Fundraising Terms: Employee Option Pool

Hi Founders,

A few weeks ago, we dove into the thrilling world of Valuation and Price. This week, hold onto your hats because it's time to explore the Employee Option Pool and its impact on the valuation of your firm, especially in your first-priced round as a company.

What is the Employee Option Pool?

An employee option pool, also known as an equity pool or ESOP (employee stock ownership plan), is a block of company shares that are set aside for employees, advisors, board members, and other service providers. The option pool gives you an advantage as it is a way to attract and retain top talent, and it gives employees the opportunity to share in the company's success.

There are some common ways that this shows up, either in the two mentioned in the previous post on valuation and price (Price & Amount of Financing terms), or in the following separate paragraph in the term sheet:

Employee Pool: Prior to the Closing, the Company will reserve shares of its Common Stock so that ______% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees, and consultants. The term “Employee Pool” shall include both shares reserved for issuance as stated above, as well as current options outstanding, whose aggregate amount is approximately ______% of the Company’s fully diluted capital stock following the issuance of its Series A Preferred.

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As term sheets have continued to evolve, a modern term sheet simply says:

Unissued Employee Pool: ______%

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Both the company and the investor will want to make sure the company has sufficient equity (or stock options) reserved to compensate and motivate its workforce. You might think, “The bigger the pool the better, right?” Not so fast.

The typical early-stage company option pool ends up in a range of 10% to 20%, with later-stage companies having smaller option pools. If the investors believe that the option pool of the company should be increased, they will insist that the increase happens prior to the financing, resulting in the existing shareholders, rather than the incoming investors, being diluted by the new options. It is important to recognize that the VC is talking about unissued options. You may have already granted options to employees. These are not included in the amount VCs are asking for in the pool size, so you should see the pool referred to as the unissued option pool.

What are its implications?

The option pool impacts a number of parameters. Let’s discuss them below:

On the pre-money valuation:

A large option pool will make it easier to give good option packages to new hires, but the size of the pool is taken into account in the valuation of the company. A large employee option pool can lower the actual pre-money valuation and is a common valuation trap.

Let’s look at an example:

At your Series A round, your investors would like to make a $5 million investment at a $40 million pre-money valuation. This will equate to a post-money valuation of $45 million. Assume that you have an existing option pool that has options representing 10% of the outstanding stock reserved and unissued. The VCs suggest that they want to see a fully diluted 20% option pool. In this case, the extra 10% will come out of the pre-money valuation, resulting in an effective pre-money valuation of $35.5 million.

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Maths time! cue confetti

–> Pre-money valuation = $40 million

–> New Investment = $5 million

–> Post-money valuation = Pre-money valuation + New investment = $45 million

–> New unissued fully diluted Employee Option Pool = 10% of Post-money valuation = 10% of $45 million = $4.5 million

–> Effective pre-money valuation = $40 million (pre-money valuation) - $4.5 million (Fully diluted employee option pool) = $35.5 million

On the price per share:

Issuing an employee option pool will lead to an increase in the number of shares available (issued and unissued). This in turn affects the price per share of your company.

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Let’s see an example:

–> Prior to the new investment, total company shares = 100,000

–> At a pre-money valuation of $40 million, the price per share = $40 million/100,000 = $400 / share

–> With a new 10% option pool being created, 10,000 new shares are created in addition to the existing 100,000. The total number of shares = 100,000 + 10,000 = 110,000

–> New price per share = $40 million/110,000 = $363.64 per share‍

This new and lower price per share means two things:

1. The total value of shares owned by all existing shareholders is less than before the new option pool was created.
2. New investors will be able to buy shares at this new price, meaning they can get more with less.
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On existing shareholders’ (founders, existing investors, etc.) dilution:

The larger the pool to be issued in the new round, the higher the dilution you and other existing shareholders will experience.

