Before I started this blog, I was a software engineer. Seven years ago, almost to the day, I signed on to become employee #7 at a new start-up and, like many start-ups, I put in long hours designing much of the database and business logic. I was a team player. I was a walking billboard for this company. I moved to be within 10 minutes of the headquarters. After a year or so, the salaries leaked out to the employees. Some careless VP left a CD hanging around. I found out that I was getting paid less than the person who was much more junior and who always came to ask me questions. To top it off, this person only worked 4 days a week – normal days, not 10 hour days or anything like that.

I was frustrated. I put together a case for my CEO explaining that critical function that I perform for the company. Since he was our third CEO perhaps he didn’t know how valuable I was. In hindsight, I should have gone to other managers, but it was never really clear who my manager was. In a company so small, it was very fluid. In my presentation, I couldn’t speak of the salary information leak. Instead, I went through with a detailed Salary.com profile that showed that I was being paid in the bottom 5 percentile for my job description and experience. The CEO said that there really wasn’t much he could do… times were tough… not much money… blah, blah, blah. I tried to negotiate for non-monetary compensation like vacation time or more stock options. I was completely stonewalled. I made it clear that I would have to explore opportunities elsewhere.

It turns out, I never got the shot to look for new opportunities in Boston. My wife was similar dissatisfied with her job. She applied for a promotion in San Francisco. It was better everything – more of a desk job, less risk (her job at the time did have some risk), and better pay. I had lived in the Boston suburbs all my life. I spent the first 28 years of my life living in my hometown – including going to college there. When my wife got the job, it seemed like the time was right for change.

On the exit from that previous company, the details of the stock options came up. As I worked there for more than two years, I had vested in a significant number of shares. When you leave the company, you have the option of either surrendering the stock options, or buying the strike price and owning the shares. So if the share price was $10 when you joined (the strike price), you have write a check for $10 times the number shares if you want to keep them. In my case the strike price was much lower, allowing me to buy my stock options fairly cheaply. The catch with this is that, as a private company, I couldn’t easily sell the shares. You can offer them back to the company, but I believe they have it in the contract that they can refuse to buy them. Then you can look for private bidders or other options. It almost never comes to that. People wait for a liquidation event – either an IPO or a purchase by another publicly traded company. I made a very risky investment and bought the shares.

The Risk Pays Off

Last week, a friend called me up. He just saw that a very large public company bought my old company. Finally, I can cash in on the private stock as it will be converted to cash and/or the public company’s stock. It wasn’t bought for a pittance either… the deal was reported to be 9 figures. That’s the hundreds place in millions of dollars. Remember the part in the beginning when I said I was employee #7? Put yourself in my shoes for a minute or two. This has to amount to life-changing money right? Well not exactly. Let me explain a little about the world of private funding from what I learned. Please note that I’m not a venture capitalist or have experience in this other than a couple of cases where I was involved.

The Dilution of Private Stock

As you may know shares of stock are fractional ownership in a company. Having 5,000 shares of stock doesn’t necessarily mean anything without knowing what the share price is. The share price is determined by the value of the company divided by the number of total outstanding shares often called the “float.” (This is a simplified overview for sake of brevity.) The value of the company, well, that’s kind of nebulous. In a private company funded by venture capital, it is largely determined by what venture capitalists will pay for ownership in your company. Companies like Facebook and Twitter can raise a lot of money this way as they are well known and have ability to make lots of money (more Facebook than Twitter at this point).

In the case of my previous company, they had to go out and raise money from the venture capitalists a few times. The money is necessary to do silly things like pay employees and/or acquire other companies. When this happens, typically the value of the company is readjusted upwards and more total outstanding shares “float” are issued. I’ll give you an example with completely different numbers than my own. Let’s pretend that when I signed on I had the option to buy 100 shares and there were 10,000 outstanding shares. Let’s say that the company’s last round of funding was $1,000,000. If they were to issue stock instead of options (again trying to make this simple) I would own roughly 1% of the company (100/10,000) that’s worth a million dollars. It would be a nice $10,000 bonus. Now let’s say the company decides to raise money. The new investors come in and say, “We like what you are doing, we think you are worth 3M so we’ll buy some shares at a higher price.”

It was billed as a joyous event at our company when new rounds of funding came in. It meant that people liked our work enough to hand us cash. That is a joyous occasion. What I didn’t know is that each time we went out to get more money, they weren’t trading stock from the original 10,000 outstanding shares. The company issues more outstanding stock, so now there are 25,000 outstanding shares of which the new investors got a good portion of. (Unfortunately venture capitalists aren’t in the business of handing out money for free).

So what happens to my 100 shares? If the company doesn’t grant employees new shares (and my company didn’t) it gets diluted. Instead of owning 1% of the company, I now own 0.4% of the company. Fortunately the value of the company is now valued at $3M so 0.4% of that is $12,000. The value of the company tripled. The value of my stake in the company rose 20%. Now I don’t mind making 20%. I’ll take that any day you want to give it to me. However, it takes about 4 of these events (if the value in the company triples every time, which an extremely unusual event that I’m using for simplicity) before the company gets valued at 9 figures. Take that 20% gain each time and my hypothetical value would essentially double to $20,000 by the time the company is sold. At this point, the company has a million shares and my 100 shares is essentially a hill of beans.

Final Analysis

When you apply the stock dilution to my particular case, it’s not as bad as I made it in the example above. There were a lot of capital raising events, but the final purchase price by the large company was more than I anticipated. I can’t say what the final numbers will be (because I don’t even know the terms of the sale yet), but in hashing through the numbers with a former co-worker it would seem that I’d make 2000% from buying my vested stock options. That’s a great return for 5 years. The unfortunate part is that the number of shares that I was granted and allowed to buy was very low (one of the things that drove me to leave the company). When I look at the cash I’ll make, it’s striking in that it is almost exactly for what they underpaid me according to my Salary.com estimates for the 2+ years that I was there.

All is not lost in my dreams of stock option riches. I few years ago, I bought more private stock in a different company. Even though I was with that company for less time and had much less of an impact on their success, I think it is worth 10 times as much as my previous company and I have a higher initial value of ownership.