the price they paid

Cue the background music [link to a streaming music play].

Watching the gyrating reports on the price paid for Apple’s purchase of music streaming service LaLa reminds me that acquisition prices are widely misreported and often misunderstood even when correctly reported.  Some people only want to know one number – the price paid – without caring about the many other numbers that are relevant to understanding who got what:  the company’s cash on hand, outstanding debt, financing history, and other numbers relevant to the capitalization of the company.

Even the best reporting often misses one important element of the analysis:  newly issued options (or other equity) shortly before the deal.  I like to call this the “options icing” – and it’s a very important concept for understanding what really happened.  For company founders, management and especially employees, it can mean the difference between a happy and tragic outcome for their startup.  The “icing” is both icing on the cake for employees, and also a good way to ice a bad cap table.

The options icing doesn’t come into play very often, but it is more common when the acquiror is a large, sophisticated tech company that historically rewards employees with equity incentive.  This kind of acquiror understands that the future success of the acquired product is less about the technology and more about the personnel continuing to prosper in the big company environment.

Let me make up an example.  A big company has got a problem if the market value of a 50-person company they want to acquire is only $20 million, while the investors have already put in $35 million into the company.  Typically, the investors have to be paid back first before anyone else gets paid, which means that employees would get nothing, which means that the big company would spend $20 million and get a bunch of seriously disgruntled employees, who will probably leave the company pretty soon after the deal. Even if the investors agree to restructure their liquidation preference, say by half, you still have very little left over:  $17.5 million to investors, $2.5 million for employees.  Let’s say that 1/2 of the employee stake is owned by 2 founders, and then you’re down to only $1.25 million for 48 other employees.  Nobody is happy with that outcome.

Here’s where the options icing comes in.  The company could issue a huge pool of options to employees who would be critical to carrying the product forward (in any scenario, whether acquired or not).  Say they issue $10 million worth of new options.  The magic here is that a smart acquiror will be willing to pay for some or all of those new options.  Even though the company is still only worth $20 million, the acquiror could be happy to pay $30 million if the options are issued to the right folks with the right terms.

The “right terms” include typical vesting terms, so the employees receiving options are incented to do great work for the acquiror.  From the employee’s perspective, this is fair because it is a whole lot better than the stick in the eye they would have been getting under the $20 million scenario.  From the acquiror’s perspective, this is a good deal because rather than flushing $20 million down the toilet, they are making a rational $20 million purchase, with a nice $10 million compensation package that addresses the compensation disadvantage that big companies face in competing with startups.

One of the key reasons that people work in startups is that you can really move the needle for the company’s value.  In financial terms, if you are part of a startup that creates, say, $100 million in value, then it’s a pretty neat feeling to have made nothing into $100 million, and you can get rewarded handsomely for that.  But if you are in a big company that is worth $100 billion, nobody will really notice, or even be able to tell, that you added $100 million in value – it certainly won’t make much of a difference in the stock price.  And that creates a compensation disadvantage for big companies that are trying to motivate their employees with equity grants.

But in the scenario above, the big company can pay for $10 million in stock grants to motivate a relatively small number of employees to execute on a product they clearly understand.  If these employees can turn that $20 million business into a $100 million business, they will be rewarded for it in a manner comparable to their rewards if they had remained an independent company.  That kind of compensation is generally not possible to award in a big company other than in this scenario because of internal “fairness” issues.

The beauty of all of this is that it is one of the few situations in this rotten ol’ world that deal dynamics favor the rank-and-file employees.  Most corporate dynamics, especially in big deals, have a tendency to screw the little guy.  But in order for this situation to be a good outcome for everybody, the rank-and-file employees have to be rewarded in a fair manner.  Coming back to my example above, the options icing can be win-win-win all around:  The investors can get a little tip for agreeing to the restructuring and the new equity; let’s say they get $18 million, just a bit more than they would have made otherwise.  That leaves $12 million for the employees – say the two founders take $3 million, more than twice as much as they would have made under the $20 million deal.  The other employees get $9 million, more than 7 times as they would have made.  The acquiror paid $10 million more, but as described above, this is money that really makes sense to spend, and it’s more like incentive compensation than it is acquisition consideration.

