Valuation and Option Pool
One of the more contentious things in the negotiation between an entrepreneur and a VC over a financing, particularly an early stage financing, is the inclusion of an option pool in the pre-money valuation. As my friend Mark Pincus likes to say, "it's just another way to lower the price".
I'll accept that critique. And take it one step further. The option pool is absolutely a piece of the price negotiation. But it is a very important one as I'll explain.
But first, let me lay out a few things for those who aren't well versed in these matters. The pre-money valuation is the value of the company before the money comes in. Let's say we call it $4mm. And let's say the financing is $1mm. Then the post-money valuation is $5mm and the $1mm round is 20% dilutive ($1mm/$5mm).
But to the entrepreneur it might be a lot more dilutive due to the inclusion of the option pool in the pre-money valuation. Let's say that the VC's term sheet says that a 15% "fully diluted post money" option pool needs to be in the pre-money valuation. What that means is that the investor wants 15% of the company, after the financing is closed, to be in an option pool that has not been granted to anyone.
In the case of the $5mm post money valuation, that means there needs to be $750,000 worth of options in the pre-money valuation. If the pre-money valuation is $4mm, then that means the true pre-money valuation to the entreprenuer is $3.25mm. And therein lies Mark's critique that the option pool is just another way to lower the price.
I am sure I lost a few of you on all of that math. If you want to drill down on it, please leave a comment and we'll help you figure this out. It is very important you understand all of this if you are or want to be an entrepreneur who raises venture capital.
The bottom line is the deal I described leaves the entrepreneur and his/her shareholders with 65% of the company after the financing, the VC investor will own 20%, and there will be an option pool representing 15% of the company that has not been issued yet. The $1mm financing was not 20% dilutive, it was 35% dilutive.
So it is not surprising that entrepreneurs hate this provision and fight about it every time. And like most terms, VCs have been abusing it for years by asking for excessive option pools making the provision hated more than it needs to be.
The first point I'll make is that VCs should be upfront about this provision and the fact that it is simply about price. In the example above, I'd be happy to pay $3.25mm pre-money with no option pool. Or I'll pay $4mm pre-money with one. They are the same thing to me. What an entrepreneur needs to do is find out what the market price for their company is with and without an option pool in the number. Once they do that, the negotiation over this point is a lot less contentious.
The second point I'll make is that the option pool request needs to be reasonable and based on some kind of budget. I generally ask the entrepreneur to put enough options into the "pre-money pool" to fund the hiring and retention needs of the company until the next financing. My thinking on this is that I don't want to get diluted between financings. So I like to see a headcount based hiring plan with expected options against each hire combined with a retention plan for all current employees who will need additional option grants.
In most of the early stage financings I've done in the past few years this work on the option pool has shown a need for around 10% in unissued options. I've seen it as big as 15% but that is rare. I've also seen it as low as 5%, but that is even more rare. But the point is this; don't guess or negotiate this number. Do the work, figure it out, and put it in the pre-money and then negotiate price.
I'll wrap with a true story about this provision. When Mark and I were negotiating the first round of financing for Zynga, we got into a real tussle about this provision. He did not want an option pool in the pre-money valuation. I did. Once we agreed that it was just a fight about price, the conversation got easier. I got him to give me an estimate of the pool he would need. We added it to the valuation we had agreed to. He got an increase in price, I got an option pool. And I got one of the best investments I've ever made.
Understand the math. Just not sure how those option pools would work. Do these options reside with the investors ?
they are managed by the company with board oversight. think about it as allocating a piece of the company to be granted overtime to employees. the founder/CEO will determine how much is granted to each employee but the board needs to approve the grants
But do un-allocated options have voting rights? how would a founder have lost control just be having the pool ‘there’ for future use.
if the options are not allocated to an actual employee, they don’t actually exist as shares; until the options are actually exercised by an employee who has received them (and the options always have vesting), they are not shares in the company – they are just options to buy shares. From a practical perspective, control in a VC funded startup is more often than not controlled by board provisions, not by percentage ownership of the company. A founder could, conceivably, sell 20% of their company but become a minority board member and have a structure where the board could well fire her (the founder) and make all the relevant strategic decisions for the business. The founder owns 80% of the company but is actually just working for the board of directors.
Elie I agree with both of your points re unallocated (and unvested) options. It won’t affect control of the company nearly as much as whatever provisions were agreed to in the subscription documents for the investment, which probably include board control. Even without effective control through that contract (which I would think would be rare, but maybe I will be corrected), the options pool in the near term won’t be fully allocated and even if allocated it won’t be fully vested so there won’t be any voting rights issues. I would assume that the unallocated/unvested options would not be counted in the denominator of any calculation of voting percentage, they would just be ignored (or they would just be assumed to be voted pro-rata which has the same effect).
Not sure how common board control by the early stage VCs is. But like anything else, it’s part of the negotiation. My perspective is that control is rarely needed by the VC or of actual value to them but is kind of a knee jerk request since it’s in the VC textbook. I’d also argue that for the entrepreneur it’s actually far more important than price and should be negotiated on much more aggressively.One of the reasons that entrepreneurs do well is that they get to execute on their vision with the minimum of friction from senior management that does not understand the problem as well as they do and wants everything to be concensus driven. The entrepreneur(s) live or die by their decisions – they are owners and have an ownership mentality (and reality) with all of the stress and positives that come with it. A board at its best asks good questions and helps take the thinking up a notch but a VC does not need control to enable that. At its worst, a VC board can end up being just a replacement of the BigCo senior management and the startup slowly but surely starts to emulate a BigCo – just without the BigCo salaries or financial resources.The board control issue is different than the financial protective provisions that all investors – VC or otherwise – should have before they invest in an early stage company.
I’ve never seen board control by VCs in an early stage deal
but VETO yes.
