Sjoerd Mol

Rockstart Law School: How to Dance the Option Pool Shuffle

Rockstart Law School is a combination of blog posts by outside contributors and vlog posts by Rockstart’s very own legal counsels Els Metten and Lisette Schuilwerve. They will show the roadmap to the legal side of starting and running a startup company. Rockstart Law School focuses on the Dutch law system and is meant as a resource and gives you lessons learned and suggestions, but is not meant to be used in the place of legal advice. Always consult your lawyer, but we hope these series of posts will give you a greater understanding of the legal needs and points of attention that you may encounter during your startup journey.

An investor that requires a generous option pool may seem not a big deal for a founder. However, if put into the pre-money valuation it substantially lowers the effective valuation of the investor and consequently the stake that the founder holds post-closing. This blog post explains how it works and how misunderstanding is created (and solved).

Creation of an option pool

In most cases an option pool is set up when a venture capital investor participates in a company. It is usually a requirement of the investor based on a strong belief that the company’s employees will work harder and be stronger committed if they share in the profits of a future exit. Most founders feel the exact same. They see the need for offering options to retain and attract skillful people, knowing that they will never be able to match the salaries that big corporates pay.

But whose shareholdings will be diluted as a result of the creation of the option pool: the founders only or that of all shareholders including the investor?

If you would ask a US venture capital investor he will most likely say that the option pool should come from the founders’ stake. If you would ask European continental investors their views will be mixed and more nuanced. If you would ask a founder, don’t matter where, he will most likely be amazed if being told that the option pool will only dilute his equity stake in the company and not that of the investor who insisted on having one.

Effective pre-money valuation

Let’s assume a startup raises €1 million venture capital financing. For the sake of simplicity, we assume that there is one founder who holds all shares. The share capital pre-closing consists of 750,000 shares. The investor and founder sign a term sheet that mentions the investor’s €1 million investment at a pre-money valuation of €3 million on a fully diluted basis (more about this below) and the creation of a 20% option pool.

The founder calculates that the investor should get 25% of the share capital, 1 million investment divided by the post-money valuation of 4 million (post-money valuation = pre-money valuation + investment) and therefore 250,000 shares should be issued to him. The issue price will be €4.00. After that, the 20% option pool would be set up, which will require 250,000 more shares to be reserved for employees. The investor ends up with a stake of 20% of the share capital and the founder holds 60%.

Then there’s the investor. He calculates that to have a 25% post-closing stake, 340,909 shares need to be issued to him and to create a 20% post-closing option pool, 272,727 shares need to be reserved for employees. The issue price will be €2.93 (1,000,000 divided by 340,909). The investor ends up with a stake of 25%, the ESOP 20% and the founder 55%. In numbers it looks like this:

How is it possible that the investor and the founder read the exact same term sheet so differently? In the example given, the investor and founder agreed on a pre-money valuation of €3 million on a fully diluted basis. In fact the misunderstanding comes for a great part from the term on a fully diluted basis. On a fully diluted basis means that the investor’s valuation assumes all options, warrants, convertible debt or other rights to purchase shares in the company, being exercised. There is no discussion between founder and investor on this, since in the example given, no options, warrants, etc. are outstanding.

However, in the investor’s view on a fully diluted basis also includes shares reserved for issuance under employee options that are expected to be granted in the future pursuant to an agreed employee stock option pool. Here the misunderstanding is created. You could say that according to the investor the option pool is included in the pre-money valuation. This comes down to an effective pre-money valuation of €2,200,001 (being 750,000 x 2.93) instead of €3,000,000.

Un-issued and un-vested options

If it is agreed between parties that the option pool is in the pre-money valuation (or in other words: it is agreed that on a fully diluted basis includes the to be agreed upon ESOP), the investor could be incentivized to have a larger than necessary option pool, since it reduces the effective valuation. This is particularly true when taking into account that the full option pool goes into the pre-money valuation, while in the beginning usually only a small percentage of it has been issued and vested. If the company is sold, all un-issued and unvested options will be canceled, which benefits all shareholders proportionally even though the option pool has been paid for by the founders only. Of course, you could work around this and agree that the underlying shares of any un-issued or unvested options will be transferred to the founder, but this could make the founder reluctant with actually issuing the options of the agreed ESOP, which is clearly not what the investor wants.

No right or wrong

In my view there is no right or wrong in the option pool discussion. It will also depend on the case at hand. Could the investor reasonably expect that given the stage the startup is in, there is already an option pool? Has the founder given commitments to team members prior to the investment, that merely need to be executed? Or is the option pool created for future employees? As long as all parties involved are fully transparent about how the option pool works and whether it should be in the pre-money valuation or not, there is a level playing field to dance a nice shuffle and come to a fair deal.

Sjoerd Mol, attorney-at-law at Benvalor (mol@benvalor.nl) and co-author of the book Venture Capital Deal Terms, a guide to negotiating and structuring venture capital transactions.

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