Taking Stock, or Why a Fruit Salad > Orange

I was recently asked by a terrific group, the Women Alumnae of Mercer, to explain equity, stock options and related concepts to a group of people interested in entrepreneurship, startups, venture capital and the related pile of stuff.  Jodi Hubler, a super cool healthcare expert and friend, also participated in this program as we explained the ins and outs of equity to a large group of businesswomen who are or have been affiliated with Mercer.   Great group.

Those of us who live in the middle of the startup swirl, like Jodi and I, take so much knowledge for granted.  We know what it means when people throw around terms like equity, cap table, dilution, strike price, preference stack, and, given current circumstances, recap and “cram down.” Or at least we should!  Articles like this suggest that as many as half of all people presented with questions about stock options, do not understand enough to make intelligent financial decisions about them.  And that includes the people who own stock options.

But most people don’t know what any of this stock option information means and why would they?  Unless you had a brush with entrepreneurial activities or a reason to learn this as an investment banker or venture capital person, which is not a lot of people, the average person doesn’t learn this stuff in school.  This means that they often don’t know enough to effectively negotiate or even understand their own compensation.  Granted, a lot of people don’t care about these fine points either.  But for people who wish to venture into the vortex of venture and startup land, it’s important stuff to understand, particularly in the context of what trade-offs you may be making between startup opportunities.  This is even more important for women entrepreneurs and employees to understand, because women currently own about $.47 for every $1.00 of equity owned by men.  Cue Barbie Movie blog post.  I am so annoyed.

As I thought about how to make this topic simple, I came up with what I believe to be the perfect metaphor: a fruit salad!  I know, obvious, right?!  Here’s the way I see it.

It all starts with stock or equity, which are, by the way, mostly equivalent terms, at least for this discussion.  Yes, there may be some fine points to the differential definition, but let’s start with the basics.  If you were buying a house, the “equity” is the amount of the house you own vs. what the bank owns.  Same idea in a company, but your equity is what you own (or have the right to buy in the form of stock options) vs. what all other shareholders own (or have the right to buy).  Let’s start by looking at an orange.

Imagine the orange is the asset – the thing that people want to own.  For purposes of this story, the startup company is the orange.  Each wedge of Orange.com represents a piece of a company and therefore a piece of its equity. I guess if I were a true Silicon Valley entrepreneur, the company would be Orng or Orangely or something, but I’m a simple person.

Okay, so if each slice of Orange is a piece of equity or a portion of stock, and you are given a stock option grant, then your potential ownership position of the company is equal to the number of slices you get of the orange as a founder or employee. For the sake of argument, if there are 8 total slices in the orange and you get a grant to purchase 1 of them as the newly appointed chief produce officer of the orange, your piece of equity (your ownership) has the potential to be one wedge (approximately 12.5% if there are 8 total wedges – the math is 1 divided by 8). Yeah, yeah, I know, sometimes there’s that weird mini slice in an orange, but let’s pretend all the slices are the same for this little exercise.  I say “the potential” of ownership because getting a grant of a stock option is literally getting a right, but not the obligation, to acquire ownership of a portion of the company’s shares at a fixed price. Until you exercise (purchase) those shares, they are not yours.  More on that later.

When you get a stock option grant as a company employee, it almost always has two characteristics that need to be understood: cliff and regular vesting.  Cliff vesting means that you have a right to purchase/exercise those stock options, or to do what is required to own 1 orange slice, only after you have stayed at the company for a certain period of time.  A typical “cliff” is 1 year, so you as a new employee may be promised piece of orange today, but you won’t get your slice until the anniversary date of that promise.  And actually, you won’t get the whole slice that day either.  The slice itself will “vest” monthly or annually or however the plan designates.  This means that you get a piece of the piece of orange every month or year or quarter until have access to the entire slice.  A very typical vesting plan has a 1-year cliff and 3 years more of monthly vesting.  All of these terms may be negotiable, by the way.  Cliffs can be waived, and vesting accelerated on a faster pace, but that is up to the parties sitting around the table with the fruit salad on it, by and large.

As the company grows, it’s worth more than an orange (hopefully).  That means your potential/actual ownership likely becomes a smaller piece of a larger whole (assuming things are going well).  It may make sense to add more fruit to the mix; in other words, it may be logical to enable the orange to go further by adding money into the company’s coffers to further its growth.  If there are a lot of people at the table wanting to buy from Orange and thus the company needs to deliver on a plan to serve many fruit-lovers, one orange isn’t going to cut it.  Hence, the fruit salad.  Someone comes in and adds some bananas, a strawberry or two, a kiwi if you are being exotic, into the big bowl that once sparsely held one orange – this is a proxy for pouring more money into a company to finance its growth.  Now your orange has friends, and by itself represents a smaller part of the overall fruit salad.  No longer are there 8 pieces to share, but rather many dozen.  Your piece of equity (your potential/actual ownership of 1 piece of the orange) is smaller as a total % of the salad.  This is what they mean when they say “dilution.”

