Valuing stock options or comparing equity offers doesn’t have to be a complete guessing game. I’ve built a simple tool that I found to be very useful for coming up with the expected value, linked at the end of this article, and which I’ll explain further below.

At my past two tech companies (Square & Docker) I have been in charge of educating new hires and candidates what their equity may potentially be worth someday.

Before we start, you need to ask for a couple pieces of information from the companies you are evaluating. If you’ve been given an offer, the company should also be able to provide you with the following numbers.

1. Current 409A price
The 409A is an obscure IRS code which basically means every private company has to have an independent value for its common shares. This is that value and also is the price you pay to exercise your shares.

2. Latest Preferred Price
The latest preferred price is the price per share paid by investors at the last preferred round (Series A, B, C, D, etc).

3. Company Valuation
The valuation is what the company is now “worth” based on the last funding round. A “unicorn” is said to have a $1 Billion valuation. For further information on valuation check out my past article here.

Fully Diluted Shares is the last piece of information you will need. This is all of the shares of the company added together (preferred, common, options, and option pool). This can be backed into by taking the valuation above (eg. $1B) divided by the preferred price per share (eg. $25). You will need either the valuation or the fully diluted shares for your calculation.

Let’s look at an example of two startups at different stages, Startup X and Startup Y:

Let’s assume both are great companies and you get the following offers:

“Startup X is giving me more options, I should go with them! Wait, Startup Y is giving me a higher percentage of the company, I should go with them!” I hear these arguments all the time. What actually matters is not the higher numbers or percentages, but what the FUTURE value is in real MONEY. 🤑

I like to use a method which takes into account the difference between the future stock price (whatever you expect it may be) and the exercise price. Add in a dilution percentage and you are on your way!

Stick with me, its actually fairly simple math.

The table below shows different exit values for Startup X and what proceeds you would expect to make at each exit value based on your offer. You do have to peer into your crystal ball and come up with what realistically this company might be worth in the future (this is where your assumptions come into play — do your due diligence!).

If you think Startup X at a $1B valuation is just getting started and could be worth $3B by the time it exits, you can expect to make around $1.1 Million. Pretty good outcome! However, if the company doesn’t grow and exits at the same value as the last round of financing, $1B, then you would yield around $255K. This model assumes 15% dilution, which takes into account a few additional rounds of financing at approximately 5% each.

Now let’s compare this to Startup Y, which if you recall is currently valued at $100M but looks very promising. If you look at the table below it would have to grow significantly to a $1.2B valuation (12 times its current valuation) for you to get a $1 Million payout. This is mostly due to your offer being only 10,000 options versus 20,000 with Startup X. This model also assumes 15% dilution, but keep in mind dilution generally will be more for earlier stage startups as they will raise more rounds of funding before going public or being acquired.

Once you have these few pieces of information (which you should always ask for!) you too can create the tables above and run some numbers. This has definitely helped me compare offers and negotiate for more options. For example, let’s say you’re comparing at what point the payoff from your options will reach that $1M payout. Using this tool, Startup X needs to triple its valuation to $3B and Startup Y needs to grow to 12 times its current valuation to $1.2B. I’d probably negotiate additional options before considering the Startup Y offer.

If you’d like to download the above tables with formulas, you can download the Google Doc for free HERE.

Also, Front has a great online tool that does the same thing HERE.

If you are trying to value Restricted Stock Units (RSUs), it’s actually an easier calculation as the RSU would just be worth whatever the price per share you expect at exit multiplied by your number of RSUs. So you can use the model but put $0 as the exercise price. You typically will receive fewer RSUs than options since they have no exercise price to pay.

Now the tools are in your hands. I encourage you to play around with the spreadsheet and tailor the exit prices to what you feel is realistic.

Best of luck in finding a future decacorn! 🦄🦄🦄🦄🦄🦄🦄🦄🦄🦄

If you found this article helpful please give it a clap. 👏

THE MINDSET

Selecting the company you want to work for is a lot like being a Venture Capitalist (VC). Especially if you are looking to work at a tech company and receive equity as part of your compensation. Full disclaimer — I am an Operator not a Venture Capitalist. But I have used the VC mindset to evaluate several job opportunities. You need to ask the same questions — What is the growth potential? What will the equity be worth someday?