Options don’t vote
How common are post-money option pools?
they are not that common because the trade-off is usually a lower pre-money valuation and once the trade is set up that way, most entrepreneurs don’t choose to do it that way
What annoys me is what happens to unissued options in the option pool if the company exits early. The entrepreneurs paid for them, they should be returned to the entrepreneurs. Instead they are allocated pro-rata amongst all shareholders.
that’s a great point Erik. in practice, i’ve not seen this be an issue if the pool is sized appropriately. most early exits happen in lieu of another round and at that time the pool is largely spent. but if the VC negotiates for an inappropriately large pool, this would be a big issue
great erik – i asked this in a seperate comment. rights on the pool are a murky area with vcs IMO
the entrepreneurs do get some of them back bc their removal from the cap table reduces dilution on everyone pro-rata. But I agree with Erik that if they are not used, the entrepreneur is the rightful owner of them.
Fred,If there were unused options in the pool, could the entrepreneur retain granting rights on these on the eve of a sale, i.e. so that they could distribute the remaining value amongst them or their team?An entrepreneur recently advocated this to me; I told him I thought this would be disputed by the investors (who wouldn’t want to be further diluted after winning) and the acquirer (who would likely see this as a strange occurrence and/or want to be involved in setting terms around any “golden handcuffs”*), and he told me that hadn’t been his experience.From your vantage point, would you fight this? Would you expect acquirers to balk?*Golden Handcuffs might be inside baseball, for anyone reading this who’s never heard that, Golden Handcuffs are “a system of financial incentives designed to keep an employee from leaving the company” (wikipedia). Think Stock Options that vest over 3 years or large cash bonuses for staying a certain length of time.
Its been done. It would have to be negotiated with all parties to the sale including the buyer and vesting would stick so that the employees would have to stay post close to earn themAll of those reasons are why it doesn’t happen very often
RT @fredwilson: a story about option pools and valuation negotiations that has a happy ending http://bit.ly/3mL7rE
What happens if the company has an existing pool of options that was setup at founding time or during seed time- is there an implication or things to consider for the Series A later?
if there are still unissued options in the pool at the time of the series Around, then the dilution to get to the new number needed will be less thanif there were nonei have seen a situation, disqus, where the pool setup in the seed round wasso large that we actually agreed to keep a portion of it out of thecalculation of pre-money valuation because we knew it would not be usedbefore the next round
really? thats the first i ever heard that.
yes. i was just about to make a comment about this, i am so glad to hear you had such a large pool setup for disqus. i think that is the right trend, especially for firms like USV that buy into the craigslist model (i.e. peer-produced, leverage the edge, etc).killer post boss. textbook example of blog stars as education providers, and blog-centric communities as schools for ongoing niche education. that’s the “wow” moment for me with all this blogging crap, how much i can learn from just spending a few minutes participating in a discussion on a blog.
kidmercuryI was just having the same thought: this is social real-time knowledge production/exchange in motion. This is stunningly powerful example of social education. But who has the UI/ b-model for the conversational wikipedia that would draw this and the 10000 related threads into a searchable and accessible and living textbook?
lol, well edbice i think you really asked the right person that question….because i do! that’s what my business is about. but i don’t think it is very much about UI. i mean that is definitely a key part, you always need good UI, but i think the big focus is on the community. getting the right group of people together — all the experts in a given niche — is i think where it’s at.i’m also a fan of human categorization for these types of sites. i think humans can package things in a way that is designed for learning. i think human classification systems will be better at creating the “living textbook” (nice phrase, i’m going to borrow it 🙂 )
Best comment/question I’ve seen lately. Who is gonna build that? Who is gonna hack education????
Fred -YOU have already hacked education with many of your posts. The content, and frequently the educated discourse which follows in the comments, is a clear hack to traditional B-School deal valuation / compensation system design curricula. I would love to see AVC comments hosted on a Google Wave blip to enable the search-ability and real time collaboration which we are (barely) missing.
Does that mean that the unissued options more or less are spread out between all parties? Thus the founders would be stuck with a lower percentage of ownership than if the options pool had been created smaller to begin with? I apologize if I’m completely misunderstanding anything.Example with 100 shares:15 shares/options – options pool (15%)20 shares – investors (20%)65 shares – founders (65%)Then let’s say only 10 shares are used in the options pool, the remaining 5 aren’t used. So effectively we now have10 – options pool (~10.5%)20 – investors (~21%)65 – investors (~68.5%)Whereas if we had started with just a 10% options pool we would have10% – options pool20% – investors70% – founders
Yup. You got it right
The valuation issue is a critical one, but the simple exercise of ensuring that management and the VC’s thinking about equity compensation is aligned is equally important. This touches a number of areas, including thinking about the hiring plans to get to the next level, org structure, and how far down the organization equity will reach as it grows. These discussions don’t get any easier as time passes. Having detailed conversations about this issue up front, and how they impact dilution, pricing and a growth plan that will attract and retain the people needed to grow the business are all wrapped up in this together.The first time a management team has to go back to their board and ask for more equity, facing that dilution discussion, they will appreciate the value of having that discussion up front.
So true. Excellent points Eric
Couldn’t agree more. If entrepreneur didn’t care to set up the option pool on his own – that just means the thought about progress/hiring was not there. I always like to stress the importance of addressing important issues yourself – otherwise they will be addressed by someone else (VC in that case) on their conditions.Thus said – it’s not always discussion about money – it’s sometimes making entrepreneur consider things he/she didn’t care to think about before.
Hi Eric – Sorry, I only just noticed you’d already mentioned alignment of interests. I commented on same.
Very true. In one financing I did as a VC, I negotiated super-hard for a sizeable option pool up-front because I knew one of the board members thought employees hardly needed any equity. It was a European company…Fred’s post prompted me to create a true pre-money calculator in the startup tool section of FastIgnite.
