Every time a company raises additional money or increases the number of authorized shares, the existing stockholders experience dilution. Although founders often anticipate some dilution when raising a round of funding, if you’re not accounting for the option pool you may experience more dilution than you’re expecting.
The option pool is the shares of common stock that a company sets aside for its employees, advisors, and consultants. Typically, the company will grant options out of the option pool, which gives optionees the right to purchase shares of common stock at some point in the future (i.e., after their vesting period). Founders and early employees are often granted restricted stock, which does not come out of the option pool. Over time, as the company grows and hires more employees, the option pool will increase. Commonly, this is done in connection with a financing round, but the company can authorize adding additional shares to the option pool at any time.
If the option pool is increased in connection with a financing round, the new investors will almost always insist that the option pool increase be carved out of the pre-money valuation, effectively lowering your valuation. This is to ensure that the option pool growth only dilutes the existing investors and employees rather than the new investors.
Assume a startup raises $10M with a post-money valuation of $50M for their Series Seed round. The investors also request an option pool equal to 10% of the post-money valuation.
Without taking into account the option pool, one would assume the pre-money valuation is $40M (i.e., $50M post-money valuation - $10M investment). However, when you account for the option pool, the effective valuation is less than $40M. Let’s look at how this would work.
A 10% option pool based on the post-money valuation of $50M would be an option pool worth $5M (i.e., 10% of $50M post-money valuation). Because the option pool is accounted for in the pre-money valuation that means that the effective valuation of the startup is $35M. The math is as follows:
- $35M effective valuation (70%) +
- $5M option pool (10%) +
- $10M Series Seed investment (20%) =
- $50M post-money valuation (100%)
Assuming this is the first round of funding with no prior option pool, the founders have been diluted to 70% while the new investors hold a 20% equity stake.
The practical implication of including the option pool in the pre-money is that the investors pay a lower price per share. Let’s assume the company has 10M shares outstanding. Without taking into account the option pool, the investors would pay $4.00 per share ($40M pre-money valuation / 10M shares outstanding). With the option pool included, the investors now pay $3.50 per share ($35M effective valuation / 10M shares outstanding).
Including the option pool increase in the pre-money valuation is investor friendly and is the most common formulation as the new investors don’t want to take on the dilution that comes with the option pool increase. When investors negotiate a term sheet that says “$10M investment on a $40M pre-money valuation” they are expecting an equity stake of 20% (i.e., $10M investment / $50M post-money valuation). If the option pool is included in the post-money, they are diluted by the option pool and do not get their full 20% as shown below:
- Founders hold 72%. As (i.e., 80 * 90% = 72%).
- Investors hold 18% (i.e., 20 * 90% = 18%)
- Option pool is still 10%.
While you often can’t negotiate whether the option pool is carved out of the pre-money or post-money valuation, you can (and should) negotiate the size of the option pool.
Best practice is to create a hiring plan and only increase the option pool only by the amount you want to hire in the next 12-16 months. There are sites such as Recruiting Plan that can help you plan for your hiring needs. Properly allocating your option pool ensures that you do not take on more dilution than necessary as a result of the option pool increase. If the option pool increase is too large and is carried over into the next round, the investors will not be diluted as much as the founders because they did not have to account for the option pool in their initial equity stake. Additionally, if the company is acquired or there is a liquidity event before the next financing, then the option pool is canceled to the benefit of all investors, a concept known as “reverse dilution”.
Next time you’re negotiating a term sheet or calculating your dilution, make sure you take into account the option pool so it doesn’t become a silent killer of your equity stake.