Archive for November 10th, 2006

10th November
written by simplelight

I am an engineer at heart. Now, however, I work in the world of finance. I once asked why engineers in start up companies earn so little despite creating so much of the value. My partner’s answer was disturbing. Engineers, he said, want credit for being smart and that’s what we give them. Everyone else wants money, and that’s what they get.

I have another theory too. I have observed that engineers in private companies often have no idea how much of a company they own. They know how many stock options they have, but they have never thought to ask how many shares there are in the company. I once encouraged an engineer to ask the HR manager what fraction of the company she was being granted with her options. She was told that that information isn’t typically divulged and was advised to treat her options like a lottery ticket. I haven’t bought a lottery ticket recently but I understand that they’re only worth a dollar or so!

If you work for a private company, here’s how you can estimate the economic value of your stock options.

First, you need to answer the following questions (ask your friendly CFO for the answers):

  1. How many shares are outstanding
  2. What was the share price of the last financing
  3. How much common stock is outstanding
  4. How much preference there is in the company and if there is any multiple
  5. Whether the preference has participation.

Ideally, all this information is contained in a one page document called the “cap table” but the company probably won’t just hand it over to you.

What you really want to know is how much preference there is ahead of you. Basically, it works as follows:

Assume there have been 3 financings, series A, B and C. Those 3 financings are all preferred stock and will get paid out before any of the common stock (which is your options). So, as an example, let’s assume that the following financing’s happened:

A: $ 8M
B: $11M
C: $16M

The total is $35M. This is the preference which is “ahead of your options”. Thus, if the company is sold for $50M, the investors in Series A, B, C will first be paid out their $35M and then the remaining $15M will be split amongst the common stock. This is why you need to know what percentage you are of the common stock. Typical %’s of the total stock are

  • CEO: 6-8%
  • VP: 1-2%
  • Dir: 0.5 – 1%
  • Eng: 0.2-0.5%

Sometimes, though, the investments are structured with what is called a “multiple” (1.5x, 2x etc). For instance, a 2x multiple on all 3 rounds of investment would mean that there is actually $70M ahead of you, in which case, the company will have to be sold for $70M before the common stock will start to get paid out since the investors will first get double their money before any of the management team and employees get anything.

The other term often specified is something called “participation”. If the preferred stock has full participation, then, (assuming the 2x multiple) after the first $70M is paid out to the investors, what is remaining is then split between the common stock as well as the preferred stock.

If you’ve read this far and know engineers in a private company who can’t answer the question: “How much will you make if your company is sold for $150M?” then please refer them to this article. There’s no need to unionize. But there is a need to demand information.