I have been thinking about this a lot recently, in particular how much options are actually worth to employees (where it seems a “bait and switch” to lower salary expectations on the promise of getting rich off options – http://www.bothsidesoftheta… )Some points to think about (from an entrepreneurs perspective);What stage is your business at? Early stage you should not generally need to be bringing in senior management but they are the ones for who the option pool is primarily aimed, so it could be argued that the option pool is not required until you intend to scale the business. Especially if non executive staff understand that options are unlikely to make them rich (and may not even cover their reduction in salary if and when you exit).Loss of control. I have heard about angels looking for 40% equity at seed stage, then a 20% option pool which would mean effective loss of control for the founders at a very early stage. Whatever the numbers are the option pool is also a further move towards loss of control (am I mistaken?) which is a point I dont think you make here, but for many founders is a key element of any negotiation.Option pool size. While sizes are often standard I think they can also telegraph some intent (rightly or wrongly). In the case above, a 20% option pool request says to me (planning for the worst) “we intend to bring in a whole new management team to replace you and need significant equity to do that”. Perhaps I am being overly cynical there but perhaps not?If options are there to incentivize staff by giving them a chance to make a significant profit from a good exit then a 5% pool for the senior management could be enough with other staff given a fair salary and great place to work as a good incentive.
Great points Ian, thanks for discussing the loss of control aspect and linking to Mark’s post.
Kind a guy I wish was in CHicago…damn him.
I don’t think 5pcnt will get it done. Good devs alone will eat that up
“I’d be happy to pay $3.25mm pre-money with no option pool. Or I’ll pay $4mm pre-money with one. They are the same thing to me” —- same thing to you on paper vis-a-vis valuation – but in terms of the investment opportunity as a whole having a pool in place is something you prefer/demand with each invesment – right?
Yes, but at 3.25mm it could come post-money
“$4mm pre-money with an option pool” is not the same as “$3.25mm pre-money with no option pool”. It would be the same as “$3.25mm pre-money with an option pool established upon closing [or prior to closing but not treated as issued and outstanding]”
what are the clauses associated with the pool? does the VC have preferentials on this? the great investment you made in marc had nothing to do with the pool and everything to do with the performance of the entrepreneur (nit pic)
The pfd is senior to common and options
You’re right also in the sense that percentage is a wrong discussion point. Value is definitely one. But at the end of the day, if some day you create a great service with huge success, the outcome will be huge too. So whether you remain with 10.5%, or 12.5% the day of the exit is a detail if your outcome is in millions or tens of millions. Doesn’t mean you shouldn’t fight of course 😉
In one sense you’re right: 10.5 vs. 12.5 will never really affect how an exit changes your life. However, if you have a big win (say 50MM), you should definitely fight for it — it’s still a million bucks that you could do something with (invest! buy a house! pay taxes on all the money you just made!)The Math:At a 5MM exit, you’re looking at 525K vs. 625KAt 20MM, it’s 2.1MM vs. 2.5MMAt 50MM, it’s 5.25MM vs 6.25MM
Good stuff all around.As I see it, the point really is a question of valuation. The question you have to ask yourself as an investor – is just how invested in the success of the company do you want the employees and founders to be. If there’s no ownership there – and no prospect of ownership you may get a different outcome relative to the team that feels that it is truly in partnership with you. Thus the balance you describe between price and pool.I think these are relatively simple things in early stage companies – but get incrementally more complicated as companies grow and need additional rounds of financing. that’s where you can set up a real conflict between a new investor coming in who wants to top up a pool of already issued options pre-money, with the existing investors taking all of the dilution, and management taking none of the dilution despite having used up the previously allocated capital. That’s where the math and the alignment really gets tricky, because after a certain point, the managers have much more staked on the options than the initial shares – and the incentives start to shift.As Warren Buffets partner Charlie Munger said in a famous speech at UCLA: ” In any given situation, look at the incentives for any of the people involved, and you will likely be able to figure out what is about to happen.”
great quote – love charlies riffs
Munger is a genius
This is instructive Fred, thnx. There is a running theme in your posts that staff planning is essential for funding and continued ease of growth. I’ve been in a number of situations coming on to build sales and marketing teams with insufficient option pools. In start-ups, if you want to hire great stretch candidates, having equity to distribute builds a winning culture. Often overlooked but essential.
“My thinking on this is that I don’t want to get diluted between financings.” So what happens when you go to market for Series B? Take the dilution before or after the new investors come in?
That’s a good question James. You would hope that Series A investors who insisted that the option pool be carved out before they came in would agree to a similar thing when the Series B investors arrived. It’s complicated by things like follow on rights, but the principal of symmetry is a good (and revealing?) one. What’s good for the goose should be good for the gander, no?
I believe this is the case Terry, although because firms will often re-invest, my guess is it’s not as hard a pill to swallow (the VC is taking a hit as a member of the A round, but dodging a hit on their B round investment).
As part of the transaction the pool will get increased againI like to do these refreshes as part of the financing negotiation since it is all about price
I think I get it (please correct if I’m wrong):Options: separate some of the value of the business venture for hiring/growingThe shares are set aside for virtual early employees/company owners that emerge as the business grows.But they also effect the ratio of cash to total business valuation.So if 10% is put aside for options in a 5mm valuation, and VCs buy in for 1mm for 20% the original owners retain 70% of the company?
great post. a sometimes trickier tussle is the one you get into with previous investors when you ask for option pool expansion as part of a subsequent round of financing. at that point it’s not simply the entrepreneur’s interests vs. the new VC’s, but the initial investor will certainly have a say in the dilution question. and at times, management and the initial investor may be split on this point, as management may want/need a bigger option pool post close and may use the transaction negotiation as a way to get it. whereas the initial investors want everyone to share in the dilution burden post close as necessary. this scenario adds another wrinkle to the problem that needs to be navigated. curious if you’ve dealt with this before and how you like to handle.