Let’s show this with some examples:‍

Extra 10% Option Pool @ $40 million pre-money valuation:

Here are the parameters:

• New Investment = $5 million
• Post-money valuation = Pre-money valuation ($40 million) + New Investment ($5 million) = $45 million
• Pre-money valuation = $40 million (this includes the 10% Option pool = $4.5 million)
• Effective Pre-money valuation = $35.5 million (This is what the total shares of all existing shareholders, including founders, is valued as before the new investment)
  

Calculation:

Fully diluted ownership of Founders & Existing Shareholder after new investment = 78.89% ($35.5 million/$45 million)

Fully diluted new Unissued Option pool = 10% ($4.5 million/$45 million)

New investors ownership = 11.11% ($5 million/$45 million)

TOTAL = 78.89%+10%+11.11% = 100%‍

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Extra 5% Option Pool @ $40 million pre-money valuation:
Here are the parameters:

• New Investment = $5 million
• Post-money valuation = $45 million
• 5% Option pool = 5% x $45 million = $2.25 million
• Pre-money valuation = $40 million (this includes the 5% Option pool = $2.25 million)
• Effective Pre-money valuation = $40 million - $2.25 million = $37.75 million

Calculation:

Fully diluted ownership of Founders & Existing Shareholder after new investment = 83.89% ($37.75 million/$45 million)

Fully diluted new Unissued Option pool = 5% ($2.25 million/$45 million)

New investors ownership = 11.11% ($5 million/$45 million)

TOTAL = 83.89%+5%+11.11% = 100%

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What if the investors are asking for a larger pool but a higher valuation, should you be excited?

Let’s see:

20% Option Pool @ $45 million pre-money valuation

Here are the parameters:

• New Investment = $5 million
• Post-money valuation = $45 million + $5 million = $50 million
• 20% Option pool = 20% x $50 million = $10 million
• Pre-money valuation = $45 million (this includes the 20% Option pool = $10 million)
• Effective Pre-money valuation = $35 million (This is what the total shares of all existing shareholders is valued as prior to the new investment)

Let’s calculate

Fully diluted ownership of Founders & Existing Shareholder after new investment = 70% ($35 million/$50 million)

Fully diluted new Unissued Option pool = 20% ($10 million/$50 million)

New investors ownership = 10% ($5 million/$50 million)

TOTAL = 70%+20%+10% = 100%

From the example above, you can see that a larger pool (20%) at a slightly higher pre-money valuation ($45 million) leads to more dilution for all existing shareholders compared to a smaller pool (10%) at a slightly lower valuation ($40 million).

How to negotiate the size of your option pool

1. You can push back the pool size, trying to get the VCs to end up at 15% instead of 20% (p.s: these numbers are just examples)
2. You can accept the 20% pool, but negotiate on the pre-money valuation.
3. You can suggest that the increase in the option pool gets added to the deal post-money, which will result in the same pre-money valuation but a higher post-money valuation. With our example above, your post-money valuation will be $49 million — $40 million (pre-money valuation) + $5 million (new investment) + $4 million (10% option pool).
4. If the VC is pushing for a larger option pool to come out of the pre-money valuation but you feel that there is enough in the pool to meet the company’s needs over the time frame of this financing, you could say something like  “I strongly believe we have enough options to cover our needs. Let’s go with it at my proposed level and if we should need to expand the option pool before the next financing, we will provide full anti-dilution protection for you to cover that.”

Remember, VCs want to minimise future dilution risks, so they might push for a larger option pool upfront depending on what they feel the company requires.  When you have this negotiation, you should come armed with an option budget. List out all of the hires you plan on making between today and your next anticipated financing date and the approximate option grant you think it will take to land each one of them. You should be prepared to have an option pool with more options than your budget calls for, but not necessarily by a huge margin. The option budget will be critical in this conversation with your potential investor.

Finally, It is very important to reiterate that despite the dilution an employee option pool might cause, it is highly beneficial that you have one big enough to motivate your workforce. The key is to calculate and negotiate the right amount when taking in new capital.

Phew! That was a long read! But we hope it was insightful. If it was, share this with other founders in your network.

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References:

• Venture Deals by Brad Feld

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