This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998. Many thanks, Scott
My co-founder and I have been talking to some VC firms on Sand Hill Road, and I think we’re pretty close to getting at least one term sheet. I read your post a few weeks ago about how one of the common mistakes startups make dealing with VC’s is focusing too much on valuation. You also mentioned that there are other important terms that affect the economics of a financing, including the size of the option pool. Can you please explain that. Our company never issued any options, and my co-founder and I each own 50% of the shares. Will the VC firms require an option pool and, if so, how will that affect us? Thanks!
As I discuss in my post “Issuing stock options? Here’s what you need to know,” the issuance of stock options by startups is quite common because options give key employees an opportunity to benefit directly from any increase in the company’s value (creating substantial upside potential), without requiring any cash outlays by the company. Options are thus an important tool to attract talented employees.
Accordingly, the VC firms will require your company to establish a large pool of unallocated options for future employees. In fact, you will probably see language in the term sheet similar to this (with the blanks filled-in): “The price per share is based upon a fully-diluted pre-money valuation of $_________ and a fully-diluted post-money valuation of $________ (including an employee pool representing __% of the fully-diluted post-money capitalization).”
As I discussed in my post “How Do I Value My Startup?”, the pre-money valuation (or “pre”) is the value of the company prior to the VC investment, and the post-money valuation is equal to the pre plus the amount of the investment.
For example, if you and the VC negotiate a pre of $6 million, and the VC has agreed to invest $2 million, then the post-money valuation would be $8 million. Accordingly, absent an employee option pool, the VC would own 25% of your company post-money ($2 million divided by $8 million), and you and your co-founder would own 75%.
Now let’s turn our attention to the parenthetical language: “including an employee pool representing __% of the fully-diluted post-money capitalization.” This is the language that most entrepreneurs do not understand and which has the effect of substantially diluting you and your co-founder, but not the VC. (Note that it’s a little confusing in the term sheet because the dilution results from the way the price per share of the company is calculated.)
Indeed, venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation. Here’s how it works: the post-money valuation of the company is divided by the “fully diluted” number of shares outstanding (which means the total number of shares, options and warrants that have been issued by the company), plus all of the shares or options that will be issued in the future as part of the employee pool.
Using our example above, if the employee pool were 20% of the fully-diluted post-money capitalization (which is fairly typical, though sometimes higher), you and your co-founder would only own 55% of the company post-money (75% minus 20%); the VC would still own 25%; and 20% would allocated to the employee pool. All of the dilution is thus borne by the founders
Moreover, as a result of the employee pool, the founders’ ownership went from 75% to 55% – which is a 26.7% decrease. How did that happen? Because of the language “post-money capitalization.” In other words, the 20% employee pool is calculated as if the VC’s shares of preferred stock have already been issued to the VC.
It actually gets worse because if your company were sold prior to a Series B financing, all of the unissued and unvested options would be cancelled, and the VC would thus share the additional sale proceeds proportionally with you and your co-founder (even though those options came out of your pocket).
Here are a couple of steps to mitigate this issue: You will never be able to negotiate the option pool out of the deal; nor will you be able to require the VC’s to dilute equally with the founders. What you can do, however, is negotiate a higher pre-money valuation to account for the option pool dilution. Indeed, Jeffrey Bussgang, a VC at Flybridge Capital Partners, notes in his book “Mastering the VC Game,” that he has come-up with a new term called the “promote” to address the option pool issue and explains (on pps. 131-132) that:
This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.
At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic. That’s why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”. The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation. It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.
Moreover, as the guys at VentureHacks advise in their solid post “The Option Pool Shuffle,” you should present a hiring plan to the VC that sizes the pool as small as possible. For example, “[i]f your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.”
The foregoing is obviously frustrating to entrepreneurs – but is merely more evidence of the “golden rule”: He who has the gold makes the rules. The bottom line is that entrepreneurs must fully understand the economics of a VC financing, which include liquidation preferences and the option pool, prior to negotiating a term sheet. Experienced legal counsel can certainly add value in this regard.