Are Startups a Good Path to Financial Independence?

We’ve all heard the stories of billion dollar unicorns created by college kids and the overnight millionaire employees that work there.  If you work at a startup you get to be one of the cool kids, change the world, and get rich, what’s not to love?  

Starting in Startups

About a decade ago, I became totally enamored with startups and had the opportunity to do a mini program in Biodesign at Stanford’s D-school.  I helped create an internal incubator inside a large fortune 500 sized company.  I read hungrily, talked to everyone I could, and attended every startup meet up event within driving distance.  I would bring back all the gold I had picked up and use it to invigorate my group.  I was training across the organization in lean startup concepts and creating minimum viable products with constant customer feedback. I also implemented the power of daily standup meetings, and Agile planning in an environment of rapid iteration and ambiguity.  After a few years it just became familiar and I too jumped ship spending several years working at and founding startups.  I’ve learned quite a bit over the last decade.  Now that I am committed to living my life outside the maze, I found myself asking if I would recommend startups to someone who is earlier on the path and looking to become financially independent.

Is Working at a Startup a Good Way To Reach Financial Independence?

My short answer to this question is no.  If you work at a startup, you will likely take a pay cut in exchange for equity and that equity is worth far less than you think with a higher probability than you realize of never being worth anything. While trading salary for stock is common, it should never result in a net reduction in comp to work at a startup. Also unless you are shown the cap table together with your options offer, you can’t really place any estimated value on those options and can only consider them symbolic.

When you begin working at a startup you will assume that your startup has a higher probability of success than average because you are excited and on board.  You may believe that you have a good chance of being a $200M company so maybe your 1% ownership options are worth $2M.  This would be very incorrect and a mistake.

Average Return on Startup Equity

There is no free lunch with options and your sacrifice of 20K salary per year is not worth two million dollars.  It is worth pointing out that even professional VCs have averaged 10-20%  annual return (IRR) over the past 35-40 years as very experienced professional startup analysts (source 1) (source 2). If you think that your return on investment through deferred salary in the form of stock options is going to beat the average return that these pros get on their money, you may not be thinking rationally. 

Analyze your Stock Options Like a VC

It is worth pointing out that banking on your startup equity for financial independence is like trying to pick the one stock that is going to outperform the indices many fold rather than investing in an index.  I mentioned a 10-20% annual VC return over the past 35-40 years above.  However, there is huge variance. During the dot com bubble of the mid 90s for example VC returns surpassed 80% while other spans of time returned losses.  Venture capital has more variance than the stock market (which is itself somewhat volatile).

Venture Capital Is About Picking Unicorns Amongst Huge Variance

“Venture capital is not even a home-run business. It’s a grand-slam business.” -Bill Gurley, Benchmark

In addition to the variance, getting a return on VC investment relies heavily on the grand slam investments in billion dollar unicorns to make a return.  In 2017 for example, the top 10% of exits generated 60% of the return. There is some evidence of a trend toward more of these larger exits but less smaller ones, which means that the chances of picking a winner may be going down but the payout overall is going up. This suggests that more diversification is needed to make a return for venture capitalists.  However, when working at a startup you have no diversification but rather one lottery ticket with lots of caveats.

Startup vs Corporation for Financial Independence

Every startup is different with different types of options, classes of shares, and general cap table weirdness that you would only want to hear about if you had six or seven figures on the line.   However, I’ll share an example that generally illustrates why startup compensation is dubious using what I believe to be common standard startup practices in my experience.

Bilbo and Pancho are room mates each with a market value salary of $100K.  Bilbo takes a job at a startup and Pancho goes the corporate route.  We’ll come back to Pancho later.

-Bilbo is offered $80K per year and as an early employee he is given stock options equalling a 1% stake in the company.  This is in line with common options grants.

-Bilbo’s options vest on a standard schedule over 4 years with a one year cliff (if you quit or are fired before one year is up you get nothing).

-Because it is well connected and funded, the company has a 1 in 6 chance of successfully exiting.

-However, the company took on $40M in VC investment to get to exit with a standard 1x participating preference to the investors.  This means that Bilbo’s stock option is not worth anything unless the company sells for more than $40M.

-It also means that Bilbo’s 1% was diluted down to about 0.4% after selling the equity to raise the $40M over multiple rounds.

-Based on his knowledge of the company and the space, Bilbo thinks that the best prospect for his startup would be a $200M exit.

-If only 28% of successful exits surpass $200M, Bilbo’s 1 in 6 chances of exiting actually drop to about 4.5% of exiting for $200M.

Let’s Look at The Startup Options Math

The company exits for $200M and $40M is immediately returned to investors for the preference.  Bilbo now gets 0.4% of the remaining $160M or $640K.  However, he only has a 4.5% chance of that happening so his actual expected value looks more like $29K.  We also didn’t account for Bilbo’s tax implications at exercise (which can actually price some employees out of their own options). We also didn’t account for the actual cost to purchase the options (which is usually just a few thousand bucks). 

In other words, Bilbo gave up $80K ($20K per year over 4 years) in exchange for an expected value of $29K that is not liquid until exit.  Instead of waiting for an exit, Bilbo could have gotten a head start on doubling $80K in a total market index fund after 9 years if it returned 8% per year compounded. 

Bilbo actually ended up leaving the startup after a year and a half (longer than the typical startup tenure). Like 76% of employees, he never exercised his stock options. Bilbo moved on and got another job.  As his old startup eventually went under like the majority of startups do, he heard the horror stories from ex co-workers about the final few months in the office.  He shared the stories with his room mate Pancho over a beer and was happy he had jumped ship when he did.      