Therefore, you should treat your decision much like a venture capitalist would. Do your due diligence. Ask for details about the company’s financials. What are the revenues and the revenue forecast? What was the latest valuation and at which round of financing? What about the 409A price and number of shares outstanding? You should get as much financial information as you can in order to make an informed decision. I’ll go into this more below.

Much like a venture capitalist, the stage of company you are looking to join should match your risk profile. Here is another Medium article covering the different “stages” of a company. If you are fairly risk averse and want more base salary, then go for the later stage company. If you are a risk-taker and can live with a smaller salary, look at an earlier stage company.

I personally would be considered a “late stage” employee, joining at the Series D rounds of my past two companies, Square and Docker. Both had valuations over $1 Billion by the time I joined, and that was the place I felt most comfortable.

While in many cases the financial gains may have lots to do with luck and timing, there are ways to put yourself in a good position for a big exit. I have seen time and time again the way to make it big is to either join early or to join at a high level. There are plenty of people who make life-changing amounts of money by joining companies at a high enough level only a few months before an IPO.

THE OFFER

How do you compare two different offers?

When comparing offers make sure to consider the number of shares outstanding and type of equity instrument (Option vs. RSU) you will be receiving. Many people have been easily fooled by a seemingly large number of options.

Let’s say you have an offer with 50,000 options from Startup X, and another offer with 10,000 options from Startup Y. This doesn’t automatically mean Startup X is the better offer and Startup Y is trying to short-change you. Why not? The number of shares outstanding matters.

If Startup X has 400 million shares outstanding and Startup Y has 5 million shares outstanding you are getting a much bigger piece of the pie with Startup Y. Here is a definition of fully diluted shares outstanding — Valuation vs Market Cap.

What about Options vs RSUs? Typically the ratio of the amount of Options you receive versus RSUs is 2:1 or 3:1. Keep this in mind when comparing offers. If Startup Y offers 10,000 Options this would be roughly equivalent to 3,000 to 5,000 RSUs.

WHAT RETURNS CAN YOU EXPECT?

Let’s go through a math exercise using Startup Y as an example. Here’s the information you will need (ask for it!):

1. Current 409A price (your exercise price)
2. Last Preferred Price and Valuation

Say Startup Y on its last preferred round was valued at $100 million at a preferred price per share of $20/share. This will give you the number of fully diluted shares outstanding: $100M/$20 = 5 million fully diluted shares outstanding.

Now, say your exercise price is $10/share and your offer is 10,000 options.

We can easily calculate what you would make if Startup Y has no further financings (more on dilution below).

To do this we assume that since the preferred price is $20 at a $100M valuation, then as the valuation doubles so does the preferred price.

Eg. $10 X 2 = $20 at a $200M valuation, and so on. See below for the calculations at various potential exit valuations.

At an exit of…

$100M — You make $20-$10 = $10/share X 10,000 options = $100,000

$200M — You make $40-$10 = $30/share X 10,000 options = $300,000

$500M — You make $100-$10 = $90/share X 10,000 options = $900,000

$1B — You make $200-$10 = $190/share X 10,000 options = $1,900,000

$2B — You make $400-$10 = $390/share X 10,000 options = $3,900,000

Notice how your equity value compounds as the valuation soars.

Granted, these calculations are making some BIG assumptions. We are assuming no further financings — which will dilute your number anywhere from 5% — 50% depending on how many additional rounds of funding the company receives. To capture this you should discount the numbers above approximately 5%–10% for each future round of expected funding.

This also assumes you stay the full (generally) four years to fully vest your options. If you plan to stay less, then divide it by how long you plan to stay.

Even with these caveats, this can be a good tool to compare multiple offers. Run the same numbers for your offer from Startup X. You should think like a venture capitalist about the potential exit value. Does this company have a product and market that can get to a billion dollar valuation? Do your research into the space and see what similar companies are valued at or selling for.

In comparing past offers I have assumed as a proxy that each company would double in valuation. You can use other factors but this is one way to look at it. Once you double each valuation, then compare the two numbers. If one is significantly higher than the other you know where to put your investment.

