The Option Pool Shuffle June 7, 2011Posted by Ian Cheng in Funding.
Summary: 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. If you don’t keep your eyes on the option pool while you’re negotiating valuation, your investors will have you playing (and losing) a game that we like to call:
Option Pool Shuffle
You have successfully negotiated a $2Minvestment on a $8Mpre-money valuation by pitting the famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has created $8Mof value.
Your teammates ask what their shares are worth. You explain that the company currently has6Mshares outstanding so the investors must be valuing the company’s stock at $1.33/share:
$8Mpre-money ÷6Mexisting shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00… this must be a mistake!Readingon, the term sheet states, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
You call your lawyer: “What the fuck?!”
As your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?”
If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost you millions of dollars of effective valuation. Don’t lose this game.
The option pool lowers your effective valuation.
Your investors offered you a $8Mpre-money valuation. What they really meant was “We think your company is worth $6M. But let’s create $2Mworth of new options, add that to the value of your company, and call their sum your $8M‘pre-money valuation’.”
$6Meffective valuation + $2Mnew options + $2Mcash = $10Mpost
60% effective valuation + 20% new options + 20% cash = 100% total.
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.33/share to $1.00/share:
$8Mpre ÷ (6Mexisting shares +2Mnew options) = $1/share.
The shuffle puts pre-money into your investor’s pocket.
Proper respect must go out to the brainiac who invented the option pool shuffle. Putting the option pool in the pre-money benefits the investors in three different ways!
First, the option pool only dilutes the common stockholders. If it came out of the post-money, the option pool would dilute the common and preferred shareholders proportionally.
Second, the option pool eats into the pre-money more than it would seem. It seems smaller than it is because it is expressed as a percentage of the post-money even though it is allocated from the pre-money. In our example, the new option pool is 20% of the post-money but 25% of the pre-money:
$2Mnew options ÷ $8Mpre-money= 25%.
Third, if you sell the company before the Series B, all un-issued and un-vested options will be cancelled. This reverse dilution benefits all classes of stock proportionally even though the common stock holders paid for all of the initial dilution in the first place! In other words, when you exit, some of your pre-money valuation goes into the investor’s pocket.
More likely, you will raise a Series B before you sell the company. In that case, you and the Series A investors will have to play option pool shuffle against the Series B investors. However, all the unused options that you paid for in the Series A will go into the Series B option pool. This allows your existing investors to avoid playing the game and, once again, avoid dilution at your expense.
Solution: Use a hiring plan to size the option pool.
You can beat the game by creating the smallest option pool possible. First, ask your investors why they think the option pool should be 20% of the post-money. Reasonable responses include
“That should cover us for the next 12-18 months.”
“That should cover us until the next financing.”
“It’s standard,” is not a reasonable answer. (We’ll cover your response in a future hack.)
Next, make a hiring plan for the next 12 months. Add up the options you need to give to the new hires. Almost certainly, the total will be much less than 20% of the post-money. Now present the plan to your investors:
“We only need a 10% option pool to cover us for the next 12 months. By your reasoning we only need to create a 10% option pool.”
Reducing the option pool from 20% to 10% increases the company’s effective valuation from $6Mto $7M:
$7Meffective valuation + $1Mnew options + $2Mcash = $10Mpost
70% effective valuation + 10% new options + 20% cash = 100% total
A few hours of work creating a hiring plan increases your share price by 17% to $1.17:
$7Meffective valuation ÷6Mexisting shares = $1.17/share.
How do you create an option pool from a hiring plan?
Many factors affect option allocations including the quality of the existing team, the size of the opportunity, and the experience of the new hire. If your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.
Bring up your hiring plan before you discuss valuation.
Discuss your hiring plan with your prospective investors before you discuss valuation and the option pool. They may offer the truism that “you can’t hire good people as fast as you think.” You should respond, “Okay, let’s slow down the hiring plan… (and shrink the option pool).”
You have to play option pool shuffle.
The only way to win at option pool shuffle is to not play at all. Put the option pool in the post-money instead of the pre-money. This benefits you and your investors because it aligns your interests with respect to the hiring plan and the size of the option pool.
Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t work.
Your investor’s norm is that the option pool goes in the pre-money. When your opponent has different norms than you do, you either have to attack his norms or ask for an exception based on the facts of your case. Both straits are difficult to navigate.
Instead, skillful negotiators use their opponent’s standards and norms to advance their own arguments. Fancy negotiators call this normative leverage. You apply normative leverage in the option pool shuffle by using a hiring plan to justify a small option pool.
You can’t avoid playing option pool shuffle. But you can track the pre-money as it gets shuffled into the option pool and back into the investor’s pocket, you can prepare a hiring plan before the game starts, and you can keep your eye on the money card.
Most VCs can appreciate an entrepreneur who is focused on building his business and doesn’t want to raise money full-time. If a VC is asking for an inordinate amount of diligence and meetings, forget them and move on. They’ll be even worse once they’re on your board.
One negotiation tactic I’ve used successfully when there’s unreasonable pushback regarding size of the option pool is to propose that upon an acquisition all unallocated/unvested options that would be cancelled instead convert into common shares (that the cancelled shares get allocated back pro-rata to common shareholders). I’ve never seen this actually get implemented, but I’ve found that this helps cut straight to the chase and reach a compromise number that works for both sides.
If you do another round of financing, those unallocated shares will go into a new option pool. This allows your existing investors to avoid playing option pool shuffle against any new investors and avoid dilution at your expense.
As you know, it all really comes down to the investor wanting to limit his dilution in future rounds by having an option pool that will not need to be topped up much in future rounds. But they are never going to admit to that.
I’ve never seen an investor actually go for a structure like this. But I’ve multiple times seen them become willing to accept a much more reasonably sized option pool. I’ve seen the discussion go like this:
VC: Carve out a 25% option pool.
We only need 7%.
VC:You should do 22% for blah blah blah
OK, we’ll do 22%, but any unused shares convert back rather than rolling over or being cancelled. Or we can just do 10% standard terms.
VC: How about 12%?
The key question is how much the new investors are valuing the contributions of the existing shareholder.