The Value of Startup Options vs. Cash

I often speak with startups that claim their compensation packages have a higher expected value than those offered by top tech companies like Facebook, Google, Twitter, or Snapchat. However, I find it puzzling that if this claim is true, startups wouldn't sell their options to investors at the claimed value and then pay their employees in cash instead. The non-obvious value of options, combined with their volatility, creates a significant barrier to recruiting top talent.

Given my personal risk function and that of venture capitalists (VCs), it seems that paying employees in cash would be a better deal for everyone involved. Like most people, I experience diminishing returns on extra income, whereas VCs have a nearly linear utility in income. Moreover, because VCs hold a diversified portfolio of investments, they can diversify away downside risk more effectively than individual employees. If startups genuinely believe their options are worth more than cash, there should be a trade that benefits all parties.

Paul Graham's essays from a decade ago argued that starting or joining a startup is a reliable way to get rich, citing the principle that "risk and reward are always proportionate." However, this assertion is not universally true. In finance, only assets with non-diversifiable risk carry a risk premium. Since VCs can diversify risk, there's no reason to believe that individual employees investing in startup options are getting a good deal due to the risk involved. Historical returns show that VC funds don't outperform other investment classes, despite having less downside risk than employee options.

So, why can't or won't startups take on more investment and pay their employees in cash? Let's explore both cynical and non-cynical reasons.

Cynical Reasons

1. Options might not be worth what startups claim: If investors pay a fraction of the company's valuation for a portion of the company, and the extra cash raised by giving the employee option pool to investors isn't enough to pay competitive salaries, it suggests that employee options might not be as valuable as claimed.
2. Misrepresentation of option values: Companies often misrepresent option values by using strike prices, public valuations, or Black-Scholes models, which can lead to inaccurate calculations.
3. Options are often free to the company: A significant portion of options are returned to the employee option pool when employees leave, making options a low-cost compensation method for companies.
4. Present value of future sums: The value of money is higher when received sooner, allowing for investment and returns, which is not accounted for when comparing startup compensation packages to those of larger companies.

Non-Cynical Reasons

1. Tax benefits of Incentive Stock Options (ISOs): ISOs offer a lower tax rate if held for a certain period, making them more attractive to employees.
2. Tax benefits of Qualified Small Business Stock (QSBS): Certain stocks are exempt from federal capital gains tax and state tax in many states, although this is not commonly taken advantage of.
3. Control and retention: Founders may prefer to give options to employees to maintain control and retain talent, although this can be a poor retention mechanism.
4. Incentive alignment: Options can align employee interests with those of the company, although this is often not the case in practice.

Investing in Startups

As an update, I've learned that investing in startups can be a better deal than joining as an early employee. With the ability to invest small amounts in seed rounds, individuals can gain more equity and diversify their investments, making it a more attractive option than taking a startup job.

Conclusion

The value of startup options is complex and influenced by various factors. While some factors can make options more valuable, others can make them less valuable. From an employee standpoint, it's essential to understand these factors and not overestimate the value of options. Companies may prefer to give options to maintain control and retention, but this can be a poor mechanism. Ultimately, whether options are more or less valuable than they seem is an empirical question, and employees should be aware of the potential downsides and make informed decisions about their compensation packages.

Appendix: Caveats

• Many startups don't claim to offer financially competitive packages.
• Some startups give out competitive offers, but there's significant variation in offers.
• Tax-related information is U.S.-specific.
• The same line of reasoning can be applied to Restricted Stock Units (RSUs).
• Some startups offer sliding scales for option and salary compensation.

Appendix: Non-Counterarguments

• The most common objection is that startups don't have enough money to pay equivalent cash, which is not a counterargument but rather an admission that startup options might not be valuable.
• Another common objection is that startup options are worth a lot if you pick the right startup and use a proper model to value the options, but if that's true, why couldn't they raise more money by giving away more equity to VCs at its true value and pay cash?

Acknowledgements

Thanks to numerous individuals for comments and corrections.