THE EXIT

Startups are called startups for a reason. They carry risk. We have all seen the various studies out there noting anywhere from a 70% to 90% failure rate. Venture capitalists are very aware of these percentages, and you will notice the top tier firms seem to have better odds. So take your time, analyze the financial data, and think about how a venture capitalist would pick the winner — the one that will pay back the entire fund — the fund of you.

Thank you to my wife Erin for editing this post. Please click on the “clap” if you found this post useful. Thanks!

I worked in Public Accounting at one of the “Big 4” firms for seven years, and at the time of this article am now well into my second tech company as the Controller. Public Accounting was, and still is, an excellent way to start your career. All the big accounting firms are consistently rated as “Best Places to Work” and “Best Places to Start Your Career.” At only a few years out of college, you’re given loads of responsibility, gain experience managing people, and are exposed to all sorts of companies with direct access to their top executives. Plus, for some hiring managers, Public Accounting and a CPA are must-haves on the resume.

But, for most people in Public Accounting, there comes a time to move on. The firms are structured like a pyramid so not everyone will become (or wants to become) a Partner. So how do you know when the time is right for you to move on? What do you need to know before you make a move in-house to a company? In my experience, you should stay until the day you are promoted to Manager and then start looking outside. If you are in a market with lots of outside opportunities, like the Bay Area, then you may even want to explore your options earlier.

With seven years at a Big 4 firm, I was a part of the audit machine for probably a couple of years too long. The accelerated learning starts to slow and peers who have left are gaining more hands-on experience in-house. If you want to start climbing the ladder from Senior Accountant to CFO, you need to see the inside of companies.

Why is that? Once you are working inside a company, the experience you gain is both different and valued differently by those looking to hire you. Before you join a company, ask yourself how fast is it growing and will there be investment in the accounting team? If the company grows, so can you. If you are a one person accounting team for multiple years, there is only so much you can learn.

I am often asked about the transition from public accounting to in-house accounting. What are the biggest differences? What is hard? What is easy? Let’s examine four big changes. Most of my examples are from my experiences at later stage pre-IPO tech companies. But hopefully you find these tips useful for transitioning into companies of any size or industry.

The most important differences between Public Accounting and In-House Accounting are:

1. SYSTEMS
2. TIME
3. OPERATIONS
4. MANAGEMENT

SYSTEMS

When you audit a company you see what systems they use and reports they run. But do you really KNOW how to create a journal entry, run a query, or how the systems all talk to each other? Learn it. Learn how to set up a chart of accounts. Learn how data feeds from the HRIS system to the Payroll system to the Accounting system. This hands-on experience is invaluable.

Another important difference is the ability to select which systems to use as you grow. Which systems give you the best bang for your buck? Which systems are right for you at the right stage of growth? When your company is small and dollars are scarce you probably aren’t (and shouldn’t be) implementing Oracle or SAP. Talk to your colleagues at other companies, see what they are using, and do reference checks with actual customers.

Below is what I call the standard tech company systems “stack.” Most tech companies start with the systems on the left and progress to the systems on the right.

ERP: Quickbooks — > Netsuite

Expense Reporting: Expensify — > Concur/Divvy

Procurement: Bill.com — > Coupa/Concur/Tipalti/Airbase

Payroll: TriNet/Gusto — > ADP

HRIS: BambooHR — > Namely/Workday

CRM: Salesforce/Justworks — > Salesforce

Cap Table: Carta — > Shareworks/Equity Edge

401K: Guideline/Human Interest-> Fidelity/Vanguard/Empower

An additional piece of advice: try to limit the number of systems you use. You don’t want a spaghetti of systems with no source of truth. Every cloud solution out there claims to have an “API” for everything, but in the end most don’t do it well. So you end up doing manual workarounds to input data into all your systems. Do reference checks with actual users prior to buying any tool, and ask them what their pain points are. How easy is it to integrate to other systems? Once you do select a tool, keep in mind implementations generally take longer than you think. Budget extra time for that. Which brings me to…

TIME

Time moves much more quickly inside of a company. The accounting team schedule revolves around a monthly close. If you can get that down to the first two weeks of the month, that gives you the next two weeks to work on projects and the “fun” stuff, like systems implementations (see above). As you grow, you will constantly be evaluating new tools so you need to carve out time for it.

