Sizing Option Pools In Connection With Financings
We've talked about this issue before here at AVC. Investors like to require that an unissued option pool is in the pre-money valuation calculation when they put money into early stage companies. If you don't entirely understand what I am talking about here, go click on that link at the start of the post. Hopefully it will explain the issue.
This post is about how to size the option pool. Many investors just want the number to be as big as possible. They'll put 15% into the term sheet and then let the entrepreneur negotiate them down from there and maybe if you are lucky you'll get them to 10%. But there is no logic in that kind of negotiation. It is just a price negotiation disguised as something else. It is bullshit. And I see investors engage in that kind of practice all the time. It annoys me.
What I like to do, as I mentioned in the post I linked to, is agree with the entrepreneur that the option pool will have enough unissued options to fund all the hiring and retention grants that need to happen between the current financing and the next one. Then we'll do the same thing at the time of the next financing. That makes sense to me. And it is pretty easy to do.
Let's say you are raising $1mm at $4mm pre-money. And the investors want the option pool to be in the pre-money valuation. Let's say the $1mm will last you 18 months. Then you determine how many people you are going to hire in the next 18 months. If the financing is $1mm, it's not going to be that many. You probably have three to five employees already. Without revenue coming in, five employees will suck up half of that money over 12 to 18 months. So at most you are going to hire another 5 employees.
Here's a formula I like to use. Take the cumulative salaries of all the hires you need to make betwen the current financing and the next one. Let's say it is five employees at an average of $75,000. Then that number is $375,000. Then divide that number by the post-money valuation, in this case $5mm. That gives you 7.5%. That's the size of the option pool you'll need. And it is conservative because I don't recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range. But early on in a company, you will need to and want to be more generous.
This approach assumes you have already granted employye equity to the existing team. Ideally they will have founders stock or restricted stock. But whatever they have, they should be holding sufficient equity to keep them happy and excited to be working in your startup. If that isn't true, you will need to add some additional equity to the pool to take care of them.
The bottom line is that sizing up option pools should not be like horse trading. It should be a science. It should be based on an option grant methodology that is driven off annual salary, and an option budget based on headcount and hiring plans. And if you do it that way, you will end up with a lot less dilution. Which is what you should always be trying to achieve.
Great informative post. Option pool analysis and determination is a tough subject to fully comprehend at times, even for folks that spend loads of time in finance-type positions if they do not do this regularly. Regarding the following part of your post:”But whatever they have, they should be holding sufficient equity to keep them happy and excited to be working in your startup. If that isn’t true, you will need to add some additional equity to the pool to take care of them.”The implicit impact being this additional equity, if needed, is coming from the Founders’ share.
Yes. Its all coming out of the founder’s ownership in the seed round. That’swhy getting this right is so important
Aye; the comment was an implicit understanding of that fact but I thought an explicit comment might be better for you readers.
Totally. Thanks for doing that
“Many investors just want the number to be as big as possible”Are you seeing this behavior by angel investors, or are you referring to VC funds, primarily?
Everyone. Some investors are enlightened. Most aren’t
Great lesson, thanks. FYI, should you tag this post MBA Monday? It really should be part of that tome.
i will do that
Great post.Not because I need that info today or I learned something (which I did) but the transparency of the information is empowering.Few entrepreneurs know this. It’s important and so much easier to address with clarity rather than some gut driven gotta-have process where you are never clear nor satisfied.Fred…you are a rarity and do a world of good by shining light on these dark corners.
dark corners are shady corners arnold.
Impressively cryptic Mark.
“It is just a price negotiation disguised as something else. It is bullshit. And I see investors engage in that kind of practice all the time. It annoys me.””sizing up option pools should not be like horse trading. It should be a science. It should be based on an option grant methodology that is driven off annual salary, and an option budget based on headcount and hiring plans. And if you do it that way, you will end up with a lot less dilution. Which is what you should always be trying to achieve.”Mr.Wilson makes these statements based on his principles, values and his moral compass. My dad always said “there are no great deals in life at the most you can hope for a fair deal.”Mr.Wilson in this post is hoping that other VC’s would share similar values and not just be money lenders in suits.
yes, that is my goal
One of the main pitfalls is that the option pool can be such an “after-thought” that the deal (on both sides) gets so much intentionality and effort put into the structure of the allocation, valuation, etc. but tends to fade off as the deal gets past the raise and into (or just past) closing. There is a lot of money left on the table and the flip side a lot of money given away for cheap because of the lack of intensity and intentionality in this area.Great post!