So, isn’t that a bad thing?  Why would someone be happy when their equity ownership gets diluted? Well, as the saying goes, you need to spend money to make money sometimes.  And the truth is, unless you’re obsessed with oranges, you get better taste and nutrition from a fruit salad, especially when you’re one of those kiwi-lovers.   With that extra fruit, the resources go further and, if used wisely, they result in a much better outcome.  This is a lot like a company; if you pour good money into a company after the early money produced real value, you should get bigger scale and bigger overall value.  Yay!

In a perfect world, it’s better to own more of a good company.  But since reality is a thing, it’s important to be practical and recognize that it’s much better to own a small portion of a massively valuable and growing company than a massive portion of a company which has a low valuation.  For instance, consider Alphabet/Google vs. WeWork.  The former company has a total valuation of $1.74 Trillion (with a T) as of September 15, 2023.  I know this because I, ironically, Googled “what is the market capitalization of Alphabet today?”  The valuation/market capitalization of WeWork happens to be $230 Million (not with a T) on the same day.

If you own just 5% of Alphabet, that’s currently worth $87 Billion.  Sounds good to me.  That will buy a lot of shoes and a truckload and a half of fruit salad.  If you own 100% of WeWork, that is worth $230 Million.  OK, not chump change, but that stock is rumored to be going to zero.  Either way, it illustrates the point: better to own a nominal amount of Alphabet’s fruit salad than all of WeWork’s oranges.  You may own less as a percentage, but it’s worth far more.  And that’s why dilution isn’t always a negative.

It’s at this point that the concept of “valuation” needs to be better understood.  Valuation is just a fancy way of saying “what is the price of the fruit salad?”  From a financial/technical standpoint, “valuation” is basically what a willing seller can get from a willing buyer.  So, if someone is willing to pay $.50 for an orange but is willing to offer $10 a pound for fruit salad, and the fruit stand guy is willing to sell at that price, you have established the valuation of a pound of fruit salad.  It’s $10.  Notably, that price has basically nothing to do with the price of the original orange.  Private companies work exactly the same way.

It’s quite easy to find out the valuation (total value) of a public company – it is called the “market capitalization” and that is published in the paper and on the internet every day for every public company.  But private companies don’t have to publish their valuations and they rarely are discoverable in a precise way without insider information.  And if you think equity is like an orange, you likely don’t have insider information.   This may worry you, but I can assure you that even if you knew the valuation (price someone is willing to pay/take) for a private company, it doesn’t mean a lot at any particular point in time except the day you sell the company.  Valuation can go up, up, up, only to crash to earth when the market goes south.  An orange is worth a lot when it’s fresh, but it isn’t worth much when it’s old and moldy.  The only time valuation really matters is the day the company’s stock is sold in an initial public offering or when the company is acquired.  Because just like with fruit, the price of private companies goes up and down based on…lord knows.  It’s mystical and magical and largely the result of guesswork disguised as math.  It’s only when the cash is in the bank that you know what the company’s true value is.  And that’s when you know whether the extra cash/fruit was worth the squeeze.

So, you may ask, is there any way to figure out what a private company’s stock/equity/orange slices are worth, such as when they offer you a job and grant you some number of stock options?  Well, sort of.  There are some standard rules of thumb that can help you evaluate whether it’s a nice orange, an impending fruit salad, or a moldy, worm-invested mush.  Those include a few qualitative and quantitative methods, combined with a sprinkling of gut feel and a soupçon of darboard.  But none of these are really 100% informative.  It’s kind of like squeezing oranges at the grocery store.  It may feel nice and juicy through the rind, but sometimes there’s a big fat worm in there you didn’t know about until after the first bite.  Ew.  And sometimes there’s a magic golden ticket.

There is also a thing called a 409A, which is an accounting/valuation analysis performed by financial entities, like investment banks, to provide companies with an “objective” stock price for purposes of stock option valuation, among other things.  A 409A opinion is intended to be an independent appraisal of the value of the company’s common stock, which is the kind of stock used to underpin stock options.  You can ask the company what it’s 409A says, but again, this isn’t proof that the stock is actually worth that amount of money in an actual transaction.  Just like orange prices, it’s a moment in time analysis subject to what’s happening in real time at any moment after the 409A opinion is rendered.

As noted above, stock options are basically the right to buy oranges or fruit salad at a fixed price.  They are a promise that you can acquire some amount of equity/stock in the future for a price set today.  The idea is that when you go to sell it several years hence, it will be worth a lot more, so the price you are allowed to pay for it (also called the “strike price” or “exercise price”) will either be a bargain, or it will be a bust.  When the strike price (price of the orange wedge) is actually more costly than the value of the orange itself, that means the stock is “underwater,” a very unhappy term in the startup world.  Having the right to buy an orange for $1.00 when you can walk into Safeway and buy it for $.25 is no bargain.  But if you can buy an orange for $.25 when the going rate is $1.00 on the open market, that is a win, assuming you like oranges.