Let’s quickly talk about the month-end close. You should be able to close the books in the first 2 weeks of the month. Best in class for a private company is around 5–7 business days. This does not give you much time to spend on each area (eg. cash, prepaids, accruals, etc). That also means the Controller is not going to have enough time to review in much detail. Much like public accounting, a lot of errors are caught in reconciling the balance sheet and performing fluctuation analysis between the current and prior month.

A big way to save time on tricky accounting questions is to consult your network. Have colleagues you can go to at other companies that can give you quick answers. Keep in mind you are not the first person facing a particular issue or decision. So keep that rolodex of public accounting friends handy.

OPERATIONS

You are going to spend an inordinate amount of time on operations. This includes accounts payable, expense reports, accounts receivable, payments, credit cards, facilities issues, and payroll matters. This is the base of the pyramid on which all other accounting areas are dependent upon. Even at the Controller level I approve almost every payment that goes out, review numerous invoices and expense reports, and am copied on all sorts of “urgent” emails from employees.

Learn these processes in and out and use software tools to automate the approval of invoices and the cutting of checks. You have to get good at operations and hire people that can run independently in these areas. If this isn’t working then everything else up the chain starts to fall behind. All is well until the power goes out in your office because you didn’t pay the bill (yes this has happened to me before). To avoid literal fire drills, focus on operations first, but don’t let it consume all of your time.

MANAGEMENT

In public accounting you get to manage all sorts of rotating individuals. Once you have a team of your own things change. Now you have real responsibility to do weekly one-on-ones, come up with real goals, and discuss real career paths. This now is your #1 job. If someone is not performing well, you have to either train them or make a tough decision to let them go.

In addition, you are not just managing people but managing multiple outside firms. You will have an audit firm, a tax firm, a valuation firm, a recruiting firm, a law firm, among others. Selecting and managing firms becomes highly important as these are an extension of your team. Pick good ones and they will follow you from company to company. Pick bad ones and your own performance will suffer. Again, do reference checks with your network to get real feedback before signing on.

OTHER FACTORS TO CONSIDER

The “Brand” of the company you work for matters. The safe bet is to pick a company others have heard of. Silicon Valley has a shortage of solid accountants, so go ahead and apply to your dream company…you might be surprised where you get a call back.

CONCLUSION

The one item I didn’t mention above is that focusing your efforts each and every day on the success of one company is highly rewarding. Just knowing that you are personally helping a company succeed is probably the biggest difference of them all. It may sound cliche but there is a certain sense of accomplishment in moving a company forward (even if it is just keeping the lights on). And if you do get to go through the IPO process it is very different from the inside!

Hopefully this was helpful to those in Public Accounting wondering what it’s like on the other side. Good luck in your careers!

Stock options are, and will continue to remain, the primary way startup employees are rewarded for their time and effort. Thus, a debate has sprung up on whether the so-called “golden handcuffs,” the 90-day stock option exercise period, is fair. Several companies have now led the way in making a change, instituting option extension programs, extending the exercise period after you leave a company from 1 year to even 10 years. When Quora and Pinterest decided to change their policies, it was highlighted very publicly in tech news and blog posts. You can read Pinterest’s Medium post on their option extension program here. Others like Asana, Coinbase, Palantir, and Square have since followed suit. As the project manager in charge of the option extension at Square, I want to share some of my findings with a focus on how to implement it.

The arguments for and against making this type of change are better covered elsewhere, but I will note the PROs and CONs we considered at Square before deciding to extend the option exercise period, and discuss how it works from an accounting perspective. I will also share some findings we saw after the implementation, which may help you make the decision of whether or not to take this on at your own company.