I like to see management own a lot so I tend to be generous in follow ons on this issue
agreed. wish everyone saw it that way…
What’s your take is on an appropriate size of an option pool for a bootstrapped start-up with all of the intentions of venture financing down the road?
I don’t think it is in your interest to set up a pool prior to doing a financing. Just issue options as you need them and save the size of pool issue for the price negotiation with the VCs
Completely agree. I’ve been asked by lots of early entrepreneurs about this term and others and I always respond – it’s just about the negotiation and supply and demand. There really are no norms though a company where the founder is the only person who owns equity is not going to get funded by most any early stage VC with good sense. In fact, among some regrettable things that Mark says in the video here, he makes the excellent point about the even more important issue of control and his B shares and control of board etc. (he made a similar point at Startup school a few weeks back) http://www.techcrunch.com/2009/11/06/zynga-scam… ). No expectation that you would comment here. How the pie is split up is important but I agree with Mark that what is even more important is to decide proactively who controls what. In the vast majority of success cases, the founders own enough for it to be a lot of money by all practical considerations. But the entire issue of who made how much is gated by whether the thing was a success in the first place and that is, IMO, mostly impacted by who got to make the decisions about where the company is going. Board members are very important and can add a lot of value – though many add no value or even hurt a company – but only the entrepreneur is close enough to the product and the business to be able to make the final call. Corporate boards did not work for large companies like Citibank – even with “geniuses” like Bob Rubin involved – and if they are the final decision making authority in a startup, they are more often than not going to make the wrong decision.
Elie, could you expand on why is a founder owning all of the equity a problem for early stage VC’s?
Because successful startups are built by teams of owners, not by one individual. No matter how important a single founder is, without a motivated team around them, it’s going to be hard to build anything of a scale that matters to a VC. The best way to have a motivated team with an ownership mentality is to have them actually be owners. A founder who has all of the equity in their business AND also won’t allocate equity for other hires shows that they don’t understand the importance of teams in building great companies. My two cents.
craigslist. one founder.but your point is valid, which is why i think the super small startups, which we will see more and more of, will need to have larger option pools — that is their competitive advantage in deals, which they can reap due to their operational efficiencies that enable them to be super lean.
true – there are definitely exceptions. Like YouTube building 1B+ of liquid capitalization in less than 2 years without ever having made any money 😉 but I agree with you on smaller companies. Also, if the team is already well rounded out – with equity split among them in some way – prior to raising capital, the argument for a large option pool is much much weaker.
Kid M, I don’t think CL is a fair example. both Jim Buckminster and Craig have equity. I’m also not sure they took venture capital (I don’t think they did).
true, but of course in order for buckminster to get his piece craig needed to be able to allocate it to him. if he rolled up with a whole bunch of founders and support staff, that might not be possible. part of the single founder/small team advantage is that they have lots of equity to give around, IMHO.
They did not
Jim owns a nice piece of craigslist
Mark certainly said what he said, but you need to understand it in contextI’d suggest everyone who wants to understand mark watch his recent startup school talk on ustream and then read his blogs posts of the past few days and then watch that video that techcrunch posted againContext matters when listening
I have done a few deals where you only allocate a portion of the pool to the pre-money valuation. I’d argue that with the way first financings are being done these days – very small rounds at very early stages, without much hiring planned at the outset – that might be a better and fairer way to go.
Although it’s a fight about price, does the size of the pool end up having an impact on how the business is run? If it’s too small is does the hesitancy for all the investors to take more dilution before the next round start pressuring comp packages or do the pools get right-sized easily? If it’s too big, is there pressure to “use it or lose it” potentially “overpaying” people.I understand it’s just industry convention but the pre vs. post money valuation concepts always seemed funny to me, as if the pre-money valuation was independent from an additional round of capital, when in almost all cases it’s contingent on new money.
Pools should be sized right for all the reasaons you cite jeremiah. That said, I’d lean slightly toward more mgmt ownership is better than less
Interesting post. I do agree that knowing the true value of the company is the best tool to get the right numbers at the end of negotiations.
Hi Fred, who designed your icon? It is both neat AND snazzy.
It is very snazzy (and unique).I’m going to apologize in advance for taking your comment as a jumping off point for an off-topic comment of my own, but I could use some feedback on something from the artistic/marketing-minded folks in the AVC community. Would you mind letting me know what you think of this draft logo for a new blog of mine?I have a minor issue with the execution of it, but I want to see if others see it the same way I do.Thanks in advance. If my blog had an options pool, I’d hand them out like Halloween candy to you all.
Actually I’ve always wanted to know if it were acrylic or oil or a fake. (art student think)
Iggy, an artist in phoenix who is friends with howard lindzon
I think you really hit the nail on the head with your point about understanding. There are basically two ways to work out a price (with or without an option pool), and once that’s explained, the rest of the math is easy. The problem is that people just don’t get it, and therefore try to fight what they don’t understand.
Which is an awful place to be
Hi FredYou write: “The bottom line is the deal I described leaves the entrepreneur and his/her shareholders with 65% of the company after the financing, the VC investor will own 20%, and there will be an option pool representing 15% of the company that has not been issued yet. The $1mm financing was not 20% dilutive, it was 35% dilutive.”This is only true in the fullness of time. At the moment of signing the deal, in the minds of both the CEO and the VC, 20% of the company has been sold for $1M. The 15% that’s been approved but not yet issued is clearly the property of the existing shareholders (I know you weren’t addressing that issue, but someone else asked about it), and should remain so.This is the main reason why I don’t like the option pool in the pre-money: it creates a mis-alignment of interests. When it’s done that way, the stakes are different when hiring new people. The VC is not getting diluted at all, whereas the existing shareholders are. So there can be pressure to hire that doesn’t properly consider dilution. The flip side is also true: management has more incentive to fire someone who may not be working out, whereas the VC is indifferent (equity-wise).In my (limited, I admit) experience, it’s worth working extra hard to find solutions to problems that reduce or eliminate mis-alignment of interests. Every point at which interests are not aligned can (and may well, when times are hard) be the basis for all sorts of trouble, hinders transparency, encourages paranoia, etc. It’s just bad news.Fortunately in this particular case there’s an easy solution: let the existing management and the VC be aligned with respect to hiring (and firing). Let them be diluted together, let them make the choices together, etc.All this has nothing to do with the particular numbers, or with whether people are happy to have the pool, how big it is, etc. It’s about getting the dynamics right.
