https://venturehacks.com/option-pool-shuffle
“Follow the money card!”
– The Inside Man, Three-Card Shuffle
Summary: Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.
If you don’t keep your eyes on the option pool while you’re negotiating valuation, your investors will have you playing (and losing) a game that we like to call:
You have successfully negotiated a $2M investment on a $8M pre-money valuation by pitting the famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has created $8M of value.
Your teammates ask what their shares are worth. You explain that the company currently has 6M shares outstanding so the investors must be valuing the company’s stock at $1.33/share:
$8M pre-money ÷ 6M existing shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00… this must be a mistake! Reading on, the term sheet states, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
You call your lawyer: “What the fuck?!”
As your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?”
If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost you millions of dollars of effective valuation. Don’t lose this game.
Your investors offered you a $8M pre-money valuation. What they really meant was,
“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call their sum your $8M ‘pre-money valuation’.”
For all of you MIT and IIT students out there:
$6M effective valuation + $2M new options + $2M cash = $10M post
or
60% effective valuation + 20% new options + 20% cash = 100% total.
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.33/share to $1.00/share:
$8M pre ÷ (6M existing shares + 2M new options) = $1/share.
Update: Check out our $9 cap table which calculates the effect of the option pool shuffle on your effective valuation.