The first step is to decide if an option exercise extension is right for your company:

PROs

• Frees employees from tying up significant dollars in financial risk
• Allows employees to keep what they have earned — seems like the right thing to do
• Keeps employees here who want to be here — avoids the “vest and rest” problem
• Reduces the number of employees using unapproved investors and loan companies to acquire the funds to exercise
• Positive tool for recruiting — shows commitment to employees and differentiator from other startups
• Consistent with culture and mission of many startups

CONs

• The “elephant in the room” — may lead to increased attrition for those already looking to leave
• Tax withholding and reporting for former employees may require putting them back on payroll
• Foreign regulatory issues may be problematic (e.g. security law exemptions may only apply to US employees) — may not be able to offer this fairly across the whole company
• Administrative costs to modify agreements/plans and track modified awards
• Stock based compensation charge — will likely have a one-time charge for all vested options and an increase in stock comp expense over the remaining vesting terms of the awards

Choices

1. Modify options for all employees, regardless of service
2. Modify options only for those with > 1, 2 or 3 years of service
3. Choose an alternate approach — eg. net exercise, partner with a lender, or tender offer

After thorough evaluation of our alternatives, we decided the best decision for Square was to extend the exercise period for all employees who had been with the company for a minimum of 2 years. The best way to go about this for us was to modify all the awards at one time (this becomes important later when I describe modifying all at once versus on a rolling basis). Why did we pick 2 years? We felt that after 2 years an employee has made a significant impact at the company, and the 2 year requirement limits some of the attrition risk.

How do you account for this change?

NQs and ISOs

Once you have decided you want to extend your option exercise period, you must first take an inventory of all your options to determine which are Nonqualified stock options (NQs) and which are Incentive stock options (ISOs). This is an important distinction, as ISOs must be converted and will lose their ISO tax status, because by definition ISOs can only have a 90 day exercise period after termination.

In Square’s case, we were lucky that the vast majority of our awards were already NQs, and we decided to not convert any ISOs except for on a one-off basis. If you have ISOs, you have to complete a 29 day conversion period to convert the ISOs into NQs (your lawyers can explain the 29 day conversion period and help you with this process).

Pick an Effective Date

You then need to pick an effective date for the modification and notify all employees of the upcoming change to their exercise period. If all options are already NQs, then you simply need to send out a one-way communication of the change to all employees, since this is a favorable modification for them. ISOs are a little trickier, as you must have each employee sign a conversion document to convert the awards to NQs, and communicate the advantages and disadvantages of doing the conversion (primarily giving up the advantage of not having to pay taxes on the spread immediately upon exercise).

At Square we modified all options on the effective date, regardless of the service period, and modified all awards at once, even if the employee hadn’t hit their two year mark. Employees would still only qualify once they hit two years of service, but their option grant would already be considered modified. This does, however, add to your stock-based compensation charge, as you are modifying all your options at once.

Another option is to modify each individual award on a rolling basis once an employee hits 2 years of service, which is what I believe Pinterest ended up doing. However, I would suggest modifying ALL the options at once and not on a rolling basis, or it becomes a nightmare for stock comp tracking purposes (you will essentially end up calculating the incremental expense each month for each award that now qualifies).

Calculating the Stock-Based Compensation Impact

As with most accounting decisions, you can either take the more aggressive or more conservative position, and this applies to calculating the stock comp impact of an option extension change. As this is changing a key term in the option agreement, it is considered a modification under stock-based comp accounting guidance.

The aggressive argument is that the change will have no impact on stock-based compensation expense. This is assuming you already use the “simplified method” to calculate the expected term of your options. If you are familiar with the Black-Scholes Model and use the simplified method, which can be used if you lack exercise history, then your expected term is probably 6.25 years, or 6.08 years for those “plain vanilla” options with 4 year vesting (1 year cliff, monthly thereafter) and 10 year expiration. Since 6 years is already a long exercise timeline, and likely higher than your actual exercise data would show, you could argue that this would not change your expected term, and therefore not change your stock comp expense. There is an argument that this change in exercise period would preclude the use of the simplified method, as the options can no longer be considered “plain vanilla,” therefore, audit firms prefer your company does some analysis to determine the impact.

The more conservative stance is to look at your data and come up with a fair value before and after the modification on the effective date. This is what we did at Square. This is also where a lot of companies calculate the impact incorrectly. Per the accounting guidance, the modification should be the difference between the fair value before and after the modification, but using the current stock price. We used a firm called Equity Methods to perform the analysis, in which they used a lattice model to measure the probability of different outcomes to come up with an expected stock-based comp charge at the grant level.

