Understanding Stock Options at Startups (and at Moz)

Last Friday, SEOmoz held our “allhands” meeting at the Big Picture theater. Out of ~98 Mozzers, 85 of us were in attendance (sadly 3 had to leave intermittently to deal with a misbehaving Riak database we’d just upgraded). We’ve grown a ton over the last 6 months (from ~50 in January) thanks in part to our funding round in April. While there were a lot of good discussions and data from the meeting that I’d like to share here, one of the most interesting revolved around stock options.

Technology startups have a tradition of providing employees with stock options. Those options are what helped make thousands of Microsoft and Google employees millionaires, and they’re also the cause of a lot of strife, confusion, and anger among startuppers.

I have some personal experience with these emotions. My wife joined the Cranium team in 2005 and received a small but attractive chunk of options that we both thought might be worth a lot someday. When Cranium sold for $77mm in 2008, the stock options were, sadly worthless. Many much earlier employees who thought those options might be a golden ticket were left in far worse shape. The experience was sobering and frustrating.

During the Mozzer allhands, we discussed stock options in a bit of detail. Embarrassingly, I misplaced a decimal and showed some very bad arithmetic on several slides. I ate humble pie all weekend over that one – a good reminder to check your math before showing potential option values to your team at a meeting!

For those who aren’t familiar with stock options, here’s a very basic primer in 10 steps (this Quora thread‘s also pretty good):

  1. Stock options give those who hold them the option to buy stock in the company at a certain price (called “excercising”).
  2. Stock options usually have a vesting period, meaning that if you’re granted 1,200 shares your first day, you can’t leave the next day with the options. At Moz, it’s the very common 4-year vesting with a 1-year cliff. If you join January 1, 2013, you’ll be able to exercise 300 shares (1/4th) on January 2nd, 2014. Each subsequent month, you’ll vest into 1/36th of your additional grant.
  3. Stock options almost never come with voting rights, or board of director seats.
  4. Holders of stock options typically need to exercise them within 90 days of leaving the company (or they forfeit those options).
  5. Exercising a stock option converts it to an actual share of stock, and requires paying the “strike price” which, at most tech startups, is set by a 409A valuation (basically, a firm like Silicon Valley Bank, who we use, evaluates the potential value of the company based on your financials and comparisons to public markets, acquisitions, and funding events).
  6. Stock options given to employees come out of the startup’s “option pool” which is set aside (usually at the company’s founding and after a funding event), representing 10-20% of total company ownership.
  7. At the time it’s granted, a set of stock options represents some portion of the company’s overall ownership. For example, at Moz, 1,200 shares of stock today would be 0.01% of the company since we have 12,000,000 total shares.
  8. Over time, that percentage value might change through dilution if the company takes on more funding or dilutes all the shareholders to replenish the option pool (when you run out of options in the pool, but need to hire more people and grant more stock options to employees, everyone takes an equal dilution hit).
  9. There’s lots of rules about stock options if a company goes public, and usually some restrictions about payout of options in a sale, too. Liquidity isn’t guaranteed, though the more mature, financially stable, and successful the startup is, the lower the risk (but it’s never zero).
  10.  Stock options at startups are common stock and are usually paid out last in a transaction. If it’s a great acquisition/public offering price, things are usually good, but if the company raised $10mm from VCs at a 2X liquidation preference and sells for $22mm, the VCs get $20mm and the common shareholders are then left to split up the remaining $2mm. Sadly, this happens a lot.

So how about stock options at Moz? What are they worth (if anything)? What’s the realistic chance that these options could provide real financial bumps to their employee holders? And how should Mozzers think about their stock options?

I’ll try to answer those out of order 🙂

How to Think About Stock Options if You’re a Mozzer (or are considering joining the team)

I personally like Mark Suster’s advice in his post on How to Discuss Stock Options with Your Team:

We give out stock options.  I hope they’re worth money to you some day.  But let them be “icing on the cake.”  If they pay off handsomely that’s great.  But don’t count on it.  Don’t let it be your motivator or your driving decision.

Not because we don’t want them to be valuable, but because we don’t want to create an “options culture” around here.  Option cultures are corrosive, create the wrong incentives and attract the wrong sort of people.”

That said, I disagree with his advice about being slightly coy around the ownership held by a team member. It requires a robust explanation with a lot of detail to be transparent without misrepresenting the details (particularly because that percentage often changes), but I think that’s a worthwhile conversation to have.

If you own 1,200 stock options in SEOmoz today, those options are equivalent to 0.01% of the company today. In the future, that percentage might change, and if our stock situation changes, you’ll be sure to hear from me about it (for example, if we take funding or if we all take dilution to expand the option pool).

One weird thing about SEOmoz stock options in particular. Anyone who was at the company prior to our April 2012 funding round received an additional grant of stock just after that event. That grant was designed to protect Mozzers from the dilution that usually comes with a funding round. Thus, if you owned the equivalent of 0.01% of SEOmoz in stock options prior to funding, you were “topped off” with shares sacrificed by the founders and put in the option pool. There’s a little more detail about this here, but do keep in mind those new options have a 4-year vesting cycle that started in April.

What are SEOmoz Stock Options Worth Today?

