True opportunity cost of early startup employee

Got asked this question a couple of times in the last week, which reminds me that an analysis could have certain values for friends who's jumping into the startup world now. Given my experience to be at various degrees of startups across the spectrum in the last several years, here're some of the takeaways based on my first hand experience.

It's certainly a risky move now, but based on the principal of "Be greedy when others are fearful", it could be one you will appreciate for the years to come. A crisis is the opportunity for a new wave of startup, just like the 2008 crisis lead the birth of AirBnb, Uber, Spotify and Square, etc., this downturn could be the beginning to reset and starting again. However, to really have a ballpark estimation of what you're earning and not earning, potentially, could help to make the best decision at this stage of your life.

What is opportunity cost

Opportunity cost is what you give up by choosing a particular course of action. As an startup employee, you are giving up been working at a public tech companies, which typically means the compound of public stocks, the opportunity to work on some project only existing in big companies and better benefits from work.

However, on the high level, what we could potentially earn is bigger scope, experiencing the growth stage of a company, feeling the dynamics of innovation more directly. If the company has a successful exit, it's a quite a good return afterwards. Maybe, really? and why?

What's the possibilities for a startup to exit successfully

If you are an early early startup employee, based on a calculation in this article, if we fire the rand(100) function once, the return distribution will probably be like this:

• 0 - 70: your equity probably worth nothing.
• 71-94: your equity grant is worth a lump sum of money which makes you about as much money as you working for a megacorp at a higher salary with better benefits.
• 95-99: Your equity grant is a life changing amount of money.
• 100: You won the lottery and had chosen to work for the next Google (btw, could rand(100) general 100 in the first place?)

To fairly evaluate opportunity cost, you have to know how much you could potentially earn, simply put, working at a public company, especially working for a megacorp. This info is quite transparent. Just take a look at level.fyi. The caveat is that the info there probably won't unveil a lot of earnings for senior director and above. People at that level tend to keep a low key while silently amassing lots of money, but that's where the pay goes over the linear trajectory and get to another level.

The natural question is that whether big tech is way more selective for employment opportunity, and in reality, it's the opposite – Big tech does orientation every week, hiring lots of folks, though on the other side, lots of folks are leaving as well (probably not at this strange time of late 2022). In contrast, certain startup is probably too pound of itself, and pretend to be more selective. Especially for real early startup, it's typically recruiting through personal connection instead of hiring any unknown guys.

What's the drop rate at the several stages of the startup journey?

Let us travel through the timeline of a potential exit of startup, and see what could be the bottle neck points through this journey.

The base condition – you get an offer through personal connection, and conducted an interview with the head of engineer as well as the founders, and totally blowed away by the vision and even got awarded an equity worth of 1% of the company. Based on the seed round of fund raising of the company, the company is evaluated at $30M, and that means, on a ball park, you were awarded $300K. This is will be granted over 4 years, with one year cliff and equally every month afterwards. Let's see what're the alarm bells here:

• On the bright side, you were persuaded that the company is target of 2 rounds of funding raise later and probably get acquired at $250M, then your share probably worth $2M. That sounds a great deal to earn $2M equity in 4 years.
• However, the valuation has a big hidden problem. One part, the fair market value is evaluated by a 3rd party firm once or several times a year. This company is hired by the employer in the first place, so there's certain interest conflict there; in contrast, in public market, thanks to principal-agent problem, certain better balance could be achieved. On the other hand, the evaluation of a startup just needs to be given by one investor, in certain circumstance, investor might be fear to miss out, and results in quite bogus number. We all know how certain famous VCs conducted their due diligence when facing FTX. Comparing with public market, the stock has been time-tested, and positive and negative info is factored into the price in more efficient way.
• You don't know whether the investor has a higher privilege class of stocks. What the investor has is preferred stocks, which typically has an at least 1x liquidation preference. In certain situation, they may even have 2x. If the company has a down sale or save level sale, the common stock holder will only be able to take the rest after investor takes their share * 2 times. Even more, some founders themselves may secretly hold preferable stock, which is an immoral thing to do, but the reality is you have no easy way to somehow to see exactly how that term sheet looking like.
• Assumed it's an acquisition exit, if it's a down sale, it's depending on the goodwill of the founder to help employees to negotiate great terms of the next firm to convert your equity to that of the other firm. If the acquiring company is another startup, you still don't have the liquidity right away. Even public company, the term typically locks you in for 2 years or above.
• Even you're not so interested in the job, there're things holding you back to leave. Unless the company are already super mature, and issuing RSU, you probably wanted to stay to the time there's an exit happens. If you are not on the boat, no one can guarantee you can get your share of treasure even you had served them faithfully for years. Another big concern is tax on vested options: when you exercise your options, you’re effectively taxed on the difference between the current valuation and the strike price. If you wanted to leave, you typically have only 90 days to make a decison whether to exercise or not.
• Moreover, Some startup employers thought option could be a "lock-in" to incentivize the employee to stay longer, so they highlighted substantially the portion of the equity in their offer package, and feel like generous enough. But in the long run, this might result in high percentage of quiet quitter in their companies. In contrast, in big company, say Amazon, if you work at Alexa but don't like it after some times, you could easily transfer to AWS to still have your whole company wide stocks accumulated.
• Don't forget the length of the years, as you're not guaranteed the number of years of the exit to happen. The longer the years, base on the time value of money, you discount back to present, it's worth less.

Back to the example, so the expected return of a startup in this case:

Your initial $2M * (1 - probably of the above event happens) ^ N (N: number of the above event), and it takes M years for this liquidity to happen. And you're using this to compare with that of a megacorp, your potential return, say M years * $150K (average annual equity), and you haven't really consider the appreciate of the stock of big tech, if we're talking about the last 10 years.

What we are really valuing here when working at a startup?

The accumulation of the skills. The beauty working at startup is that you will be wearing multiple hats, though with higher pressure, yet you are assgined to lots of different areas, and expected to delivery quickly to truly benefit the business. Lots of time there's not corp ladder to climb, and surviving is always a real warning thing hanging around all the time. It's a perfect situation to train your skills. Just as laid out by Julie Zhuo in this article,

Your career is defined by your skills and how you’ve used them, not by any external measure of your progress - How to think about your career

Be really specific of what you are learning and striking for, and constantly seeking for that.

Secondly, if you goal is founding your own company, needing to have an expertise at a related area and need more broad understanding of the business from more aspects besides engineering and products, hopefully some connection being built within the VC circle. On the other hand, depending on life stage, if you wanted to go all in for your own firm later, it's better to have a peace of mind in terms of financial security. It's one of the patterns that people would go to megacorp to stay for some time to get money accumulated, but you have to really be clear about how the end game looks like.

How to decide

Just for working at startup, in terms of return on money, I really like this fair estimation from a similar article.

There are a number of factors that can make options more or less valuable than they seem. From an employee standpoint, the factors that make options more valuable than they seem can cause equity to be worth tens of percent more than a naive calculation. The factors that make options less valuable than they seem do so in ways that mostly aren’t easy to quantify.

Whether or not the factors that make options relatively more valuable dominate or the factors that make options relatively less valuable dominate is an empirical question. My intuition is that the factors that make options relatively less valuable are stronger, but that’s just a guess.

However, there's always more going on than just a number in the bank, for that, to choose your carrer, I really like the following quote.

My best career advice: At every job you should either learn or earn. Either is fine. Both is best. But if it's neither, quit. – Garry Tan (source)

Again, this article is not necessarily championing for you to go for startup or not, but as a reality check on the two sides of the coin. Don't completely trust every words like this "start or join a startup, a reliable way to get rich for hundreds of years", but also see the bright side and excitement from startup time. Let's go!

Resources

[1] https://danluu.com/startup-tradeoffs/

[2] calculation stock option https://secfi.com/learn/calculate-the-value-of-your-startup-stock-options