Hey Terry,All shareholders (including investors) will be diluted as options are exercised. For example, If a company has 10MM shares, including a 1MM share option pool, and the investor owns 2MM shares, this leaves the entrepreneurs with 7MM.So the value of the investor’s shares 2MM/9MM. With every option granted (assuming it is later exercised) the denominator increases.
Hi TylerIt doesn’t work that way (in my experience and in what I’ve read). The investor comes into the deal agreeing to buy 20% of the company for $2M. When the entire option pool is issued & exercised, that’s the position they’re in. At the moment after signing the deal, the employees own 80% of the company. Over time, as the option plan is used, those original investors are diluted down to owning 70% of the company, the incoming employees grow to own 10% and the investors arrive at their original figure of 20%. So it’s the original owners of the company who are diluted along the way by the new hires, and not the investors. That’s a big part of why a pre-money option plan is not popular with entrepreneurs. The investors are insisting that the dilution of future hiring is taken out of your hide, and that it’s not shared.
Right, but until the entire option pool is issued and exercised, theinvestor owns more than 20%, right?Best,Tyler WillisDirector of Marketing, Involver415-683-1742
No, not if the unissued employee pool stock is treated as the property of the pre-VC owners. Someone else was asking about this on this page too. That needs to be spelled out – I have seen deal documents where it was not. Similarly, it needs to be considered what happens when an employee leaves mid-vesting and can exercise their partially vested option. The remainder should go back into some form of treasury to potentially be re-issued, and revert in the meantime to being owned by its original owners.It’s a lot of work to keep track of all this. I once wrote about 6K lines of code to support running a stock option plan, and there were lots and lots of details and special cases.
Its not the property of anyone. Its a pool that the company manages
Your point about being true in the fullness of time is absolutely correct and that is why your point about misalignment is wrongWe all get diluted together
Hi Fred> Your point about being true in the fullness of time is absolutely correct> and that is why your point about misalignment is wrong> > We all get diluted togetherIt could and should be set up this way, but I think it typically is not. If it were, the entrepreneur’s dislike of the pre-money carve out would vanish.Here’s an example.Suppose that pre-VC funding the company has 70 shares. The company agrees with a VC to sell 20%, with the proviso that a 10% pool of employee options is carved out ahead of the deal. Once the deal is signed, the original team still holds 70 shares, the VC is issued with 20 shares, and the shareholder’s agreement allows the board to issue another 10 shares for the pool. If the company is sold one hour later, the VC should logically still own 20% of the company. If the approved but unissued option pool is not regarded as owned by the orginal team, the VCs would own 20 shares out of 90, or 22.2%. That’s obviously (to me!) wrong. The math works correctly if those 10 shares are treated as owned by the original team, pending their issuance to future employees.That way, if the company is sold after an hour, the VCs hold exactly 20%. If the company later hires 1 person who is awarded 1 share (which vests and is exercised), the original team then holds (70 + 9) / (70 + 9 + 1 + 20) = 79%. They have been slightly diluted, down from 80%. The VC holds their 20% all along – they are not diluted by the issuance of the shares in the pool: that’s the original reason for carving out the pool ahead of time. When the pool is finally entirely issued (& vested & exercised) there’s no need to continue counting the unissued shares as though they were held by the origianl team. The 100 shares are all issued: the VCs hold their 20%, the original team now holds 70%, and the new hires 10%. The math all works very cleanly that way.To have the VC argue that not only should the company a priori set aside stock for the pool ahead of the financing, but ALSO that the VCs own a proportion of that pool too (which they don’t even purchase) is a bit rich! If you’re buying 20%, you should be happy with 20% :-)That’s how it *could* be set up. Of course the deal docs can be papered in any way the parties like. But those approved but unissued shares should be on the books somewhere, otherwise the deal is not as it might seem.Fred – if you don’t mind, or even expect, to be diluted along the way with new hires (which IMO is *great*, and the way it should be) then what’s the point of carving out an option pool ahead of time? The traditional point of contention with the original team is then removed.Sorry for such a long comment!
A quick way of summarizing what I just wrote, along with you saying “we all get diluted together” is that yes, it can be that way. But (using the numbers in my example) to do that with a pre-existing option pool, the VC is diluting down from 22.2% to 20%. Doing it like that means you didn’t originally buy 20%. You bought 22.2%, but you only paid for 20%.All these details (like keeping track of unissued stock, inequities before the pool is fully issued, interests not being aligned) go away completely if the original team and the VC simply agree that they’ll issue stock to new employees as the board sees fit and that new stock will be issued as needed at those times. One way or another, a pre-existing pool of phantom approved but non-yet-existent unissued stock is a mess – it means (until the pool is fully issued) that either the VC got more than they paid for, or that interests will not be fully aligned in hiring/firing.Apologies if this sounds in any way pedantic or like I’m lecturing. I’m actually trying to learn. Maybe there is a way to avoid these problems with a pre-existing pool, but I don’t see how. If I could ask a favor, please use an example with numbers if you reply 🙂 Thx!
