The declining value of stock options in an IPO free world

One of the tricky bits about massive valuations, and long drawn out periods before an IPO is cash compensation for employees.

This article does a really good job of pointing out another emerging crisis.

The basic challenge is that as the time to IPO expands because of secondary private equity markets, employees begin to devalue the value of their options because they are not liquid putting upward pressure on their salaries.

Let me explain.

Suppose you earn 100k a year. A pretty awesome chunk of change mind you … Now at Big Corp you can expect to earn 400k over four years.

A startup makes an offer, and it has less cash and more equity. The cash component is 70k. And so at the startup you can expect to earn 280k over four years.

The gap between Big Corp and Startup is 120k over four years. Over eight years the gap is 240k.

Basically every four years at the Startup is equivalent to working one less year at Big Company.

Thank goodness you say for options. The options will cover the difference between the Startup and the Big Company, hopefully by a lot.

And here’s where things get dicey, the longer it takes to get the option money from Startup, the bigger the financial exposure from a startup failure.

In a normal environment to compensate for the increase risk exposure, you would need more equity. The longer it takes to see if an investment pans out, the higher the rate of return should be.

Let’s put it this way:

Big Corp Comp = 400k

Startup Comp = 280k  and 2 million dollar option outcome with 10% certainty.

The expected value of Big Corp is 400k

The expected value of Startup is 480k (280  + 2000*.10)

This looks pretty good! Except I am probably overstating the probability of the 2 million dollar option outcome… And if we start adding notions of present value of money, the startup outcome may not look so good…

If the time horizon gets extended out to 8 years,and option outcome is the same.

Big Corp Comp = 800k expected outcome

Startup Comp = 760k expected out come

Now you’re starting to lose out by staying at a startup.  And again if we consider that Big Corp gives you 30k a year more than Startup Comp, and that money can be invested then it’s even more favorable for Big Corp.

Therefore employees at Startups either have to larger salaries or bigger equity packages or have to believe that the option outcome is going to be much higher.

Given that the time horizon to liquidity events is increasing, my expectation is that salaries are going to increase.  If salaries do not then we may be in a bubble because we are all collectively underestimating the risk of the option outcome.