Dan Shapiro: Startup pay kind of sucks.

This is not a well-kept secret. A great startup with a dozen or so people will typically pay its employees about a third less than a big company. Some will argue that that's because of the value of the equity that startups give you. I argue that that's the price of doing something that's more fun, but of unproven economic value.

But regardless of why you're doing it, there's no question that startups ply you with ownership in the company, typically in the form of stock options. They will argue that there's tremendous value in those shares, more than you'll get from a big company, but they tend to get all nervous-looking when you ask them how much value.

Now there's no doubt that 1000 options on stock in a startup with one million shares outstanding (0.1%) has a lot more upside than 1000 options on stock in google (0.000003%). This of course raises the simple question: what are they worth?

I'm going to give you a few tools you can use to take a swag at that value. More importantly, I'm going to give you a checklist of key questions to pummel your potential new employers with that will simultaneously put you in a position of much greater knowledge, and making them think you're a badass negotiator.

I AM NOT LEFT HANDED:

Note that many people would prefer you not know this stuff.

At most startups, the equity's worth a lot less than you might imagine (as you'll see below). One of my favorite bloggers, Mark Suster, argues that you should just assume the equity is valueless and be pleasantly surprised if you find otherwise. This is one of the reasons I admire Mark -- he's so good at closing candidates that before he does it, he takes on voluntary challenges. It's like he's working on an Xbox achievement.

Me? I want my potential new hires to know exactly what they're getting, erring neither high nor low. I don't want them misled with a number that's too big, or there's hell to pay when they realize they've been had. And I don't want to sandbag, because closing a hire is hard enough without telling people to ignore the equity upside.

So that's what I'm here to tell you: how to know if you're getting a good deal from a startup. And my secret ulterior motive is this: I usually give my employees a great deal on their equity. That means that if they're informed consumers, my companies' offers look awesome compared to anything else they're seeing.

Let's start with the basics, which are completely misleading. Then I'll get to the important stuff.

The value of a whack of equity is this:

Value of company * (shares you get/fully diluted shares)

Quite simply, it's your percent ownership times the company's value. Seems simple enough, but it's totally wrong.

OPTIONS VS. SHARES:

There's a little reason why and a big reason. The little reason is that the above equation describes the value of shares. You're probably receiving options. An option is worth less than a share. How much less is excruciatingly difficult to model accurately. It's about the same before your first financing round, but it can be a meaningful difference if your company has taken on a few subsequent rounds of capital.

The big reason is something investors don't like to talk about, but here it is: the existence of preferred, "investor" shares significantly devalues regular, common shares.

This isn't some sort of rant. It's basic economics.

You see, investors typically take rights when they invest that put them "in front" of regular investors. If they invest a million bucks and the company sells for a million bucks, they get their money back and everyone else gets nothing. It's called a preference, and Brad has explained it much better than I can. It has a colossal impact on the expected returns.

They also often have something called participation, meaning that after they get their money back, they continue to get returns as if they hadn't. And then they have a set of terms called "protective provisions" which (more Bradness) explicitly allow them to block actions that are in the best interest of the company's shareholders, as a whole, and supported by a majority of shareholders.

Back when the IRS allowed such things, the rule of thumb was that common stock was worth one tenth as much as preferred stock. And the "value of company" number, above, is a preferred stock number. Yikes.

So that's the bad news: options on common shares in a venture funded company have a pretty crappy book value.

FIGURING OUT YOUR STAKE:

If you thought the company was worth what the IRS does, you probably would just take Mark's advice and ignore the equity. But there's other ways to look at it.

Another, quite reasonable way to consider the value of the options (or at least their value to you), is to look at what you predict they'll be worth. Most startups that try to sell the value of your options do this in an optimistic (some might say "false") way.

I've heard the phrase: "Our company just wouldn't accept an offer of less than $500,000,000" uttered by recruiters. But there's a right way as well as a wrong way.

The basic math for this one is:

Sale Price * Percent/ownership

That means you take your shares, divide by total shares, and multiply by what you think it'll sell for. Of course, nothing's that simple. You have to:

• Account for the possibility that the company may fail
• Consider dilution from subsequent financing rounds
• Subtract any preference
• Account for any participation
• Subtract bonus/retention/carveout packages

And a bunch of other tricks that investors (and management) can use to manipulate the return curve.

This becomes unbelievably complicated, since key factors are things like how good a negotiator your CEO is. To try and capture all of this, I banged out a set of heuristics (definition: "statements people will argue about") that you can use to make a crude estimate.

1. Do you believe in the company? Really, really believe it's going to be awesome? Feel in your guts that it's going to be something amazing? 90% of new companies fail, so if you don't, then you should assume your stock is worthless, and stop here. Also, you should go work elsewhere, because life's too short.
2. Ask the company: "What is your expected exit range, and what comparables did you use to get there?" (in English: how much will you sell for, and who do you use as a basis for comparison). If you agree that this company looks like the comparables, then take the low number and divide it by 2. If they say it's going to IPO, divide by 10 instead. This is X.
3. Ask how much money has been raised, and how much more they expect to raise before they exit. If they say they they won't raise any money, then follow up by asking if they're profitable, have more than 18 months or runway, or are crazy. Add together the amount raised plus the amount they plan to raise, then double them, to get Y.
4. Ask if there's a preference, and if so, what multiple. Ask if there's participation, and if so, is it capped.
5. Cube the preference (as in, 2 x 2 x 2). That's Z.
6. If there's a capped participation, add 1 to Z. If it's uncapped, add 2.
7. Ask who's on the board. If a majority of board members are employees/founders, do nothing. If it's a 50/50 balance between founders and investors, add 1 to Z. If it's tilted towards the investors, add 2 to Z.
8. Now for the grand finale:

And that's what they're worth. Here's an example:

X-(Y*Z)

You're being offered 0.1% of a great company that thinks they'll exit for $250 to $500 million. They've raised $5 million and expect to raise $10 million more. Terms are 1x preference, capped participation. The board is evenly split between founders and investors.

X: 250/2=125; Y: 15*2=30; Z: 1^3+1+1=3.

125-(30*3) = $35mm.

You should consider your shares to be worth 0.1% * $35mm = $35k.

I love startups. I love it when people get rich from startups. I want you to join a startup, and I want it to shower you with riches beyond your wildest dreams. I want you to blow all this math out of the water. It's all guesstimates anyway... but it's better than fencing left handed.

(Special thanks to Dave Schappell of Teachstreet, Rand Fishkin of SEOMoz, and Tony Wright for proofreading and edits). Dan Shapiro is CEO of Sparkbuy and former CEO of Ontela. Opinions expressed in guest posts are those of their authors, and don't necessarily reflect the views of TechFlash or its staff