The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

In any seed or early stage round negotiation between a company and a VC, one of the first and most contentious issues to be negotiated is valuation.  A company’s pre-money valuation will determine how much equity will need to be issued to the investor for any given amount of investment, and thus on its face would appear to be the most critical term in any term sheet.  But as I will show in this two-part series, a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money shares outstanding and/or by a generous liquidation preference.  In this Part I of the series, I will concentrate on the option pool.

VCs almost always insist on a pool of options to be set aside for grants to key employees, both to recruit new talent and to retain existing talent. Startups and emerging companies are typically cash poor and thus have no choice but to use stock as compensation currency.  Options (or restricted stock) also serve to incentivize the management team with the chance to ride the upside potential of the company.  The existence of an option pool in and of itself is not controversial; the way it’s structured can be – if founders are paying attention.

Option pools are typically expressed as a percentage of the post-money shares outstanding on a fully-diluted basis, usually in the range of 10% – 20%.  So if the post-money number of fully-diluted shares (i.e., outstanding shares plus all shares that are subject to options and other rights to acquire shares) before adding the option pool is one million, a 10% option pool would consist of approximately 112,500 shares (112,500/1,112,500 = 10%).  So far so good.

Where the option pool gets interesting is in its impact on price per share of the VC’s investment, which in turn dictates the number of shares and the percentage of total equity to be issued to the investor.  Price per share is calculated by dividing the pre-money valuation by the pre-money number of shares outstanding, typically on a fully-diluted basis.  The issue then is what constitutes “fully-diluted”, i.e., which rights to acquire shares are included in calculating the total number of “fully-diluted” shares.  Should the options to be included in total shares be limited only to those that are outstanding (in other words, those that have been granted but not yet exercised), or should it be viewed more broadly to include options that have been authorized but not yet granted as in the option pool to be agreed upon with the VC?

If option pool shares are included in the pre-money fully-diluted outstanding, the price per share will be reduced and more shares will get issued to the VC.  Accordingly, whether or not the option pool gets baked into the pre-money fully-diluted outstanding shares is an issue with real consequences, as it determines whether founders get diluted disproportionately or just pro rata with the VC.  If the shares in the option pool are included in the pre-money fully-diluted shares, the founders get diluted disproportionately by the option pool shares; if the option pool is excluded from the pre-money shares outstanding, both founders and the VC get diluted proportionately.

VCs will almost always include the option pool in the pre-money shares outstanding.  A typical term sheet submitted by a VC will contain a provision on this point as follows:

“The purchase price per share is based upon a fully-diluted pre-money valuation of $[_____] (including an employee pool representing [__]% of the fully diluted post-money capitalization).”

Most entrepreneurs obsess on the portion of the foregoing sentence preceding the parenthetical; they should focus on the parenthetical as well.  Simple illustration: Assume a pre-money valuation of $4 million, one million shares outstanding, a VC investment of $1 million and a 15% option pool.  Now assume the company is sold for $10 million (the liquidation preference impact on valuation will be explored in Part II of this two-part series).  The difference in outcomes is illustrated in the charts below:

Pre-Money Valuation $4,000,000
Founders Shares   1,000,000
VC Investment $1,000,000

Scenario 1:  No Option Pool

Founders Shares 1,000,000   (80% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (20% post)
Proceeds per Share $8
Proceeds to VC $2,000,000
Proceeds to Founders $8,000,000

Scenario 2:  Option Pool Not Baked into Pre-Money

Founders Shares 1,000,000   (68% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (17% post)
Option Shares 220,588 (15% x 1,470,588 = 220,588)
Proceeds per Share $6.80
Proceeds to Employees $1,500,000
Proceeds to VC $1,700,000
Proceeds to Founders $6,800,000

Scenario 3:  Option Pool Baked into Pre-Money

Founders Shares 1,000,000 (65%)
Price per Share $3.25 ($4,000,000/1,230,769)
VC Shares 307,692 ($1,000,000/$3.25) (20% post)
Option Shares 230,769 (15% x 1,538,461 = 230,769)
Proceeds per Share $6.50
Proceeds to Employees $1,500,000
Proceeds to VC $2,000,000
Proceeds to Founders $6,500,000

As indicated above, the consequence of the option pool getting baked into the pre-money shares is that the founders get diluted from 80% to 65%.  In absolute dollar terms, the result becomes more dramatic as the proceeds on the sale of the company increase. The VC, however, remains at 20%.

As between the VC and the founders, the VC actually has the better argument here.  The pre-money valuation is predicated on a management team capable of successfully implementing the business plan.  If the founders themselves do not constitute a complete management team, any equity needed to recruit talent should come out of their basket.  The pain to the founders could be mitigated by limiting the option pool to a reasonable level.  As a general rule, the pool should be just enough to cover the grants expected to be made until the next funding round.  The founders should endeavor to present a credible plan showing how many options the company will need to grant to satisfy its recruiting and retention needs up to that next round.

The other way to approach all of this is to treat the pre-money option pool placement as an alternative to lowering the valuation.  In the above example, by putting a 15% post-money option pool in the pre-money calculation, the VC was essentially asserting that the company is effectively valued at $3.25 million, not $4 million.  But the term sheet will not say “the effective pre-money valuation is $3,250,000.”  That’s for the founders to figure out.

My next blog post will explore the other major valuation buster, liquidation preference, which could have an even more dramatic effect on the founders’ bottom line.