Pancho Takes the Corporate Path

Pancho was offered $100K when he took his corporate job and it was ok but not really that exciting.  He got used to wearing a badge and commuting.  At least he had health insurance and a 401K unlike his room mate Bilbo who was working at some penny pinching startup downtown.  Pancho worked an hour past 5pm every day and got a reputation as an up and comer.  He still got home an hour earlier than Bilbo.  Annual raises came for Pancho and a promotion too.  He was working at a company that was doing well and was generating good returns for it’s shareholders so he even got a small year end holiday bonus that he wasn’t expecting. Pancho wondered if Bilbo was going to become a millionaire while he was stuck in fluorescent lit cube land but aside from Bilbo’s stock options when Pancho added up all the benefits and his higher salary and bonus, he was making about $35-45K more per year.  He invested his excess in a total market fund and it was building even more while Bilbo’s options were tied up for years hoping on an exit.  When Bilbo ended up leaving the job, Pancho was actually kind of happy for him because Pancho had seen how the environment had dragged his room mate down.

Financial Lessons on Startups vs the Corporate Path

In my experience, the examples above are not exceptions but the norm.  It is always prudent to base one’s finances on the norm rather than the exceptions.  The prospect of a possible high six or low seven figure windfall in startup options is exciting.  However, if the goal is financial independence alone, one has essentially needlessly leveraged his financial future on a long shot gamble.  What is better, a 1 in 10 chance at being rich in 8 years or an 8 in 10 chance of being rich in 15?  

What About My Buddy Making $250K at Netflix?

There may be a few exceptions in the bay area or in silicon valley but generally speaking startups can’t offer comp to match successful established companies that are throwing off cash.  That’s why startups have to offer options.  While even big corporations talk about hacking and breaking stuff, they are not really startups anymore (sorry Facebook).  Call me old school but I’ve always resonated with Steve Blank’s definition that a startup is an organization formed to search for a repeatable and scalable business model.  This means that if you have proven this model and are making a real business with it, you are no longer a startup but rather a rapidly growing company that has found a scalable business model.  Hence most publicly traded companies are not startups (Netflix, Google) nor are private ones that have shown viability at scale (Uber, AirBNB).  Nor are rapidly growing small businesses like your cousin who is killing it selling cupcakes or that hot software dev shop.  These types of businesses want to hold on to some of that startup mentality which is great but I would not lump them in with Bilbo’s example.

Personal Costs Of Working at a Startup.

So far we’ve looked at the financial costs of working at startups but the personal ones may be even more important in my experience.

Working at a startup is not a job but a lifestyle.  Working 60 or even 80+ hour weeks is typical.  If financial independence is the goal, one could alternatively take that extra 20+ hours per week and get some substantial income from a side hustle.

I have not been able to find data, but everyone in startups understands that startups are a burden on your personal relationships and that entrepreneurs have a higher divorce rate.  Some have even shared their stories.

Many founders have staked their financial security and their future on their startup.  This creates impossibly high stakes and can make business challenges into personal ones.  Since startups by nature are always failing until they succeed, tension can be the norm.

Large companies have a process for opening a new position and they have an HR department that ensures that this position is do-able by one person.  Startups on the other hand are always understaffed and you will never be able to get it all done.  You will always be asked to wear multiple hats and do more than you can. If not careful you may feel like you’ve never worked harder to feel like a failure.    

Since startups often fail, you will often be out of a job when this happens.  Severance packages are very rare at startups.  Because relationships are strained during failure, good references may be more challenging to maintain at a startup as well. 

Why Working at A Startup May Make Sense

Really the only reason that I would suggest working at a startup is that you would like to found your own or be a small business entrepreneur.  If it is just financial freedom you seek, I recommend that there are better ways to get there.  However, If despite everything that you have seen, you feel driven to enter startup land, that’s fine.  After all, I took this path and was still able to get my financial independence.  I consider myself well prepared if I one day choose to do another entrepreneurial endeavor.  

Some people launch successful startups with no prior experience.  These cases had some combination of great connections, a super strong entrepreneurial academic background, and luck.  The lucky may simply be outliers that were in the right space at the right time and learned quickly.  Working at startups accelerates your learning about business and your development in general because it is trial by fire.  However, that can also mean you get burned out if not careful (it’s a pun).  Working at a startup is your entry point to learn and to build a network in the startup and investor communities.  It gives you the opportunity to fail a lot and fix it on someone else’s dime so that can succeed when it is on your own.

Founding Your Own Startup

Founding your own startup takes a personal burden that an employee may not understand. You will privately think that there is no path to success several times but will keep composure and somehow make it through most of them. You are responsible for all the employees as well as the money invested. The hardest decisions will make their way up to you and you will sleep (or not) with the concerns of the business each night.

The good news with founding your own startup versus working at one is that your lottery ticket becomes much more meaningful. In the same Bilbo example above, a founder might have retained 15% ownership of the company through to the $200M exit for a $30M payout. Even at a 4.5% success rate this yields an expected value of $1.35M which is interesting.  A founder also has the ability to accept or deny funding terms early on, and can sway when to sell the company.  In short, you have much more up side potential and much more control.  If you have created value, you have more ability and flexibility to realize that value as a founder. While working at a startup may not make financial sense, founding one looks different but it is still a lottery ticket. It may be worth noting that if you have everything to be a successful startup founder, you may also have everything to be a corporate executive where your comp package over a four year vest timeframe may look similar to a startup founder’s expected value but without the variance or emotional insanity.

Are you considering a startup and have questions?  If you have startup experience how do you feel about my assessment? What are your thoughts on startups and financial independence?  Please join the conversation in the comments below.