Funding your startup — the impact of the option pool shuffle

Marcus Gosling

How might a difference of 5% in your series A option pool affect your eventual earnings at an exit? Use our interactive calculator linked from this post to understand the impact of pool size on ownership and exit proceeds.

When a startup raises VC money, one of the first steps in the negotiation is for both parties to agree on the value of the company today, before the addition of any new capital. This is called the pre-money valuation. If a startup’s pre-money valuation is agreed to be $8M and there are 6M shares outstanding, then each share of stock should be worth $1.3333.

$8M pre-money ÷ 6M existing shares = $1.3333/share.

However, most venture deal terms require the creation of a stock option pool to compensate future employees. This pool can have a significant effect on the price per share, your ownership and your ultimate earnings in the event of a sale or IPO.

Let’s look at a simple cap table.

Shuffleless, Inc. has 6M shares outstanding, divided equally between the two founders.

Here’s the impact of a new investment with no option pool included.

$8M pre-money ÷ 6M existing shares = $1.3333/share.

However, when an investor offers a $8M pre-money valuation what they really mean is:

“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call the sum your $8M “pre-money valuation”.

$6M effective valuation + $2M new options + $2M cash = $10M post

The $2M (20% of the $10M post-money) option pool is lowering your effective valuation to $6M. According to the investor, the actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.3333/share to $1.0000/share:

Here’s the impact of adding the 20% pool.

And here’s the updated cap table after the investment.

The combination of 20% post-money dilution from the option pool and 20% dilution from the Series A investment has diluted both founders by 40%.

So what does this unexpected dilution mean at the time of an exit?

In the table below we see a breakdown for an exit of $50 million. For the purposes of this example no new employees were hired — the option pool is 100% unallocated and its 2M shares are not factored in. This leaves 6M shares with the founders and 2M shares with the investors. A 75% : 25% split of the proceeds.

Note that although the founders took all the dilution from creating the option pool, both the founders and the Series A investors benefit from any “reverse dilution” due to all unallocated options “going away” at exit. Only the founders pay for the pool but the investors share in the benefits of any unused options — further justification for creating an option pool that is only as large as needed.

The unused options that you paid for in the Series A will go into any eventual Series B option pool. This allows your existing investors to once again, avoid dilution at your expense. — Venture Hacks

For a $50M exit, with a 20% option pool, the founders each earn $18.75M from the sale of their company, but could their payout have been greater? Potentially.

How can I ask the investor to pay their fair share of the dilution caused by creating an option pool? The short answer is you can’t. Despite the term “post-money option pool” the tradition of putting the option pool in the pre-money has become the norm. You can’t avoid playing the Option Pool Shuffle but you can play it smartly if you know how the game works.

Put simply, your goal should be to minimize founder dilution by creating the smallest option pool needed. Your actual hiring plan and the equity you need for those future employees should drive the size of the pool, not any supposed standard.

Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation. — Venture Hacks

For example, what’s the impact of a 10% option pool?

$7M effective valuation + $1M new options + $2M cash = $10M post

70% effective valuation + 10% new options + 20% cash = 100% total

A few hours of work creating a well thought out, substantiated hiring plan and negotiating with purpose has increased your share price by almost 17% to $1.1666:

$7M effective valuation ÷ 6M existing shares = $1.1666/share.

Because the share price is now higher, for their $2M investment, the investors receive 1,714,285 shares rather than 2,000,000.

And what difference might this smaller pool make on an exit? Let’s look at our $50M exit scenario again.

After the unused option pool is factored out, the proceeds are divided 22.22% to 77.78% between the investors and the common stock holders. (A non-trivial improvement on the 25.00% to 75.00% ratio from the 20% pool.)

The time spent planning your option pool and negotiating it down to 10% just changed each founder’s outcome from $18,750,000 to $19,444,446. That’s a $694,446 difference for each founder, and this difference would be even greater for larger exits.

So why would your series A investor agree to a smaller pool?

Well, although a larger pool is pro-investor and can act as a defense to them from future dilution, they can’t really argue that. It’s only reasonable for them to argue that you need the pool for hiring purposes while you are a series A company.

If you can put together a sound hiring plan that reserves a smaller percentage, e.g. 10%, you can negotiate firmly and save yourself dilution and potentially millions of dollars.

Alternately, if your investor does not want to budge on the size of the pool, a good understanding of its impact is essential if you choose to negotiate for a higher pre-money valuation instead.

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