It is standard for startups to dangle equity compensation as a big benefit when hiring employees, and it deserves to be treated as such. However, many private company shareholders don’t understand how much their equity is worth. Most people are aware that their equity is worth “something,” but without a reliable way to quantify its value, equity remains a major unknown factor.
Employees must decide whether to purchase their equity or let it expire when they leave a company. Even though it is often obvious if a company is performing well or not, employees should have some ballpark idea of how much their shares are worth before deciding to invest their hard-earned cash into the stock. This article aims to provide a few ways employees can think about valuing their equity.
FMV: an easy valuation floor
Valuing startup equity IS NOT a perfect science, and there is more than one way to go about it. One of the safest and most reliable ways is using the current Fair Market Value (FMV), also called the 409A price. The FMV is used as the strike price for any new employees receiving equity and is the value of one share of common stock as determined by a third party.
This number is usually conservative because the FMV evaluators discount the price heavily due to a lack of liquidity. Hence, the FMV is typically a safe, albeit low, estimate for the value of your stock. This number is also easily accessible for employees, and the IRS uses the FMV to value your shares for tax purposes.
When compared to your strike price, the FMV can be used to determine how much the value of your stock has grown since you received your option grant. If the FMV is equal to or less than your strike price, you should consider why the company has not gained value over that period.
LRP: The best metric (when it’s fresh)
If your company has received funding in the last year, the price paid by the last round of investors is the single best metric for valuing your equity. This price, which we will call the Last Round Price (LRP) represents how much Venture Capital investors paid for their Preferred Stock in the previous funding round. If it is fresh (i.e., Within the last year), it will almost certainly be higher than the FMV. If LRP is over a year old, it loses its reliability as company performance and broader market pricing can change drastically over multiple years.
LRP is a reliable metric because 1) investors paid this much for shares in the company, meaning they will lose money if the shares become worth less than LRP, and 2) these investors typically expect to make a return on their investment, meaning they hope the shares will eventually be worth more than the LRP.
Note that Preferred Stock is technically worth more than Common Stock (hence why the FMV is typically much lower than a fresh LRP), but when a company IPO, the two types of equity are treated as equals. Not all companies openly share their LRP with employees, but most US startups are Delaware-based C-Corps and are required to file this price publicly in their Certificates of Incorporation.
Secondary Market: great indicator when available
Another great indicator of the value of your stock is Secondary Market pricing. The Secondary Market usually prices shares at a premium or discount to the LRP based on market conditions and company performance. Typically, only later-stage companies nearing an IPO will have reliable Secondary Market information. Still, if your company has either buyers or sellers, it is a great place to look when trying to value your equity.
When looking at Secondary Market pricing it is important to understand the “Bid-Ask Spread”. This spread is the area between low prices that buyers are attempting to purchase stock at, and the high prices that shareholders are attempting to sell shares at. In most cases, real transactions happen in the middle of the Bid-Ask Spread.
You need to be careful when evaluating Secondary Market pricing, especially when there are only bids or asks. Anyone can submit a lowball offer to buy shares, just like anyone can submit a high aspirational price to sell at. Unless there is consensus on both sides, the pricing is unreliable. However, if there are buyers and sellers, and transactions are happening at a certain price, it is a justifiable valuation for your equity. In many cases, you literally can sell your shares at that price, so it is safe to use it for valuation purposes.
Market Comps and Tying It All Together
If you are privy to financial information at your company, you can go even deeper and come up with your own valuation of the equity. People spend years in school and on the job learning valuation based on financial information, so we don’t have time to cover it here. The gist is that you can find a bundle of public companies similar to your company called public comps. These public comps have reliable pricing information because the public stock market is very efficient. You can compare how these public companies are priced relative to their revenue and back into a valuation for your company.
Whether you dive into your own valuation or not, using all the sources available to you (i.e., FMV, LRP, Secondary Market Pricing, etc.) is always going to be the best way to value your equity. When making decisions like joining a company, exercising stock options, or selling your shares, it is very important to at least have a baseline understanding of how to value your equity.
