Offered Shares in a Startup? Ask these questions

Not too long ago I was offered the opportunity to be an early employee at a startup. I believe in their mission and I liked the founder. But, I passed. Why? One reason was that the compensation wasn’t right. I don’t mean that the salary wasn’t enough. It was reasonable given their stage of funding (Series A, about to raise a B round). Instead, the issue was the structure of the shares I was offered. If you are ever offered shares in a startup, here are the questions I suggest asking before you accept.

Shares in a Startup Aren’t Always Money in the Bank

The allure of being an early employee, and therefore getting shares in a startup, can be hard to pass up on. But, not all offers are equally valuable. A lot has to happen for your shares to turn into real money in that venture.

To determine how likely it is that those shares will become valuable enough to join the venture, here are some questions I recommend asking:

• How much money have they raised? The more money the startup has raised doesn’t always equate to a good thing. In fact, the more money they have raised the more likely that a lot of the available equity has already been claimed. This feeds into other issues.
• How many shares are outstanding? You need to have a basic understanding of how shares in a company work. Here’s the quick pass at that. When a company is formed it creates the number of shares that represent 100% ownership. All shares are not immediately issued. Some shares are held back, or not issued right away. Those that are already issued are outstanding.  For example, in a one-million share startup, the founders may have already issued 300,000 shares to each founder. If there are two founders that means 600,000 of one-million shares are outstanding. Then they raise a round of funding and have to give the investor 200,000 shares in exchange for their investment. Now 800,000 of one-million shares are outstanding. Some portions of shares are typically left unissued to cover key advisors and employees. We call this a pool of shares. The fewer shares outstanding the less they can afford to offer you and other key employees as they come along.
• How much revenue is currently being generated? Many startups raise multiple rounds of funding before they become profitable. However, most startups, except maybe science-based startups that require many-year runways to prove the viability of a solution, are able to get to revenue generation early on. Remember, revenue generation does not always equal profitability.
• How much revenue has to be generated for the shares to be valuable? The most common thing valuations are tied to, especially in the public markets when a startup IPOs, is the revenue being generated. If the company isn’t generating enough revenue then the shares you are offered are “underwater” or worthless.
• What are the market comps? Startup valuations tend to follow some semblance of logical comparison. If startup A and startup B are in the same industry, with similar solutions, similar executive teams, etc. then they are comps for one another. If startup A just completed an IPO, then startup B can use that IPO as a way to determine the value of startup B’s shares. You, as an employee, can use this to determine what your shares are worth or might be worth in the near future.
• Is there a preference stack? Early investors often have a preference stack built into their investments. This means that they get paid before others. If the preference stack is so big that the investors would eat up the entire profit from a sale or IPO of the company then your shares as an employee are worthless. So, you have to ask whether or not you believe the startup will become worth much more than the preference stack.

I’ve talked with startups that try to justify lower salaries for employees in lieu of enticing them with shares in a startup. What you need to understand is that, although exciting, it is a bit of a gamble whether or not those shares ever come into the black (meaning they are worth anything). It is a whole other issue whether or not they become valuable that the key employees become “minted”, i.e. millionnaires.

At best, my advice is that you decide if you want to join the venture based on their mission, getting to work with people you enjoy, and on projects that excite you. Let the shares in a startup be like a bonus that either happens or doesn’t.