Note, when you are granted stock options in a company, just like fruit, they have an expiration date, which is the date upon which you lose your right to purchase (or decide not to purchase) the options.  Think of it as the “sell by date.”  Usually that date is set at about 10 years from the date the options are issued to you, but that can be affected by two primary things:  1) if you leave the company, you usually have 90 days to purchase or decline to purchase your stock options at the exercise price.  FYI, this is sometimes negotiable.  You may want to hold onto your purchase right because if you exercise stock options before you actually sell the stock, you may be liable for taxes on whatever gain there is on paper.  On the other hand, you do start the clock ticking on what may be taxable at a lower capital gains rate later.  Bottom line: do not exercise options without a clear understanding of the impact on your taxes.  2) if the company is acquired, you may get all or some of your options “accelerated,” by which I mean they become available to purchase immediately without further vesting or are transitioned to stock or stock options in the acquiring company.  This is generally a win, as it means you will be getting cashed out or similar.  But not always.  So again, the tax accountant is your friend in these circumstances.    Stock option buyer and seller, beware.

FYI, it is also important to understand whether the company’s stock option plan allows for “cashless exercise,” which is a way of buying stock without using your own cash.  You basically trade a chunk of your slice of orange for the rest of the slice owed to you.  Think about buying a fruit salad but paying for it in kiwi slices deducted from the salad, rather than by using Apple Pay.  Some plans allow for this and others do not.

One thing you should try to understand about a company in which you are getting stock through employment or investment is what the capitalization table looks like.  Think of the “cap table” aka the capitalization table, as the list of people who have purchased or have the right to purchase the oranges, or the fruit salad, as the case may be.  That’s basically what it is.  It shows what people own and how much they paid for it and what percentage of the fruit salad they are entitled to at any given time.  No magic, just a ledger.

The ledger is important, though, because it also also shows you how much money has been invested and how much of the stock that money bought will get better treatment than the stock you may have.  This is because not all parts of the fruit salad are created equal.  Some own the lowly grapes, some the fancy kiwi.  And that is kind of like the “preference stack” you may hear discussed at company meetings. The “preference” relates to which stock has greater value, not because it has a higher price, but because it is last in, first out when the company is sold, as a result of its “preferred” status.  This is a right that one can purchase for an agreed upon price.  Different pieces of fruit can come with different special properties (an orange may have extra Vitamin C while a preferred stock may have the right to 2 times it’s money before anyone else gets any pay out on the sale of a company).  The preference stack of a company is important to understand when you are evaluating whether your particular stock options might or might not have value someday.  But the only way to know about the preference stack is to read the investment contracts and it’s not likely you will get to do that.  Or want to do that.  Unless you have insomnia – this will definitely cure it.  But you can ask about it.  Again, this may or may not matter in the scheme of things – if the company is soaring, your odds of having stock that is valuable are higher than if the company has had a strong brush with gravity.

Recap and its crasser partner, cram down, are terms that mean that someone took the capitalization table and made it into a giant etch-a-sketch, wiping out some or all of the list of owners so their previous fruit cup is now a grape…or a memory.  Yes, this can happen, and it does in down markets.  The good news is that many times, albeit not always, employees who had stock options when a recap happens get “refreshed,” aka get some new options to replace the old moldy fruit that got left out in the sun too long.  The investors are the ones that usually take the brunt of a recap.  But there are no guarantees that employees won’t also be affected.  Everyone’s fruit salad is up for grabs when the supermarket runs out of produce like a company runs out of money and must go begging.

Bottom line: all of these terms seem complex, and they are, but there are people who can help you understand them.  My best piece of advice is that if you don’t understand terms being said to you or a job offer being made that includes stock options, phone a friend.  Don’t stay in the dark because this isn’t what you learned about.  Use Google too, and Carta, where many of these questions can be answered.  Ask someone who does know so you can enter a new job negotiation with your eyes wide open.  I can’t tell you how many worthless stock options I have gotten over my career, but I knew the risk when I took most of those now amusing pieces of paper (which make excellent wrapping paper, by the way).  And don’t worry, most people don’t know this stuff at all, so you are not alone.

Believe it or not, I have not covered all the relevant terms and topics around stock options and equity here, but I thought I’d go with the basic fruit salad, not the version that includes weird starfruit and, god help me, raisins.  What’s with raisins anyway?

Here are some excellent resources should you want to dig further into this topic:

• AngelList
• Carta
• NVCA – look in the “Our Work” section
• YCombinator – in the Library section

Good luck and may your fruit salad by free of raisins!