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.