Once you have the total stock-based compensation expense you must immediately recognize the amount related to the vested portion of the options. The remainder will be recognized over the individual vesting periods of the remaining options.

New Stock Options Issued After the Effective Date of the Change

Once you know the effective date of the option extension then you should amend all the option agreements going forward with the same terms. For Square, this did not require any change to the Stock Option Plan itself, but thoroughly check your own as all plans are slightly different.

Most companies also consider switching to restricted stock units (RSUs) immediately after the change so that no more options are being granted. If your startup is in the very early stages and just starting to issue stock options, you can save all this trouble by issuing NQ stock option grants with the extended exercise period already in the grant agreement.

So what happened afterwards?

At Square, we noticed no notable increase in attrition due to the change. No increase. This was a terrific outcome as this was arguably the biggest risk of the whole project. At the time we implemented the change to the exercise period, only one-third of the company had been with Square for more than two years, which helped limit the exposure, but as more and more hit their two year vest, there was still no noticeable increase in attrition.

Understanding the logistics of extending the option exercise period will hopefully open the door for other companies to consider making the change. At Square, the change was overwhelmingly positive. As startups are taking longer and longer to go public, this should be the default, not the exception, for employees that worked so hard to grow the company. It’s time to release the golden handcuffs.

UPDATED JULY 2018: Thank you to everyone who continues to read this post as an outline for extending the post termination exercise period at your own companies. I see more and more startups updating their plans to offer extensions. Over the past couple years I have noticed a couple changes I would make to my recommendations. For the accountants out there, I would actually just modify each eligible employee grant once they decide to leave. You will have to do this if you take the Carta approach and keep increasing the exercise period for each year of service. This will be more work each month to do modification accounting for each award, but think it is a bit easier to track than doing it all in one shot. The impact to your stock comp is also less of a one time hit and spread out more over time as employees depart.

Disclaimer: These are my thoughts and observations regarding this topic and not that of Square. The impact of this change has already been reflected in the company’s latest public filings.

Thank you to my lovely wife, for all her edits and feedback on this and other posts.

On November 19th, Square, Inc. entered the public market. Leading up to its IPO, the company valuations quoted by the media were all over the board — $2.4 billion, $2.6 billion, $3 billion, $4 billion, $6 billion… So which one is it?

Because various ways to value a company can get quite technical, misinformation and misunderstanding are inevitable. While taking Square through the process of its initial public offering, I noticed a lot of incorrect assumptions and thought a simple guide would help as others go down the same path.

Valuation can mean so many things. Is it the price an investor is willing to pay right now? Is it based on common shares outstanding, or fully-diluted shares, or fully-diluted shares using the treasury stock method? How do weighted average shares fit into the equation? What do these calculations mean and what are the differences?

Valuation and market capitalization are easily confused. Though they do have similarities, the differences between them can have significant impact on the way we value so-called “unicorns,” particularly in today’s changing tech market. You can’t compare apples to oranges and call the difference dramatic. I’ll explain below.

Private Company Valuation

This is the most common valuation for private start-ups we hear about in the media, and what current “unicorn” statuses are based on. This valuation is based on the price paid per share at the latest Preferred stock round multiplied by the company’s fully diluted shares.

“Fully diluted shares” is defined as:

Common Shares outstanding
+ Preferred Shares outstanding
+ Options outstanding
+ Warrants outstanding
+ Restricted Shares (RSUs)
+ Option Pool (sometimes included)

Using this method, we get to the $6 billion valuation for Square commonly referred to by the media. It is calculated by taking all shares, options, and warrants noted above and multiplying by the latest funding round — the Series E price of $15.46 per share.

Why is this method different than how public companies are valued? Valuing a company using this method is like valuing a concert by taking the price of a front row seat and multiplying it by every seat in the house. A front row seat commands a premium over other seats in the house, and in the case of Square (and many other tech “unicorns” and start-ups), that premium includes preferences upon liquidation, and in some cases guaranteed pricing upon an exit. The preferred shareholders are buying different rights than the common shareholders bought during an IPO roadshow.

