Option Pools and Dilution

Once you’re granted your stock options, you’re feelin’ good.

You may have a one year cliff with standard four year vesting, but you know you’re going to be there a while.  Plus, you think this startup’s got a real shot at getting acquired by one of the big guys, and you’ll be on your way to a healthy payoff.  Option pool whatever.

Until the company takes any additional outside funding.

What’s an option pool?

An option pool is an amount of the startup’s outstanding common stock that is reserved for future employees and directors, among others.  It’s typically 10-20% of the outstanding stock.  Investors typically require an option pool to exist because it ensures that their shares will not be immediately diluted by the issuance of new stock for employees after their preferred stock has been issued.

However, the pool starts to have consequences when outside funding is taken.  A VC typically wants the option pool to be as a percentage of the (buzz words incoming) fully diluted post money valuation.  This means that the VC wants that percentage of the company to be in an untouched option pool after the financing is done.

For example, if Fundco has a $10,000,000 post money valuation, and VCFirm gives $1,000,000 while requiring a 15% fully diluted post money valuation regarding the option pool, there must be $1,500,000 worth of options in the pool after the financing is done.

What about dilution?

Unfortunately, option pools have the effect of seriously diluting founder/employee stock, as opposed to VCs because of the timing.  As mentioned, VCs will always insist on an option pool being present before the funding event because it protects their shares from being diluted.  Here’s how:

Returning to the previous example, the founders of Fundco do NOT own 90% of the company, as you might assume.  They only own 75% of the company and their shares are only worth $7,500,000, because the VCs would still own 10%, and 15% would go to the option pool.

However, if the option pool was created after the funding round closed, then both the founders’ and the VC’s stock will be diluted as a matter of adding more slices to the pie.

Simple guidelines

(1)   Investors want an option pool before the money.
(2)   You should want the option pool after the money.
(3)   #2 may not be possible
(4)   Find out if your company is planning on seeking funding.


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