Terry, I may wrong, but surely a post-money option pool makes all these problems go away?
its a shame – i would like to have seen freds response to this as this is the exact issue i struggle with.basically – entrepreneur provides a pool of options – if they are not used they share them with the VC.
Consumer web entrepreneurs face the following problem: prospects rightly think a piece of that option pool is not worth a lot because: (a) they made a ton of money from it already (from GOOG etc) and the piece looks small; (b) they don’t think they can make a ton of money from it anymore because exits are smaller (.2% of 50MM after 2-4 years is only 100K ie a bet not worth taking) and the IPO market is way too closed; (c) there are other opportunities that make cash faster, because liquidation of attention is instant on ad networks for the consumer webProblem (a) is a particular problem in Silicon Valley with stratified wealth, where the same level of talent maps into very different chunks of wealth, you pretty much have to take the log of someones net worth to know what options to give them. Because of this I think the 5-15% haggling is misplaced — it doesn’t take into account the changes in how consumer web has changed in the last decade.You can pretend it hasn’t with a headcount options spreadsheet, sure, but the realities are that 100K for US people isn’t a lot anymore. I think a lot of us are now wanting to get the options math to work *systematically* with equally talented people (with less attitude, more hunger) in India and elsewhere, where 100K IS really life altering. Otherwise, entrepreneurs want to hire entrepreneurial type people here, and that can’t be done with “what is .2-.5% of 10% of something like 25-50MM, maybe” math easily anymore. Now the entrepreneur has to attract people because its fun to work together on something, or because its a good education to become a founder.
I second this. Only reason I want to do this is because I want to turn an art theoriest eduction into something a bit more err practical.
Sourabh,I think you’re getting at a more fundamental issue: Are option pools the appropriate compensation vehicle for employees #3-#20? And the answer will increasingly be “no”. If I’m talented enough to be #5 in your company but you’re limited to giving me 0.3% – 1.0%, it’s not going to work. I’ll go and start my own company where I’ll be getting at least 10%-30% of the equity for what will amount to approximately equal work to helping you start yours.I think what needs to happen is that VCs and Founders will have to start expanding option pools or creating larger straight equity reserves in order to get talent that can really launch a start-up. The barriers to entry are falling and keeping an outsized proportion simply for creating a demo around a good idea for a VC is not enough to keep value from the people who actually do the hard work of making the company successful.
Agree with you completely.I wonder that given the current economy and the growing body of folks who have started companies and lived to tell the tale that the “essential” employee deserving of equity as part of a balanced compensation program is a decreasing number and that the threshold is moving upward.
Your macro points are well taken and so trueBut that doesn’t mean employees shouldn’t own a fair piece of the company they go work for100k is better than nothing
I’m kleaving a comment on options since I know it is a kind of derivative contract, and I just got my first preif lecture on it last night. it involved fish and was funny. I know this has to do with what the future price of the company will be. Can we get some charts? So I can play with with them?
I don’t think you should start a company without a meaningful option pool, profit share or some other “alignment of future employee interests” piece in place…..regardless of whether or not someone else is investing.
Great post, and thanks. I am clear on the math, but I have a question about “I generally ask the entrepreneur to put enough options into the “pre-money pool” to fund the hiring and retention needs of the company until the next financing.”If you are in the seed stage, and you expect multiple rounds of institutional investment, doesn’t in make sense to earmark a budget that covers all expected options needs through multiple rounds. What if I think 30% should be set aside for key hires, employees grants, etc. Is there any reason why I wouldn’t want that set aside early? Wouldn’t I want to communicate that with seed and Series A investors?I am just wondering if the option pool negotiated for a given funding round should only cover the expected needs prior to the next funding round, or if a healthy pool should be established early to make the priority/expectation clear.Thanks for anyone that cares to provide their perspective!
Round to round is better because you can never know where this thing is headed and when you’ll sell
Options should dilute all owners in proportion to their ownership. Let’s say the company is worth $X today. It has the chance to hire a superstar that will increase the value of the company tremendously. The cost is 1pt in options. Should you do it? Yes if the value produced by said hire is greater than the cost to you as an individual owner. with proportional dilution the incentives across all owners is the same (if i own 25% of the co, i will receive 25% of the benefit of the superstar and it will cost me 25% of the total equity cost (I will end up being diluted such that i contribute 0.25pt of the 1pt)).Perhaps we should “carve out” of the investment amount the NPV of the cash comp of all future pals and flunkies of the VCs we are pressured to hire (and all the time spent on bod meetings)? So maybe in a $1mm VC investment the VC would only get “credit” for $750k?
Haha, pretty damn………………………………………clever! LOL
Read the post. I said its just about price. We are giving you 15pcnt higher price and asking you to take 15pcnt dilution
A most interesting and thought provoking post, as always.I suggest the employment arrangement with the founder is probably as important or more important than the option pool discussion. The option pool may have some material impact on how the loot is split when the pay window is cracked open but the Employment Agreement and its mix of salary, benefits, perquisites, short term incentives, long term incentives and equity will be at least as important to the ultimate motivation and impact on success.In the final analysis, the option pool discussion is just a bit of camouflage as to the real pricing of the investment.
Yes, and I want to take the camoflauge off of it
An informative article on early-stage financing between entrepreneurs and VC’s by @fredwilson – http://j.mp/3gdh9S
Fred, the title of the post is “valuation and option pool,” but obviously is focused on how the option pool works (lot to be learned, particularly as you dive into the comments).I’d love to hear your thoughts at some point, though, on how you like to get to the pre-money valuation, which anchors the whole thing.I don’t remember you ever writing about this so I did a quick search here for “pre-money valuation,” and it gave me three posts, including this one.One of the three was your Geocities post from April of this year and it was as fun to read for a second time as it was the first:http://www.avc.com/a_vc/200…As you said, it was ride on a rocket ship where, as a reader, it seemed like you had to do a (re)valuation about every fifteen minutes with more and more at stake!It would be enlightening to know how you, and Woody, and the rest of the folks here approach this particular piece of alchemy.
