The Option Pool Shuffle

With an employee stock option plan, startups and other employers offer their employees the option to purchase stock in the company. It’s a great benefit, and an important tool for startups to use to attract talent. To set up an ESO plan, you’ll need to allocate shares to it. And this is where the option pool shuffle takes place. 

Of course, for a pre-funded company, it’s pretty easy to understand the dilution from setting up a plan. You hire your first employee, then provide some shares to them … and it’s pretty clear that you, as the founder, now don’t own 100% of the company. You’ve been diluted.

But it’s a lot more abstract at a fund raise.

VC’s want shares set aside for new hires

Frequently the VC investor will require an option pool as part of the term sheet during a funding round. That’s 100% normal. Founders will hire – that’s a big reason to raise venture funding - and setting up an option plan ahead of time makes bringing on new employees easier. (You do not want to be doing one off option legal work – that gets expensive!) 

Where the valuation hit and hidden dilution happens is when the VC demands X% set aside for the pool, created PRIOR to their investment. So, essentially, the new shares set aside hit only the existing startup owners – the founders, any existing employees, and previous investors who hold shares. 

And if the dilution happens prior to the investment coming in, it disproportionately impacts the founders, to the benefit of the incoming investors.

With that in mind, let’s look at an example of the option pool shuffle using a hypothetical startup with 10 million shares as a starting point. Each share has a price of $1, which means you’ve got a $10 million pre-investment valuation. A VC investor wants to invest $5 million in your company in exchange for one-third ownership. You’ll add 5 million shares to your existing 10 million to provide the VC with 33% ownership.

Without an option pool, your startup’s capitalization table would look like this:

We are about to introduce two ways that an option pool can be added around a venture round. It’s important to note that we almost never see the ‘founder friendly’ approach – it just doesn’t happen. However, it’s a great illustration of how dilution works, so let’s dive in: 

The Founder Friendly Approach

At this point, AFTER you’ve accepted the funding, both you and the VC investor agree that you’ll need a stock option pool to help you hire top talent. You decide to allocate 10% of the final total of shares to the ESO Plan. Now your cap table looks like this:

Why are we adding 1,666,667 shares? Because the founder and VC agreed that the option pool should be 10% of the final total. In math terms, that means Founder + VC = 90% of TOTAL. If Founder + VC = 15,000,000 shares, then 15,000,000 = 90% of TOTAL. That means TOTAL = 16,666,667 shares (15,000,000/90%). So the founder has 10 million shares, the VC has 5 million, and the option pool now has 1,666,667 shares. 

However, now the VC doesn’t own 33% of the company any more.The VC’s ownership stake was reduced since the option pool was created AFTER the VC provided funding and got one-third ownership of the startup.

Again, we pretty much never see the founder friendly approach. Ten times out of 10 you are going to see the VC friendly approach: 

The VC Friendly Approach

For obvious reasons, VCs don’t like that method. They wanted 33%, not 30%. So they often propose the VC Friendly Approach, where the option pool is allocated BEFORE funding. Now our cap table looks like this:

How do we get here? Again, the founder and VC agree that the ESO pool should be 10% of the final total of shares, and the VC insists that they want 33% of the final total. So Founder + 10% + 33% = 100%, which means Founder = 57%. Right away you can see that the founder’s position has declined from 60% to 57%. 

Let’s fill in the actual numbers. To get to our final share total, we divide our 10 million shares by the founder’s final percentage (10,000,000/57% = 17,543,860). The VC gets 33% of 17,543,860 which is 5,789,474 shares. And the ESO plan ends up with 10% of 17,543,860, which is 1,754,386. It also drops the share price from $1.00 to $0.85 ($10,000,000/11,754,386) 

So now the VC does own 33% of the company, but the founder’s ownership is down to 57%. Basically, by allocating the ESO pool before the VC funding is received, the founder’s stake was diluted.

Unfortunately for founders, the most common, non-priced investment vehicles – SAFEs and convertible notes – are going to end up getting their shares priced at the close of the venture round. This means that these investors (the SAFE and convert investors) also are NOT impacted by the increase in the ESO plan, so the dilution to founders is even greater. 

Review the possible scenarios

It’s worth the time and effort to model various scenarios. There are software programs that make it easy to change variables and review the results of different plans. But the most important thing for founders to understand about the option pool shuffle is that it exists. If you’re aware of how the option pool funding will affect your ownership stake in your startup, you can assess your options, get information to negotiate, and make appropriate decisions. If you need more information on the option shuffle, capitalization tables, and startup funding, please contact us.