Twitter has recently launched an IPO that resulted in a $24BN valuation. Facebook came out at over $100BN last year. The average engineer and white collar workers at those companies made out like rock stars who likely don’t need to every worry about money again. With this kind of rampant success, I couldn’t help but wonder whether I should be chasing the next billion-dollar start-up for employment. As a professional statistician, I am used to crunching numbers in order to validate business decisions, so I tried to calculate how much on average the typical start-up equity is worth. The calculation is somewhat straight forward and presented in the following paragraphs, but the results may surprise those who dream of hitting it big by joining the right start-up.
As a summary of results, if you averaged the value of equities you receive as a valued employee in a very early stage start-up that has not received any funding across ALL start-ups in the United States, the value of the equities turns out to be worth around $8K a year. This is assuming that the start-up goes IPO after 7 years (the average is around 10 years) and that the valuation of the start-up at IPO is the average valuation of all start-up IPOs in the country. This value is easily offset by the fact that start-up salary on average tends to be 30% less than an established company. The lower salary is supposedly compensated by the equity grants, but this doesn’t appear to be the case. For a typical $100K a year senior technical position in the Silicon Valley, this is roughly a $30K annual salary hit. This translates to a loss of $22K a year ($8K from equities minus $30K salary loss) even without factoring in the time value of money (the fact that you only get to spend the money from stock options after 7 years versus the $30K in salary you collect every year). Consider the fact that you typically work much longer hours at a start-up than at a mature company and we start to wonder whether the payoffs of chasing start-ups is really justified.
The overall calculation involved in this assertion is pretty straightforward. I calculated the average IPO valuation in the United States and multiplied it by the typical share of the company a founding employee owns by the time the IPO occurs. The average IPO valuation ($45MM) was calculated by taking the top 10 valuations since 2004 along with statistics from a well-known start-up incubator. The data for IPO valuation as well as the typical share that a founder or very early employee owns at IPO after fundraising dilution (0.125%) were estimated from web resources shown below.
Since how much an employee makes is directly related to the IPO valuation, the first step is to calculate the average IPO valuation or acquisition value across all start-up companies in the US. To start, I first collect data for the biggest successes. From www.techi.com/2013/02/what-are-the-most-successful-start-ups-since-2004-infographic, we can get a list of the most successful start-ups since 2004 along with their estimated valuations. I take these as reasonable estimates of the IPO value of these companies (I’ve updated numbers for FB and Twitter IPOs) . We really only need an estimate of these to get in the ballpark. The data is as follows (in billions of dollars):
Facebook: $104, Twitter $31, Workday $4,Dropbox $4, Groupon $3.56, Square $3.25, Homeaway $2.08, Spotify $2, Zynga $1.6, Airbnb $1.3, Box $1.2, Evernote $1.0 , Instagram $0.74.
So we have the most successful start-up valuations in the last 10 years that we can roughly assume would be their IPO or acquisition. This is only a very small list of companies. What about the IPO success rates of all other successful and non-successful companies on average? If you go to www.businessinsider.com/start-up-odds-of-success-2013-5 , you have a decent article about the success rates of Y- Combinator , an American seed accelerator, which is basically a place that screens out what they believe will be the most successful start-up ideas and then tries to nurture them towards IPO. These are guys who evaluate start-ups for a living and their success rate is roughly 10% (according to BusinessInsider). This actually means that they are getting the cream of the crop. Their program acceptance rate is around 5%, which means that most of the other companies don’t even have ideas that merit their attention.
Let’s be optimistic and assume that the success rate in the general start-up ecosystem is as good at the Y-Combinator program. That means a success rate of 10% for all start-ups in the US. The article also defines success as bringing a company to a $40MM valuation. We take that as the average value of a successful IPO in the US since a lot of companies do not IPO but instead are acquired by other companies, which results in similar windfalls for the employees who have equity. As the final piece in the average successful start-up valuation, we need to know how many start-up companies are out there (oddly this was the hardest number to find). According to the information contained in news.yahoo.com/us-universities-big-bets-start-ups-210545522.html, there are around 4000 start-ups in the country. This seems to agree with the general consensus that claim about 500 to 1000 new start-ups are created every year in this country. We assume most of them go bankrupt, but 4000 seems like a reasonable approximation for the total number of start-ups in the country (if this number seems slightly high it will be offset later by optimistic assumptions about start-up success rates and share percentages of employees at acquisition or IPO).
So out of 4000, 10% are expected to succeed and reach $40MM. Let’s assume that the failures reach a $1MM valuation on average. This is likely a large overestimate but this number doesn’t matter too much since the top 10 IPOs have such large valuations that $1MM per failed start-up becomes insignificant.
Now we have enough information to come to a reasonable estimate. The following are the assumptions I used:
- 4000 start-ups.
- 10% of start-ups reach $40MM in valuation.
- 90% reach $1MM in valuation.
- 4. Also add in the data from the top 12 start-ups since 2004 that actually account for most of the IPO/acquisition value ($150BN, $100BN of which is Facebook).
