This is a nice piece and I would certainly commend it to founders for its insights.
Of course, much of Silicon Valley is a living testament to the fact that options can have incredible value for the right cases. Every startup has a rhythm to it and, if you are holding .5% of a "hot" startup in the form of options having a low exercise price, it normally is worth the gamble of biding your time, taking reduced pay, and seeing if the big payday will come. Many founders think in these terms and, if their startup fails to galvanize and moves instead in only fits and starts, will seek to cut their losses and move on. In this sense, the perceived value of the options as seen at the entry point does not turn on what average returns may be for such options considered generically among the entire universe of startups. It turns on more subjective factors such as whether the startup is doing something exciting, whether its key people make up a strong team, whether it has attracted quality backing, and the like. If those factors are there, then founders do not really view it as a matter of average returns across a broad class of startup types but rather view it as a matter of the likelihood of a big outcome for the particular startup being considered.
That said, options can prove illusory in many cases and caution is definitely in order. It normally does not pay to hang in with an uneven venture in the vague hope that it can somehow turn things around and yield a great equity return for your small piece of the company. Among other things, if a venture goes through multiple rounds of funding, the liquidation preferences get to be so great that option holders may easily get a very reduced payout, or even no payout whatever, on acquisition. Also, if you hang around while all your options vest and then leave the company, you typically have only 90 days within which to exercise them or you lose them altogether. That means a cash payout that only increases your risk or, even worse than that, a large tax hit with no cash return if the stock price is high following a series of fundings. Of course, there are (as the author notes) many good reasons to be in a startup apart from equity payout and it may still be worthwhile to stick it out in a doubtful venture for a time owing to those other reasons. But don't stick with a dubious venture based primarily on the hoped-for equity payout in such cases because, in that case, the odds definitely are against you.
Your analysis points to why the authors analysis is flawed. He calculates the expected value of the option and says that this leaves the value of the stock options to be very small. What he neglects to mention is that the employee is also granted a 'real option' which is his right, but not obligation, to leave the company if it does badly. This 'real option' significantly increases the value of stock options because the employee can leave after one year (or less) in the case that the startup is not on track to succeed. This means the forgone salary is reduced in the down scenario. Google 'real options' or 'strategic options' for the maths behind how to price these, it's a beautiful mathematical theory.
Another point further complicating the analysis is that companies which start to do really well simply turn around and reduce the amount of subsequent grants. There is less risk of failure; the expected value of the grant has increased, so the company offers fewer shares to existing employees in the next grant cycle. This effect can be significant as growth companies tend to hire a lot of people (including hot shot VPs with huge price tags) and take more rounds of funding, both of which can dilute initial grants substantially before the liquidity event.
The author assumes no subsequent grants, but realistically everybody factors subsequent grants into their back of the envelope calculations.
100% agree. This is definitely a simple analysis meant to give people an idea what the value of their options is.
I'm going to caveat the rest of this comment with my very little understanding of real options. I've only worked with a real option calculator once about 6 years ago. with that being said, here's my thinking on real options: You can do a much better analysis with a real options calculator, but you would have to make a lot of assumptions in your real option calculator about the different branches the individual could travel down at each node. At some point you could say that there is some very unlikely probability that this job allowed the person to travel down a path in 5 years that enabled them to start their own company and IPO'd that company. This would have an impact on the value of the options offered today, but I cannot imagine all of the possibilities of a real option calculator.
I agree this is an important aspect to consider. However I don't think it would affect the OP's estimate of the value of the option grant itself. It would instead affect the price payed by accepting a below market salary.
I.e. the 'real option to leave' can affect the ROI but not absolute return.
There is another important bit here, which is to think of it in terms of individuals rather than startups.
The companies that get big (FB, Twitter, Google) hired hundreds or thousands of people before IPO'ing. AirBnB, Dropbox, Uber, and others in their weight class must employ at least 100-300 people.
By contrast the companies that fail tend to fail small.
So rather than saying "1.4% of startups make it to IPO", what if we looked at it by individual? That is, if you are being hired, it's more likely that you are being hired at a company that is likely to be successful (as they are able to pay your salary/hire you).
I'm not sure what the answer is and you'd need to do the math here. But my overall intuition is that a skilled engineer who did say 3-4 startups between 21 and 35 has a pretty good chance of getting a decent payday (say $500k-$1m+), while having a lot of fun. Of course, if you just want to optimize money you should just save and not spend. Alternatively you can go to Wall Street, but (a) that's not what it used to be, (b) it's not fun, (c) many of the people there are leaving for here and (d) it won't even remain what it is for long if the market takes a serious downswing.
And you're of course right, the interesting question is not what an options grant in the average startup is worth, it's what an average options grant is worth.
Or phrased slightly differently (to make it obvious this is the relevant question): "What is the expected value of the options grant I have been offered?"
On the other hand, all but the first few of those hundreds or thousands of employees will get rather smaller option allocations than this article is assuming, which may well cancel out any increase in their expected income.
Of course, much of Silicon Valley is a living testament to the fact that options can have incredible value for the right cases. Every startup has a rhythm to it and, if you are holding .5% of a "hot" startup in the form of options having a low exercise price, it normally is worth the gamble of biding your time, taking reduced pay, and seeing if the big payday will come. Many founders think in these terms and, if their startup fails to galvanize and moves instead in only fits and starts, will seek to cut their losses and move on. In this sense, the perceived value of the options as seen at the entry point does not turn on what average returns may be for such options considered generically among the entire universe of startups. It turns on more subjective factors such as whether the startup is doing something exciting, whether its key people make up a strong team, whether it has attracted quality backing, and the like. If those factors are there, then founders do not really view it as a matter of average returns across a broad class of startup types but rather view it as a matter of the likelihood of a big outcome for the particular startup being considered.
That said, options can prove illusory in many cases and caution is definitely in order. It normally does not pay to hang in with an uneven venture in the vague hope that it can somehow turn things around and yield a great equity return for your small piece of the company. Among other things, if a venture goes through multiple rounds of funding, the liquidation preferences get to be so great that option holders may easily get a very reduced payout, or even no payout whatever, on acquisition. Also, if you hang around while all your options vest and then leave the company, you typically have only 90 days within which to exercise them or you lose them altogether. That means a cash payout that only increases your risk or, even worse than that, a large tax hit with no cash return if the stock price is high following a series of fundings. Of course, there are (as the author notes) many good reasons to be in a startup apart from equity payout and it may still be worthwhile to stick it out in a doubtful venture for a time owing to those other reasons. But don't stick with a dubious venture based primarily on the hoped-for equity payout in such cases because, in that case, the odds definitely are against you.