One thing you can do is create a sufficiently large option pool (e.g. 20% or 25%) right at the start when you found the company and issue the founders options over the unallocated options that remain in the option pool at the time of the exit of the company. These additional options can be part of the standard option contract.In that way, you can claw back all options that remain unallocated and that you don’t need. Argument goes: “The team was obviously strong enough, so we didn’t need to give these shares to somebody else”.When you do this, the entire discussion becomes rather irrelevant.
only if you can convince investors not to use the entire pool in the calculation of valuation
Great post and love the logic. It is transparent. Investors I’ve seen use this approach build huge credibility with the management team, where those who just have round %’s in mind with no logic often cause lasting damage.Fred, what is your approach for dealing with some of the potential “big” hires that can consume a good chunk of the pool or where you have a significant difference in expenctations of level ? The traditional example was a CFO who the investors will be needed prior to the next round and who will get a big chunky grant if hired, founders may not believe is needed or who may believe should be a Director/VP of Finance. I’ve seen less big CFO hires lately but similar examples in how much your head of Sales will get once you need one.
big hires are something you need to sit down and discuss with your investors. they do require big grants and you need to carefully consider when the right time is to bring them on
Science, not horse trading. I like that.
Fred, I hope your readers appreciate the intimate insight your informative post provides. You have snatched even the Emperor’s invisible garments off and he is naked before all. Hung like a sparrow to boot.Of course, there is also a decent likelihood that someone is letting a contract on you right now in SV.Get a concealed handgun permit ASAP.If you keep providing these kinds of insights, you will need it, my friend.In life, we don’t get what we deserve, we get what we negotiate.This post will allow one and all to negotiate a better deal in the future. Bravo!
JLM…I couldn’t agree more with you.My line earlier this morning was–“Fred…you are a rarity and do a world of good by shining light on these dark corners”
i hope that this post does what you predict JLMi was inspired to write it because i saw this happening to an entrepreneur the other day and it pissed me off
Very informative post.It is key to have the founders, employees and investors aligned as @ccrystle:disqus mentioned. I would add the need to enforce with good faith the respect for the early investor who’s main concern is their assuming greater risk while the taggers come in later getting as good… or sweeter deals.
Love reading the rules of Fred’s thumb another highly effective one that I am surprised has absorb more criticism from your peers. Any thoughts on Phantom Stock Options? I have only seen them a couple of times. I know they seemed to make a private acquisition to go more smoothly, but at the same time it created a lot of skepticism among the senior staff.
i don’t really have any experience with phantom stock. i suspect it won’t be quite as valued by employees as real stock
Interesting. I have seen a lot of comp analysis for option grants, but I haven’t seen it pegged to salary. That’s another great reasonableness check. Kudos for encouraging one and only one price negotiation. Everything else should follow from what is best for the success of the business, not what is some kind of economic shell game.
Talk about coincidence: I just sent today to our lawyer a blueprint regarding our option pool (we have raised angel money 2 months ago)! Very useful, thanks.
Have you ever seen a situation where scaling had to happen faster than was previously thought? How do you handle the options pool then?
you run out and issue more and everyone shares in the dilution equallymost of the time scaling happening faster is good news
Fred, your formula is easy to understand and seems fair to all parties (investors, founder(s), and option recipients). Would you say this methodology is pretty standard?
not yet 🙂
Impeccable time Fred, thank you.
What do you mean by the “dollarvalue” of the options? Is it the strike price times the number of shares, or the present value based on Black Scholes?
neither. it is the number of optioned shares times the last round price that an investor paid
big like – go tell you colleagues in your industry.
that’s why i wrote it mark
This is gold. Thanks for sharing
in your formula you “take the cumulative salaries of all the hires you need to make between the current financing and the next one.” if the assumption is 18 months to the next financing, why wouldn’t we use $562,500 as the cumulative salary amount (1.5 yrs) rather than the $375K? Maybe I missed something… thanks!
just because i like to size option grants as a function of annual salary
What next, have the VCs pay for their own legal fees?
or don’t use lawyers and use standard forms. the past three deals I have led, we’ve done that way. no lawyers, no fees
Sounds great. Is this only for seed, or also A rounds? What forms did you use?
we used gunderson’s series seed and series a docs without any negotiation
really? impressive. are the frameworks available?
