Early-stage startups are risky ventures. Most fail. So people who join them take a big risk. The startup gives ESOPs (shares in the company) to employees to compensate for this risk. ESOPs can yield a fortune if the startup becomes a Unicorn.
ESOPs are one big reason why people work for startups. Early-stage startups can't pay market salaries because they don't have the money. Thus, they compensate their employees through ESOPs. These ESOPs carry a big risk and potential reward. They can become extremely valuable if the startup becomes successful.
Companies like Google and Facebook have created hundreds of millionaires through ESOPs. It's the same story in India. Early employees of Zomato and PayTm became wealthy through ESOPs. But for every unicorn startup, hundreds sink. Several others achieve moderate success – big companies acquire them at lucrative valuations.
Most startups create a 10% ESOP pool before they raise their 1st big round (Series A or pre-Series A). Incoming investors want founders to create an ESOP pool from their equity to avoid dilution. This percentage gradually decreases as the startup issues new shares for new capital. Hence, founders have 10% ESOPs to divide among early employees and save something for future employees. Thus, ESOPs are always a bone of contention between founders and employees. Founders want to give fewer ESOPs while employees want more.
So how many ESOPs should you ask for in an early-stage startup to compensate for the risk?
You should remember that the total ESOP pool is 10%. So, you can't ask for 5% or even 2% because the startup will hire at least 10–15 people post-Series A. If you have a few years of relevant experience, 1% is a good number. The founder will try to bring this down to as low as 0.05% or 0.1% by showing you a grand picture. But you must assign a probability of success and compare it with your opportunity cost. You will likely take a big salary cut. Thus, you better have a big payoff in case the startup becomes an (unlikely) roaring success.
Let's say a startup raised $3MN at a $9 MN pre-money valuation. It has 10,000 shares ($900 each share), and the founder offers you 5 shares (0.05% stake). Let's ignore the strike price for now. So 5 ESOPs are worth $4,500. That's hardly anything. But the founder shows you a projection in Excel (Founder's scenario). Your ESOPs will be worth $562,500 in a couple of years. Seems a lot, right? You will soon be rich.
But how likely is this? The founder says 100%, but I say assign 5% weight to this scenario. There is also a chance (say 15%) that a bigger company will acquire this startup (Acquisition scenario). This gives you a payoff of $67,500 from 5 shares.
Assign an 80% probability of the ESOPs ending up worthless because the startup will fail. So, what is the risk-adjusted value of your ESOPs?
$562,00*5% + $67,500*15% + 0*80% = $38,250
Now all of a sudden 0.05% of shares don't look attractive. So you should ask for more, at least 0.5% if you are leaving a high-paying job. At a 0.5% (50 shares) stake, your expected payoffs will be around $400,000, not a fortune but good enough for a 3,4-year commitment.