I fired up Excel and made a row for each of the companies in the top 12 along with their IPO/acquisition valuation. Then I created a row for the average successful (10%) start-up and gave it a $40MM valuation. Then I created a row for the average unsuccessful (90%) start-up and gave it a $1MM valuation. The final valuation is done by taking a weighted average of all valuations weighting each of the top 12 companies by one, the successful start-ups by 400(4000 x 10%), and the unsuccessful start-ups by 3600(4000*90%). This is the same as creating 400 companies with $40MM and 3600 companies with $1MM and taking the straight average. With this information, the weighted average IPO valuation in the US is $45MM.
In order to calculate the expected payout from a successful IPO, we need to know how much of the share percentage an early employee typically has by IPO. I got some reasonable information from two sources (angel.co/salaries and www.bothsidesofthetable.com/2011/10/14/understanding-how-dilution-affects-you-at-a-start-up). Typically, high-level people who join early stage start-ups at or before Series A receive about 1% share of the company. This is at the director or lead technical level. The typical person who joins a start-up early will be an engineer who will probably be lucky enough if he can get 0.25%. That number drops significantly if the company is post series A funding. For my calculations, I use 0.5%. However, this isn’t the actual share at IPO. By the time the IPO has occurred, an employee who started from the ground up will have his shares diluted by at least 25% of the original stake due to subsequent rounds of funding.
According to this data, if you joined a start-up as a very early founder with 0.5% of the company, you would own 0.125% of the company by the time IPO rolls along. Multiplying the average IPO value from above by 0.00125 will give you the expected value of the total equity grants, which is roughly $56K.
That seems reasonable. On average across all start-ups in the US, you can expect your equity grants to be worth $56K. This is a good amount of money, except that the typical IPO takes 7 to 10 years (http://www.businessinsider.com/barry-silbert-heres-why-start-ups-now-take-so-frigging-long-to-ipo-2012-3). Let’s again be optimistic and assume your start-up makes it after 7 years (we really want to justify the start-up trend). This means that the equity grants are worth $8K each year over 7 years, bringing the total at the end of IPO to our original $56K. This is all well and good, except for the fact that pay at a start-up is actually less than at an established company (http://venturebeat.com/2013/01/20/5-things-you-need-to-know-before-working-at-a-start-up). We need to factor in this reduction in our total cost benefit analysis. From personal experience, the 30% reduction reported here is pretty accurate. This means a typical $100K salary will pay $30K less at a start-up in exchange for options. We will use $30K here as the typical reduction in annual pay.
You might now see why chasing start-ups may not be a good idea. You would actually be down $22K a year on average if you worked for a start-up. In fact, the $56K of equity over 7 years would be less than half its value if Facebook did not exist because it is such an anomaly. FB IPOed for twice the valuation as the next 10 biggest IPOs combined, thereby skewing our results in favor of start-ups. We also used optimistic assumptions such as a general 10% start-up success rate and a high employee share of equity.
The following are some revised numbers given different assumptions:
1. If you believe Facebook’s $104BN dollar valuation was a fluke and it will not happen again soon: down $27K ($3K in equities minus $30K salary differential) per year working for a start-up compared to working for a mature company.
2. If you believe you are great at picking start-ups and that you have a 10 times higher chance of picking the top 10 start-ups than any other start-up because you are a keen business person. (we assume another Facebook will happen in the next 7 years): up $40K ($70K in equities minus $30K salary differential) per year.
3. Same as 2 above but we believe that another IPO like Facebook’s likely will not happen again soon: down $5K ($25K in equities minus $30K salary differential) per year.
On average, we see that the odds are stacked against the start-up employee. Again, we have not even factored in the fact that most start-up employees work longer hours than their mature company counterparts. The numbers also show how unusual the Facebook IPO was in terms of an extremely high valuation and how it skews the statistics. It should also be mentioned at this point that we always chose numbers that favored start-ups in terms of time to IPO as well as a typical founding employee’s share at IPO. This analysis applies to the case of joining a very early stage start-up. The numbers change for the worse if we only considered mid-stage start-ups that already had several rounds of funding. The percentage of an employee’s equity would be much lower but the time to IPO would shorten. If we consider the equity of a mid stage employee to be a fifth of a founders (still VERY generous) but shortened the IPO time by over half (3 years), we would arrive at a yearly loss of $26K instead of the original $22K.
Sadly, these calculations seem to reinforce my own personal experiences. I worked at a start-up where the early stage employees worked 70 hour weeks to have the company become acquired and net them a total of $14K per year in equity over 6 years. Given the salary differential between that start-up and a large company, it is unlikely they came out ahead. My gain at that company from equities was only $4K a year, and I was underpaid by $10K. At a subsequent start-up company, the equity payout was roughly similar because the start-up IPO occurred during a down year. Oddly enough, my most successful equity experience was with a small public company that I joined when the strike price for options was low. I ended up with a $12K in equities a year over 4 years with no differential in market pay because it was already a public company. Of course, there are many other reasons to work for a start-up that are unrelated to personal financial gain. Many thrive in a much smaller work environment that allows more freedom outside of large company politics or bureaucracy. In addition, a lot of the most cutting edge products and technologies are brought to market by these small groups of people. I would easily forgo a portion of my salary for a chance to work on something truly ground breaking and exciting. Analyzed from a strictly monetary standpoint however, the start-up environment does not seem to pay off.