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September 8, 2009

How to Value Stock Options

by Dan

During my career, I’ve worked for five startups, one larger company and one startup that was acquired by a large company. I was offered or promised stock options each time I joined a new company except once. I didn’t know what they were worth, so I usually discounted them when making a decision.

It turns out that the most likely value of stock options in a startup is zero. Things do work out sometimes. And when they do, it can be great. But mostly they don’t. Options at an already-public company are a different matter since you can be sure you’ll be able to sell your stock eventually.

Here is my rule of thumb for estimating the value of stock options at a public company:

Value = Number of Shares * Exercise Price * .4

For example, if the company’s share price is $10 and the grant is for 1,000 shares, the approximate value is 1,000 * $10 * .4 = $4,000. Since options typically vest over four years, I would count this grant as $1,000 per year for four years. This assumes I don’t sell any of my shares until the end of the four years.

The .4 factor comes from estimating how much the company’s stock price will go up over the next four years. From 1871 through July 2009, the S&P 500 Index has gained 8.7% per year which, if compounded annually, gives you about 40% over four years.

Of course, life doesn’t always happen as planned. This rule helps me figure out a reasonable estimate of value so that I can make a decision and move on.

UPDATE: Ironman at Political Calculations, created a nice calculator based on my thoughts and added some insightful comments.

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