Efficiently Pricing Your Equity

Understanding What Your Startup Equity is Really Worth

There's a lot of early-stage employees out there asking, "What's my equity worth?" And a lot of, frankly, useless responses:

"It's worth nothing until an exit" (then admit this is a bad deal financially).
"You figure out what it'll be worth" (not much of a guide).

Instead, let's build an "objective" model -- relying on how the most sophisticated players in the game — the investors — value it.

The naive approach is just multiplying your_shares * preferred_price_per_share. By that math, most startup offers will look like crap compared to a FAANG package.

In reality, there are three additional advantages you have over the investors as an employee to consider that drives the expected value upwards:

1. High Expected Returns (The Asset Class Premium)

Startups are risky and illiquid. To compensate for that, the asset class as a whole must generate high returns. Top VC funds, the ones that set the market price, target ~30% IRRs for their portfolio companies. That is the valuation the investors assume is based on this high level of expected growth, which is far beyond what might be expected at a public company.

2. The Ability to Quit

While the investor must put in their funds at the one-time capital call, as employee, your decision to invest and continue vesting your typically 4-year equity grant is a continual decision. That is, you can recall your "investment" by quitting, unlike investors.

This is why your equity functions like (if it isn't literally) a call option. And more volatility means the call option is more valuable. To see why, think of a simplified binary model:

Heads: The startup 4x's in 2 years. Your vesting equity now makes your total comp eclipse anything you'd get elsewhere. The culture of the valley is such that they'll keep paying you to retain you, as opposed to firing you to save future equity dilution.
Tails: The startup is going nowhere in 2 years if not dead. You just quit and retry this lottery.

3. Much Lower Taxes

With the Qualified Small Business Stock (QSBS) if you invest (including with your human capital!) in businesses with under $100M in assets, your first $10 million in capital gains can be federally tax-free. That's a 0% rate, compared to FAANG RSUs that are taxed as ordinary income (~40% federal + Medicare) or for non-QSBS equity, long-term capital gains (23.8% federal + NIIT). This tax shield can raise your post-tax comp by 80% or so in California.

This calculator models your equity's value by combining these three factors. It calculates your risk-neutral upper bound. Why "upper bound"? Because the model deliberately ignores two things:

Your Personal Risk Aversion: The calculator gives you an objective number based on market parameters. You should apply your own "sleep-at-night" discount to this number based on your personal finances.
Investor Liquidity Preferences: In a mediocre outcome, investors get paid first. This shaves a bit off the expected value, but since the expectation is so dominated by the massive upside scenarios, it doesn't move the needle much.

Note: You should use this calculator as a comparison tool between different offers. Look at the headline "Adjusted Total Compensation".

Some presets to get you started:

Typical Public Tech: Public market returns, typical volatility, RSU tax treatment.
Unicorn: Late-stage VC returns, higher volatility, RSU tax treatment.
Series A: Early-stage VC returns, very high volatility, QSBS eligibility.

Play around with it!

Technical Details

We assume California tax rates and Federal tax rates are calculated using your presets.

To handle the equity returns, factoring in higher expected returns and ability to quit, we produce a very simple model for an upper bound:

Your common stock goes to $0 in some time period with odds p; else multiplied by k.
p and k are constrained by expected returns on valuation and volatility of the stock.
If you go to $0, you quit and get a new startup job (with 0 lag).

Equation 1: Recursive expected value

                expected_val_n = (1-p) * k + p * expected_val_n+1   <recurrence>

                expected_val_n = discount * expected_val_n+1   <discounted future>

              expected_val = (1-p) * k + p * discount * expected_val

            expected_val = (1-p)*k / (1 - p * discount)   <simplified>

We can set discount to general stock market returns (FAANG) to represent opportunity cost.

Equation 2: Derive k and p from Volatility (σ) and Equity returns (μ)

Volatility is the standard deviation of returns. We'll use variance (σ²) to make the math cleaner. The two possible arithmetic returns are -100% (or -1) if the value goes to 0, and k-1 if the value goes to k.

        Variance (σ²) = E[Return²] - (E[Return])²

        E[Return] is simply μ

        E[Return²] = p * (-1)² + (1-p) * (k-1)² = p + (1-p)(k-1)²

        So, the variance equation is:

        σ² = (1-p)(k-1)² + p - μ²

Then with these two equations, we can calculate the upside multiplier k and odds of failure p:

        k = (1+μ) + σ² / (1+μ)

        p = σ² / (σ² + (1+μ)²)

In the model, we use a time period of 2 years. Value for μ may be set (or used presets). σ is set using known numbers. The numbers are then linearly scaled to their two year figures.