There is no science to early stage valuation. Its simply a matter of supply and demand. So generate a lot of demand and you’ll get a good price
Hmm, seems shockingly simple when you put it that way, although there must be at least an art, if not a science, to follow-on rounds. But, now I understand what you mean.For others who may be interested, I’ll leave links to two useful posts, one written by you in 2004 about valuation and one by Brad Feld, inspired by that post, on valuation algebra:http://www.avc.com/a_vc/200…http://www.feld.com/wp/arch…
Thanks for explaining these important topics Fred, I know for me option pools have long confused me but now I feel more confident in my understanding of them, so good job.
This topic inspires me to share a great site — Real Deal Docs — which has copies of all kinds of publicly filed documents which are drawn from the SEC filings of public companies.These documents are often a pain in the butt to get from the SEC’s EDGAR filing system because they are Exhibits to 10Ks and 10Qs and may only be referred to but not really be attached. So this site provides great utility as they catalog them by the purpose of the document.You cannot imagine the number of such documents which exist. The legal work for these publicly filed documents was done by the largest and best law firms in the country. I must confess to routinely plagiarizing not the actual draftsmanship but the intellectual concepts contained therein. The shear depth of the pool is breathtaking.The reason I mention it here is that should you find yourself feeling your way along on the provisions of say an Employment Agreement, Non-compete, Option Plan, etc. you can take a FREE look at hundreds of such documents and learn every possible concept employed therein.It is also an opportunity for an entrepreneur to arm themselves against the proverbial — “that’s the way it is done” kiss off.Monkey see, monkey do. But, ahh, fear the informed monkey!
Looks like a very useful site. Thanks for the tip, JLM.
Great share JLM!
Not to throw a monkey wrench into the conversation but in light of FASB 123(R) and the implications of accounting for stock options together with the frequent misapplication of the Black Scholes formula (primarily in the determination of pertinent variagles e.g. “volatility” given almost no actual or useful data) in determining the expense of stock options, the use of restricted stock — essentially an option with a $0.00 strike price — is an excellent tool which typically provides less dilution as well as being able to deliver all of the “golden handcuffs”, motivation and compensation features of stock options vis a vis option life and vesting alternatives.Because you are delivering more absolute value per individual unit of stock the delivery of value is increased — or more likely stays the same — while the dilutive impact is decreased.In its simplest application one (1) $1 restricted share is equal in value to two (2) options with a strike price of $0.50/sh.The recipient receives the same amount of value — $1 — while the remaining owners are diluted by a single incremental share rather than two shares,Restricted stock also provides an opportunity for thoughtful investors to create a liquidity event for management at some interim period while in effect “repurchasing” the long term dilutive impact of the restricted stock.This is an example of an investor/VC taking a bit longer view of things and bartering short term liquidity for long term reduction of dilution. In effect, a reverse option as it pertains to dilution.
Yup. Even better are RSUs. Facebook uses them
So I’m new with derivatives. What if you develop a pool of options, and yoiu have a contract set up, and your company then sucks, and the options vest? How do you deal with the mispricing? (thank you)
I see a census. I see apparently it is weird I am a student. HMMM
what continues to suprise and frustrate me is how many entrepreneurs/inventors/founders enter into negotiations with investors without having done their homework and gotten an education into how VC deals work.when i started out in tech startups back in the jurassic era (1990) that was pretty damn hard to do… but we did it anyway. (by hiring an attorney who had done a bunch of investment deals and paying him to teach me about the contracts, paragraph by painful paragraph)but nowadays neophytes can get educated eight wasy from sunday, with a few clicks of the mouseone huge caveat (with apologies to fred and the scant few others like him who speak on these subjects plainly and sincerely) — nephytes should NOT look to VCs and professional investors to tell them how they should negotiate or think about finncing terms. you wouldn’t ask the seller of a house to manage the house inpsection for you, right? you don’t ask the car salesman to decide what car you drive, right? why the heck young entre[preneurs expect investors to give them unbiased views is just impossible for me to fathom. but it happens everyday. i’ve seen serious accomplished people giving neophytes advice to not consult with attorneys before signing term sheets. WTF!neophytes: hire a seasoned lawyer. pay him/her for 3-4 hours of their time to be your tutor. there WILL be a quiz!
Good advice steve. But by all means, please hire a lawyer who does a lot of venture deals
Mark Pincus your friend the malware specialist scam artist? I’ve heard that you’ve turned down profitable projects because they were “scammy.” Or maybe they just weren’t scammy — e.g. profitable — enough. Mr. EthicalVC you need to say something about this…
He did say something about it:http://www.backtype.com/fre…Feel free to come back and tell us what you think.
I’ve said a bunch. In this comment thread and at the techcrunch comment thread
Is there ever a case where the company does okay, but not amazingly well, and the next fundraising round is at a barely higher price, but with a larger option pool, so the true pre-money valuation for the 2nd round is actually below the true pre-money valuation for the first round? Is that a down round? Technically the face price is higher, but the true price is lower.
Very interesting post. I think you should also include a third stakeholder in this discussion — the hard-working, but often uninformed rank-and-file start-up employees.I have never worked at a start-up that the entrepreneur/senior management explains the details with regard to “liquidation preference”, “preferred participation”, etc. Those details could have huge impact on how employees would be compensated when an exit event takes place.I wrote a post on my own blog called “Don’t get screwed! Stock option questions you should ask before you join a start-up” (http://www.geekmba360.com/?…. And I got quite an opposite reactions from employees vs. entrepreneurs.I think it’s time to call for more transparency in term of VC investment for all parties involved.