And this deal gets reported as a $30 million price paid.  But really from the right perspective it should be regarded as a $20 million deal.  Now, I am not saying that anything like this is what happened in the Apple-LaLa deal – actually the discrepancy in the reported numbers is too large to be explained by options icing alone.

weighing your options

A friend asks:

I’m working through a start up analysis based on a web-based software app. What is “options consistent” with a start up?

The short answer:  show the prospective employee a 5-figure number, and convince the employee that it makes sense.

The long answer:

This is highly dependent upon the type of startup and the position of the employee. I’ll answer for a typical situation of a VC-backed startup and a developer from entry-level to senior (sub-exec) level. You could have a very different answer for startup that was not VC funded, or an executive level position. You might even have a slightly different answer for non-developers, certainly in the areas of marketing, administration, customer support. (I’m putting aside for the moment the question of whether it is “right” to treat execs or different functional areas differently.)

Many propspective employees seem to take a highly illogical view of evaluating startup options. They compare the raw number to that in their other offers, or to offers that their friends received. (“Well I think I deserve at least 30,000 shares in this company, because my friend Jonny got 20,000 shares in his company, and he’s an idiot!“)

This seems nonsensical because the value of the options must be calculated with respect to the specific company situation, especially in terms of the company’s existing capitalization and prospects for liquidity and growth. Having 20,000 shares in a company that has 10 million shares outstanding is, absent other facts, five times more valuable than 20,000 shares in a company that has 50 million shares outstanding. That’s simple enough, but it is by far less important than the other main factor. Having 20,000 shares in a company that is about to go public might be much more valuable than having 20,000 shares in a company that has just started.

Might be. Or might not.  What if the company that has just started is the next Google, as they all think they are? The problem here is that you have to evaluate both distance to liquidity and prospects for growth. Figuring out which startups will be successful and when and how big they can get is extraordinarily difficult – these are things that professional money managers routinely get wrong. A prospective employee has very little hope in getting this evaluation right.

So let’s look at it from the other side: how do companies decide how many options to offer employees? Typically a company budgets a particular target of dilution from issuances of options over 12 to 18 months. For an early stage startup, this target is often around 15-20% of total capitalization (including the options pool). A one-year hiring plan in that stage might call for something like one new executive, 3 senior employees, and 12 employees from entry to mid level. So the company would budget its options accordingly, obviously also aligning grants with external market conditions.

A prospective employee who wants to know whether an offered grant is “fair” really has no better method of evaluating this than by asking the company to explain how they came up with the number. Ideally as an employee you’d want to ask:

  • What’s the fully diluted capitalization?
  • How far is the company from liquidity? What type of liquidation event does the company anticipate?
  • What are the company’s business prospects for the current year?
  • What is the options range for my position, and where am I in this range relative to other recent hires?
  • How far into the hiring plan is the company for the current year? How many and what positions will be hired?

And you ask these questions not because you can actually value the company based on the answers.  You ask as a test to see if the hiring manager has thought through the offer, and sounds as if there has been rational thought behind your compensation.  You want to work at a place where the management can provide sensible answers to these questions, independent of whether the answers can add up to a company valuation.

Many candidates do not feel comfortable asking these kinds of questions. Worse, some companies will not answer them, and will view the asking of such questions as a sign of impudence.  I’d say you should think twice about working for any company that would be insulted by the asking of these questions, but unfortunately that company attitude is not uncommon.

As a result, the best guideline to fall back upon for many prospective employees is back to good old Jonny:   What have I been offered at other companies, and what are my friends getting at their companies?

Which turns out to be not such a dumb way of evaluating offers, because many companies use more or less the same budgeting processes and have similar investor and advisor networks. So most companies end up in a similar range of options for similar positions. For most mid-to-senior positions, this will be a 5-figure number, and as long as that number can be justified to the employee, then you can move on to more important questions, such as why anyone would want to work at this company in the first place. There should be a lot of answers to that question, and the options offer should be only a very small piece of the puzzle.