Perfect material for MBA Mondays, but also perfect material for a rainy Wednesday.Thanks Fred, I think there are a number of VCs out there putting up a picture of you on the wall with a hand drawn bullseye and a bucket of darts.Love the way you frame the level of options, enough to survive until another round of financing or sufficient revenue is rolling in.You have the practicality of an engineer in an investor’s suit.
i’m an engineer at heart
Your engineering mindset is likely why a passing read turned into a daily habit for me. You must have an abnormally large heart since it also has room for Teacher and Zen Hippy Capitalist. Financial engineers have just picked up one more amazing fellow. My former coworker Paul Thomas moved on to quant school and recently graduated (Carnegie Melon’s Quant program). He landed an internship for a bank/hedge fund in Manhattan. I have hedged my bets with a contingency plan of offering to be his limo driver in a few years if my other plans don’t pan out :). Every rich guy needs a limo driver they can trust.
“zen hippy capitalist” – that’s quite a compliment mark. thanks
I appreciated your point on how to size option grants. I’d love to see a little more detail on that in a future MBA Mondays post.I’m guessing it’s something like this, but it’s nothing but a guess…C-level 1xVP 0.75xDirector 0.5xRank and File 0.25xAdmin 0.1x
exactly right on the multipliersi think i did a post on this in the pasti will look for it
Would these salaries be market-rate? Should the option pool be larger if the team is taking below market salaries?
the salaries you use should be market rate. if someone is taking a discountto work at your company, you should compensate them for that a bit more thanthis formula
Bravo, Fred. It’s not so much the information (as great as it is) but the fact that you shared it. You being the type of VC and person who would share this information is a big part of why we have this amazing community. I’m feeling particularly grateful to you at this moment because later today and tomorrow, I will be in your town to explore an opportunity. While you are not directly involved, my openness to this opportunity is influenced to a large extent by the time I’ve spent at AVC.Not only that, while there I am going to connect with a few people that I have met through AVC. People I’ve never met in person, but have come to like and respect a great deal. I would have never met these people if not for you and this community that you’ve established.Pretty cool. Thanks.
wow. welcome to the big apple!!
“…I don’t recommend giving options equal to the dollar value of the annual salary of your hires.”Why is this — or am I missing something that is obvious?
only for c-level execs and superstars would i do that
Doesn’t that sort of depend on the salary, though? What if employee #1 consents to take a 50-60% salary, as I did? I think at that point it would be pretty reasonable to insist on equal+ options to compensate.In my case, I got huge push-back on the request, and then the sub-2% offer that resulted was attached to a guilt-trip that “the investors think we’re crazy to give even this.”
well that is differentthen you need to account for thatyou should get even more equity for doing that
what is the logic of carving out option pool from pre-money vis-a-vis post-money? IMHO, post money seems more fair to me as future employees add incremental value to post money situation. Also, post money conveys that VC and entreprenuer are in it together. I’m sure that there is a reason for carving out option pool from pre-money as Fred seems to be totally for it, can someone explain?
it’s just conventionthis is all about valuation at the end of the dayyou could include the option pool in the post money and simply agree to alower valuationit’s like showing prices before or after taxit’s just how it is done
fantastic post! thanks
hey, Fred I just read your post ,it’s cool and also did a translation on it for more people to read, but this is the part i don’t quite figure out : And it is conservative because I don’t recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range.
Hi Fred,Quick question – i plan to base my options pool allocation based on a multiple of salary like you suggest here and in an earlier post. However with this approach – isnt there something inherently unfair in that early employees get paid less than market rates (because they get options!) but are effectively penalized for doing so because their options are tied to a multiple of that lower salary?Be great to get your thoughts!ThanksPaul
you need to use market rates for salary
very insightful and a great way to size the options based on salaries. Keep up the great work
very insightful. Keep up the great work
I’m so glad you posted about this. I’m not pursuing funding yet, but when I do, I really can imagine this is a huge snag for entrepreneurs. I went to an panel a few weeks ago with some angel investors, and having never been exposed to cap tables and term sheets before, it certainly is confusing for your first time out. Thank god there are blogs and resources a’plenty to get a handle on all this! Although, I just read some of RobGo’s blog over at his site, and that’s still a bit over my head, haha
@charlie, that is an interesting thought/comment “both should absorb the cost of the options.” I did not deal with this type of stuff much at all back in the day, so probably why I never thought much about that type of theoretical position.
art and science
I remember the posts – it doesn’t really deal with how to deal with the squeeze when those options aren’t there because you have to emergency scale