The Option Pool Shuffle Pt. 2

Today’s post continues our discussion of the “Option Pool Shuffle.” Last time we discussed the two general approaches – VC friendly and founder friendly.

To educate by means of example, consider the following:

Buffy has a lumber company, Stakes’n’Stuff LLC, and she’s managed to negotiate a $2M (2 million dollar) investment on an $8M pre-money valuation by playing Angel Investments and Spike Capital against one another. She returns to Sunnydale excited to tell the rest of the gang that they’ve created a company worth $8M.

Xander, Willow and Rupert want to know what their shares are worth, and Buffy explains that since Stakes’n’Stuff’s outstanding shares are 6M (6 million) – the investors must be valuing the company’s stock at $1.33 a share. She expects the calculation will look something like this:

$8M pre-money ÷ 6M existing shares = $1.33 per share

Unfortunately when they finally get the VC’s term sheet, it lists the share price at $1.00. Willow becomes distraught. The term also includes language to the effect of, “The $8M pre-money valuation includes an option pool equal to twenty percent (20%) of the post-financing, fully diluted capitalization.”

So what happened?

Most VCs will try to control the creation of your option pool in a manner that benefits the VC first. Their pre-money valuation will always include a large, unallocated option pool for new employees. It is essential, as a founder or owner of a company, that you control the option pool and the manner in which it is created.

What Spike actually offered Buffy was not tantamount to an $8M valuation. What the term sheet actually revealed was that Spike Capital really thought the company was worth $6M, but they wanted to add $2M in new options, add that to the “value” and call the total $8M the “pre-money valuation”. Rupert explains that what the calculation actually looks like is:

$6M effective valuation + $2M new options + $2M cash = a $10M post-money valuation; or,

         60% effective valuation + 20% new options + 20% cash = 100% total.

Sneaking the option pool in the pre-money lowers the founders/owners effective valuation to $6M. The actual value of the company Buffy built is $6M, not the $8M the Spike keeps talking about – and the new options lower Stakes’n’Stuff’s share price from $1.33 to $1.00.

VCs benefit from the pre-money option pool in many ways.

First, the VC will make sure the option pool only dilutes common shareholders. If it came out post-money, the option pool would dilute both the common and preferred shareholders proportionally.

Second, the VC-created option pool eats into the pre-money more than you’d think. To the uninitiated, it seems smaller because it is presented to founders/owners as a percentage of the post-money even though it is allocated from the pre-money. Using the example we used above, the new option pool is 20% of the post-money, but is actually 25% of the pre-money!

Third, if Buffy sold Stakes’n’Stuff before a further round of investment, all un-issued and un-vested options would be cancelled. This “reverse dilution” would benefit both preferred and common stock proportionally – even though the common stock holders paid for all of the initial dilution in the first place – and would effectively, upon exit, put more money back in the investor’s pockets!

Moreover, if Buffy had to do a B or C round of investment, the A and B (and potentially C) VCs will all try to play the option pool shuffle against one another. Unfortunately, all the unused options that you “paid” your VC for in the A round will go into the B option – and so on and so one. The shuffle allows your existing investors to avoid playing the shuffle and, over and over again, avoid dilution at the company’s expense.

Welcome to the wonderful world of venture capital funding!