify this principle that $1 of stock in a grant is worth more than $1 – the optionality in a call is worth more the higher variance the underlying asset is, and start-up equity is one of the highest variance underlying assets out there.

If you solve things out, the primary term that affects the value of this option is how quickly you find out how much the start-up equity is worth. You should treat equity packages from start-ups where you’ll gain lots of information very quickly if they’ll succeed or not as being worth quite a lot more than comparable dollar amount equity packages from start-ups where it takes longer to gain that information, precisely because the hidden option is more valuable.

So, the correct adage should be:

You must be emotionally prepared for your start-up equity to be worthless, but if you think you’ll have substantial info on if the company is going to succeed or not within a year, then the hidden optionality might add something like 50% to 100% on top of the naive value of the equity package – if you think it’ll take a few years to figure out if you should quit then the optionality is worth a lot less than that.

Footnotes

  1. All of this is assuming equity plans where the number of shares is fixed up-front. If a company says they’ll give you $100k/yr of equity where they reevaluate how many shares that is per year then of course a bunch (but not all) of these arguments disappear. ↩

  2. There’s yet one more small source of value here, pointed out to me by my friend Shachaf. Even if you model equity in Google as just being alpha=0, beta=1 then you still probably prefer for your wealth to be sitting in unvested Google stock rather than “unvested cash”, as you probably expect markets to rise a bit, and would prefer beta=1 over beta=0. ↩