I agree. A lot of startup employees read this blog and other vc blogs. I think that’s a good first step
Sorry for the late contribution, but I hope it is a worthwhile contribution: I’ve had this discussion many times and found that a simple spreadsheet example really helps people understand and test different scenarios. I have a sample early capitalization spreadsheet which I put together mainly to demonstrate that calculating the per share price from a negotiated premoney valuation and postmoney pool percentage is NOT a recursive calculation, which I just posted on Google Docs http://bit.ly/4FVpNc . You should be able to view the formulas there using View>Show formula bar, or select File>Download as>Excel to view and edit offline in Excel.
Thanks for sharing it ginsu. That’s great
Fred:Great post and follow-ups. Very educational.I am co-founder of early stage software company in HongKong and plan to seek VC funding in the New Year so your post very important for us to understand pre/post-money for options pool (we’re thinking 10% pool), both social and economic benefits. When you say “.. enterpreneurs need to find out what the market price for their company …”, how does one “find out the market price” for an early stage company? Isn’t “market price” what is finally negotiated between owners and investors?
get multiple offers
Excellent points by @mrodov. As a corporate attorney for entrepreneurs, I can attest to the fact that the “option shuffle” drives entrepreneurs crazy. Indeed, the methodolgy that VCs impose with respect to the option pool is arbitrary and has no foundation in corporate-finance principles. I spent most of my legal career doing M&A transactions at two major law firms in New York City — and I remember seeing the “option shuffle” for the first time a few years ago when I moved out here to California and started doing VC deals. All I could do was scratch my head; like a lot of the other onerous VC provisions I saw, this one fell in the bucket of “heads I win, tails you lose.”
mdorov makes a really good point. What Fred didn’t make explicit is that the choice isn’t whether to have an option pool, but whether it comes out of the pre-money or the post-money valuation. If it comes out of pre-money, it’s funded entirely by the entrepreneurs and any preceding investors. If it comes out of the post-money, it’s funded by the VC as well. mdorov is right to note that as these options are to be granted to employees hired after the financing, and will produce future value, it would make sense for them to come post-money.But that’s precisely why both Fred and Mark Pincus agree that “it’s a question of valuation.” If options come out of post-money, it’s a discussion between management and investor about how much of their mutual equity they want to give up to future employees. If it comes out of the pre-money, it is a question of valuation.
I don’t want to shuffle anyone thus this post but I do want options in the pre moneysounds like we won’t be doing business together which is okThere are a lot of deals out there
I come at this from a little different perspective in that I run a public company which while very small is further down the road than a typical VC funded deal. This might be the product of a VC funded company after an IPO in which it must drag all the accumulated baggage to the subsequent public marketplace.Options are quite problematic whether from the perspective of having to value their “non cash” GAAP implications or the securities implications. In my view the situation described runs right up to the edge of some of the most dangerous and problematic “dilution” implications of securities law.All option plans have to be (or at least should be) in writing and must at the very least be “approved” by the Board prior to the first option pursuant to the plan being issued. There should therefore be some thought given to this long before the second round of financing is contemplated. Pollyannish thinking, I concede.The approved plan should contemplate the implications of dilution on issued and vested or issued and unvested options. There is a simple equity problem here.The issue of dilution — of existing option holders — is most commonly handled in subsequent balance sheet transactions (raising money whether through VC activity or the issuance of common, preferred or some other more exotic security) by the modification of strike prices and the issuance of additional options to compensate for pure arithmetic dilution. One could argue that the manipulation of strike price provisions alone should adequately compensate option holders but that is often not the case.Public companies have to report earnings on an “as issued” and on a “fully diluted” basis which takes into account, amongst other things, “in the money” but unexercised options as well as other classes of securities which may contribute to “potential” dilution. This calculation is a good discipline for private companies also. It is a kissing cousin of liquidation analysis.I would further suggest that the issue of stock options as part of a balanced compensation plan incorporating salary, benefits, short term incentives, long term incentives, equity incentives and perquisites for CEOs and CFOs and CIOs, etc., should be addressed in their Employment Agreements and should therefore not be drawn materially into valuation discussions. The compensation cost for a CEO should not be materially impacted by who owns the company and how.I suggest that this is an area in which a sharp securities lawyer is of more utility than a VC deal guy.Understanding my thoughts are colored by being a founder/entrepreneur/CEO type, I don’t think one can fashion a good management team without allocating at least 10-15% for management plus whatever the founders own.
It makes perfect sense to me if you are transparent about it which was the purpose of this post. Its just about price
Miles, Miles, Miles, my boy — when swimming in the drink w/ sharks you never ever get what you deserve, you only get what you NEGOTIATE!Trust should be reserved for only those things which nobody could ever have contemplated, the balance should be in writing.
As usual JLM, bang on the money.The Italians have a saying “Clear pacts, long friendships”.Agree with a handshake, then write it down. Always.
Miles works for one of our portfolio companies JLM. He’s in good hands. But your advice is sound and well given
Right. Its just about price. We offer a higher valuation than we would because we want the options in the pre-money valuation
Not true. But I’ll save my thoughts on these points for a future post(s)
Yes. But the times they’ve not been are rare and you can always fix that in those cases
We took this value versus recruitment/rentention into account in both Fred and mdorov’s point of view. We are creating an profits interest system (http://meetkendall.com/2008… our employees.The founder and investors are in traunches, in seniority and then the employee pool will also be a traunche based on the additional value that is created by the company.Each employee will have shares from the traunche once the founding team and investors are paid (for a liquidity event) at a pre-defind level. The remaining traunches will pay determine the level of profits back to the team.Frank – in the VC world, would this be blown-up by a A or B round terms? It acts as the same and I assume we could classify the VC firm’s equity with a super senior position in one the first traunches?
Yup. That’s the whole point of the post