Negotiating the Option Pool

The latest Cooley Godward venture capital report spells out that a common Series A financing these days is a split of 40/40/20, where 40% is for the founding team, 40% for the investors and 20% for the option pool.

One of the trickier areas for an entrepreneur to get his/her head around about the deal can be the role of the option pool.  You will often hear a venture capitalist tell you that they are not interested in owning a majority of a company, and it's more than likely true.  It just turns out that sometimes it doesn't end up that way.   The purpose of this post is to walk through a typical scenario which might help the entrepreneur approach the option pool negotiation.  It builds upon a classic post by Brad Feld here and you might read that post first since it clearly explains some of the terms I use here.

As Brad mentions, the amount of the option pool is almost always determined on a post-investment basis ( i.e. the 20% above) but it is almost always the case that investors are successful in having those options issued before the price per share of the investment is determined.   The impact is significant since it means dilution is occuring solely to the founders, not to the investors.   The two charts below show two different cap tables both before and after an investment.

In Chart A, the investor is not asking to increase the size of the option pool.  You can see that the price per share is calculated by dividing the pre-money valuation of $3m by the fully diluted stock of 5 million shares, equating to a purchase price per share of $0.60.  Thus, if the investor puts in $2m, they will be entitled to 3,333,333 shares, or 40% of the company.  Since no additional options were created, there are just 11% of fully diluted shares that are left to be issued to new employees.  Most Series A investors will find that amount insufficient to allow for the proper incentives to be issued to future employees.

In the scenario where an investor asks that 20% of stock  be available for issuance as options after the financing, watch what happens.  Chart B shows that a total of 1,200,000 new options will have to be created before the financing in order to get the amount of available options after the financing to 20%. The dilution caused by the option creation causes the valuation of the company of $3m to be divided by a lot more shares, resulting in a lower price per share.  With the lower price per share and the same investment amount of $2m, an additional 800,000 shares end up going to the investor.

Since the parties are dealing with fully diluted percentages, the investor still gets 40%.  However, since a lot of options now remain unissued, the actual percentage ownership of the company is quite different.   Whereas in the Chart A scenario the investor did not own a majority of the outstanding stock (45%) , in the Chart B scenario the investor owns more than 50%.  Thus, it is not unlikely that an entrepreneur may end up selling control of a company despite the perception of having given up only 40%.  Now the company's attorney can advise the company on the types of protections that could be put in place to prevent the investor from being in a position of being able to take control.  However, sometimes the fixation on fully diluted share count may cause this situation to be overlooked.  Obviously issuing more options to employees will correct the situation over time.

The purpose of this post is not to warn you against  selling control of your company.  There are lots of reasons why founders willingly do so on their path to building a great and big business, and the reality is that many investors truly don't have interest in having control.   Rather, I wanted to illustrate the importance that the option pool can play in negotiating a venture investment and its impact on price per share and valuation.  So long as the founders can understand this impact (particularly before settling on a final valuation amount), the focus of the parties should actually turn to whether or not 20% is the right amount of options to be available for issuance.   

I'll end with just a few final points on that negotiation. Remember that investors are looking to build big companies, and for really early stage companies the investors are going to see a long road ahead to recruiting employees and new executives.  In an ideal world, no more options will have to be issued before they exit (although most investors will accurately tell you that this situation is itself very rare).  The founding team needs to be prepared to build out an option budget for new employees - at least a few years out - which they believe adequately represents how many new options will need to be issued to make a big company.  It is around the actual option budget that intelligent discussions can occur.

It also a good idea for the founding team to look at what has already been issued to itself and other employees.  When the founding team/employee group is strong and the stock is subject to vesting as is typical for a venture financing, then there are some compelling reasons to keep the option pool lower since fewer key hires are necessary.  If an investor makes the point that one of your team members could leave and may need to be replaced, you should point out that the unvested stock can be used for that replacement.   Likewise, particularly where the investor is genuine in a concern of having a sufficient option pool to attract employees, you could suggest having any unused options revert to the founding team in the case of a successful liquidity event.  After all, if those options were never needed to get the outcome the investor wanted, why shouldn't the founders who took the dilution in the first place benefit.

Negotiating the option pool will not always hinge on an intelligent budget or rationale arguments, however, so at least ensure that you understand the impact the option pool is actually having on valuation and price per share.

Comments

[waterhousehe]

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[Noclegi Ustka]

Realy interest article.Thanks