But the big thing to keep in mind here is that all outstanding options, warrants and RSUs are included in this number. The importance of this becomes apparent when a company goes from private to public, and valuation then becomes primarily determined by market cap.

Market Capitalization

Market Capitalization or “Market Cap” is the value that public companies are based on. Apple (AAPL), for example, has a market cap of around $662 billion, the largest out there today. Market cap is calculated by taking a company’s outstanding common shares multiplied by its current stock price. In the case of an IPO, this would be the number of common shares outstanding + the number of preferred shares which convert into common upon the IPO + the number of shares sold in the offering, multiplied by the IPO stock price.

Note the difference here. Market cap does not include the options, warrants or RSUs included in private company valuations.

So by comparing a private company valuation to its market cap value once public is a bit like comparing apples to oranges, and differences become especially apparent when there are a significant amount of options outstanding. In Square’s example, let’s call the market cap “apples” and the private company valuation “oranges.” The market cap at the closing stock price on the first day of trading ($13.06) was around $4.3 billion — the apple. If you added up the same amount of shares, options and warrants included in the private valuation noted above and multiplied this by this same closing stock price, you would get around a $5.9 billion valuation — the new orange. A pretty big difference. But remember that the original orange, the private company valuation, was $6 billion. Now you can see that the two oranges aren’t that different after all.

Now that we’ve mastered apples and oranges, let’s throw in a few more tools used in valuation — the Treasury Stock Method and Weighted Average Shares. These calculations are not often reported in traditional media, either because they are not properly understood, or because of a lack of information, but are important indicators of valuation, and therefore worth better understanding.

Treasury Stock Method

This method comes from accounting literature and defines how to convert the outstanding options left out of market cap into your diluted earnings per share (EPS) calculation. The Treasury Stock Method calculates the net common shares potentially created by unexercised “in-the-money” options.

For example, let’s assume that a company currently has in-the-money options for 10,000 shares with an average exercise price of $50. If the current market price is $100, the options are in-the-money, and based on the treasury method, need to be added to the fully diluted EPS denominator. The proceeds the employees holding these options will receive upon sale will be $500,000 ($100 — $50 = $50 x 10,000), which theoretically allows them to purchase 5,000 shares at the $100 current market price ($500,000/$100).

In terms of valuation, banks use this calculation to convert all those outstanding options and warrants not calculated in the market cap into shares of common stock. In our example, the 10,000 options would add 5,000 common shares to your share count. This method doesn’t count every outstanding option as one share, but it doesn’t exclude their impact either (like market cap would), and therefore gives you a valuation somewhere in the middle of the first two methods. Sort of an apple-orange hybrid.

Weighted Average Shares

Here is an entirely different concept that causes additional confusion. Weighted Average Shares is calculated under accounting guidance solely for purposes of the earnings per share (EPS) calculation, and should not be used to value a company. Often, banks, investors or the media take this number from the financials, multiply it by the stock price and call it the valuation. This is incorrect. The weighted average shares number is based on a daily weighted average, so it will always be smaller than the ending amount of outstanding shares, assuming no large buybacks.

Continuing with our Square example, it had around 150 million common shares outstanding before the IPO. On November 19th, all 137 million preferred shares were converted to common shares, as well as 27 million offering common shares. But remember — these new shares are only weighted for a portion of November and December, and were not outstanding the other ten months of the year. So your final weighted average shares outstanding does not simply add these all together, but will weight them to give you a much smaller share number — higher than the 150 million common shares but much lower than the 314 million combined shares (150 million common +137 million preferred +27 million offering). The key here is that weighted average shares and total outstanding shares are different. The weighted average share number should not be used to value a company, and on the flip side, the total outstanding shares should not be used to calculate EPS.

The Takeaway
When valuation numbers are reported to the public without understanding the calculations behind them, and without the context of the differences in calculation methods, swings in tech company valuations can sound like a big deal. The drama makes for a good story. But when you understand the difference between private company valuation and market cap, you can cut through the sensationalism and see that the reality is far less dramatic.

(Disclaimer: This post is intended to be educational and represents my personal views and not of the company. Any and all numbers included above are public information and can be pulled directly from the S1)