It depends on what valuation you believe in, actually! Our most recent funding from Foundry & Ignition gave the company a pre-money valuation of $75mm and a post-money of $93mm. Just after that, we received a 409A evaluation from Silicon Valley Bank that set the value of common shares at $2.85 (x 12mm that’s $34,200,000). And at the board level or in acquisitions, we generally talk about the company being worth ~$110mm today if we were for some reason looking to sell the company (which we’re definitely not).

From the perspective of an employee or potential employee being granted options today, a low 409A price is extremely attractive because you only benefit financially from the delta between the current strike price and the future value. For example, if you were granted stock options in Google on Dec. 28, 2009, when the stock price was $618.48 and wanted to execute today when the price is $681.79, you’d benefit from a delta of $63.31/share you held. If you’d received those options around the time of Google’s IPO when shares were valued at $106, you’d benefit from a delta of $575/share!

The true value of SEOmoz stock options is impossible to say. It’s based entirely on the future, which could be anywhere from fantastic to dismal. This is why it’s so important to think of stock options as a high-risk bet, not a guaranteed return.

What’s Are the Scenarios in Which These Options Could Be Valuable in the Future?

Take this with a grain of salt, but I made a few sample scenarios showing some possible outcomes:

click  for a bigger version

These scenarios are merely arithmetic imagination, but they show how one might think about the growth of SEOmoz and relative value of options. For example, in our scenario where a new employee joins the team and is granted 1,200 stock options with a strike price of $2.85, then doesn’t receive any additional options over the next 5 years (nor takes any dilution), those options would return $33,276 in 2017 in the “low growth” scenario, which is a very nice sum, but certainly not life-changing money.

Note that SaaS companies don’t usually IPO below ~$75mm in annual revenue (which is where I set the cutoff here) and that valuation multiples are often related to growth rate (along with other things – this is obviously a hyper-simplistic model), which is why the faster growing scenarios also have higher multiples of revenue for their valuation.

I know many folks in the startup world discourage this kind of projecting because it creates unrealistic (or soberingly disappointing) expectations. But I believe strongly that when there’s nothing to hide, there’s no reason to hide, and startup stock options certainly don’t seem worth putting in a dark closet and never discussing realistically.

And for those interested, stock option grants at SEOmoz aren’t something we can be transparent about because it’s not empathetic. However, I can say that in the first couple years of the company, grants were on the order of 0.1-1% of the company. As we’ve gotten more mature, less risky, and more able to compete in the area of salaries, those grants have gone down. Grants today might be in the few hundreds to low thousands ranges depending on the position and the candidate, and next year, those numbers will likely go down again.

I shared this information over the weekend with everyone at the company, and I couldn’t help but share part of a response I received from one of our team members over email:

Hey Rand! Just wanted to say thanks for sending this out and for your transparency and honesty. Also, don’t beat yourself up over the all-hands. Your true passion and desire to see all of us become extremely successful (both monetarily and in our careers) is something that I believe no Mozzer questions. It is definitely a rare quality to have in a CEO and something I know we’re all super thankful for.
I think it’s this passion that made a lot of us join the Moz family. I can only speak for myself, but I know that when I took the job at Moz, I took a decent pay cut from my previous job at Microsoft and it was the easiest decision I ever made. I didn’t take the job because I thought I’d become rich off the stock options. I took it because the opportunity to work for a TAGFEE company (something I had never heard of before and didn’t believe existed) and to work on our mission of helping people do better marketing was something I thought was truly unique and something I wanted to be a part of. Also your interview with me where you talked about your passion for the company and the employees definitely helped! 
I think most people at Moz look at their stock options as something that will just be extra gravy at the end of an amazing journey. To me, the value of the journey we’re on and the problems we’re trying to tackle, are something that you can’t put a dollar value behind. I feel like I’ve learned more in 15 months of working here than I had in my entire time at Microsoft, and that knowledge will help me for the rest of my career. 
The other thing I’d like to point out quickly is that while it might not be 100% realistic that every employee will become millionaires off of their stock options at Moz, I believe these stock options are more valuable than the stock grant I got when I joined Microsoft. As one of 100,000 employees there, I never felt motivated or empowered that I could actually affect the outcome of our stock price (which hovered between $25-$30 the entire 3 years I worked there). However, here at Moz, we all play a direct role in how successful we’ll be some day. I personally would rather have 1,000 stock options at Moz where the sky really is the limit when it comes to our success than to have 1,000 shares of stock in an established company where the stock value is never going to change dramatically and I can’t really impact. 

I could live on ramen 3 meals a day, sleep on a couch, and get paid in peanuts with feedback like that. I don’t know what magical dial got turned up to 11 at SEOmoz lately, but I hope we can keep it there. After what I thought to be a pretty terrible talk I gave to the team at the allhands, I had a rough weekend, but re-reading this again, I feel like the luckiest CEO in the world.

p.s. I used a picture of Green Bay Packers stock in the introduction to this post because I think it’s a great analogy to startup stock options. They’ll probably never return anything financial, but it’s a good sign if the startup you’re joining is offering them, and even better if they’re totally transparent about the value today, the percentage of the company represented, and the future potential.