Option Pool Shuffle for Founders and Investors

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Posted Nov 8, 2024

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An option pool shuffle is a process where a company's founders and investors adjust the allocation of stock options to existing employees, new hires, and themselves. This shuffle can be a crucial step in maintaining a healthy and competitive equity landscape.

The goal of an option pool shuffle is to ensure that the company's equity is distributed fairly and in line with its growth and hiring needs. Typically, a company's option pool is set at 15% to 20% of its outstanding shares.

As a company grows, its option pool may need to be adjusted to accommodate new employees and maintain a competitive compensation package. This is especially true for startups, where talent acquisition is a top priority.

A well-executed option pool shuffle can help a company retain its top performers, attract new talent, and maintain a healthy equity culture.

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What Is the Option Pool Shuffle?

The option pool shuffle is a way to add an option pool to a company's capitalization table after a venture round. This is done by reducing the founder's ownership percentage and increasing the VC's ownership percentage.

Discover more: Buying a Call Option

Credit: youtube.com, Term Sheet Teardown: Option Pools | Venture Capitalist Explains

A hypothetical startup with 10 million shares as a starting point is used to illustrate this process. Each share has a price of $1, which means the startup has a $10 million pre-investment valuation.

The startup adds 5 million shares to its existing 10 million to provide the VC with 33% ownership. This means the founder's ownership percentage is reduced from 100% to 67%.

Here's an example of the capitalization table before and after the VC investment:

The founder's ownership percentage is reduced from 100% to 67% after the VC investment and the addition of an option pool.

Setting Up an Option Pool Plan

Setting up an option pool plan can be a complex process, but it's essential to get it right. To start, you need to allocate shares to the option plan, which is where the option pool shuffle takes place. This is when the company's ownership structure changes, and the founder's stake is diluted.

Credit: youtube.com, Series A funding 101: Sizing your option pool | ESOP basics & stock options for startup founders

The size of the option pool is a crucial decision, and it's not just about setting aside a certain percentage of shares. You need to consider the company's growth plans and hiring needs. For example, if you're planning to hire a new CEO, you may need to allocate more shares to the option pool.

To size the option pool, you can use a hiring plan to determine the number of options needed for new hires. This will help you create the smallest option pool possible, which is essential to minimize dilution. According to the article, a 10% option pool is a reasonable size for a company that's planning to hire new employees in the next 12 months.

Here's a rough guide to option grants for new hires, based on their role and experience:

Keep in mind that these are rough ranges, and option grants can vary depending on the company's needs and the new hire's experience. It's essential to negotiate the size of the option pool and who should pay for it, as these are the two points of negotiation for founders.

VCs and Option Pool

Credit: youtube.com, How the stock option pool at the Series A impacts a Founder’s ownership

VCs often require an option pool as part of the term sheet during a funding round, which is 100% normal. This is because founders will hire new employees, and setting up an option plan ahead of time makes bringing on new employees easier.

The option pool is typically created after the funding round, but VCs often demand that it be created prior to their investment, which can lead to hidden dilution. This disproportionately impacts the founders, to the benefit of the incoming investors.

The founder-friendly approach is to allocate the option pool after the funding round, but this is rarely seen in practice. The VC-friendly approach is to allocate the option pool before the funding round, which can lead to significant dilution of the founder's stake.

Here's a rough guide to option allocations for new hires:

These are rough ranges and not bell curves, and option grants go down as the company gets closer to its Series B.

VCs Want Shares for New Hires

Credit: youtube.com, Series A funding 101: Sizing your option pool | ESOP basics & stock options for startup founders

VCs frequently require an option pool as part of the term sheet during a funding round, which is 100% normal. Founders hire new employees, and setting up an option plan ahead of time makes bringing on new employees easier.

The valuation hit and hidden dilution happen when the VC demands X% set aside for the pool, created prior to their investment. This disproportionately impacts the founders, to the benefit of the incoming investors.

To create an option pool from a hiring plan, you can use the following rough ranges for new hires once a company has raised its Series A. These ranges are not bell curves, but rather rough estimates.

These ranges go down as the company gets closer to its Series B, starts making money, and otherwise reduces risk.

The VC-Friendly Approach

The VC-Friendly Approach is a common tactic used by venture capitalists to increase their ownership stake in a company. They propose allocating the option pool before the funding is received, which can have a significant impact on the founder's ownership.

Credit: youtube.com, Venture Investments and Option Pool Increases

This approach is often used when the VC demands a larger share of the option pool, such as 33% of the final total of shares. As seen in Example 3, this can result in the founder's ownership stake declining from 60% to 57%.

The VC-Friendly Approach can be calculated by dividing the final share total by the founder's final percentage. For example, in Example 3, the founder's final percentage is 57%, so the final share total is 17,543,860. The VC gets 33% of this total, which is 5,789,474 shares, and the ESO plan gets 10% of this total, which is 1,754,386 shares.

Here's a breakdown of the share ownership after the VC-Friendly Approach:

This approach can have a significant impact on the founder's ownership stake, as seen in Example 3. It's essential for founders to be aware of this tactic and negotiate the terms of the option pool carefully to protect their ownership.

Calculating and Managing Option Pool

Credit: youtube.com, Management Rollover vs. Option Pool: LBO Incentive Structures, Formulas, and IRR Impact

Calculating and managing your option pool can be a complex task, but it's essential to get it right. To start, you'll need to know your pre-money valuation, the amount raised, and your existing pool size.

You can use a calculator, like the Option Pool Dilution Calculator, to understand the impact of increasing the size of your option pool during a venture fund raise. This calculator uses the VC friendly approach.

To determine the size of your ESO plan after the round closes, you'll need to consider the new pool size. This will help you allocate options fairly among your employees and investors.

The Option Pool Dilution Calculator requires you to know the amount raised, your existing pool size, and how large of a ESO plan you'll need. This information will help you make an informed decision.

A larger option pool can be beneficial for attracting and retaining top talent, but it can also dilute the ownership of existing shareholders. It's essential to strike a balance between these competing interests.

Negotiating and Funding Option Pool

Credit: youtube.com, Term Sheet Teardown: Option Pools | Venture Capitalist Explains

Negotiating the option pool size is crucial to ensure it meets your startup's needs. The standard option pool sizes are 10%, 15%, or 20%, but these are generic amounts and can be negotiated.

A strong hiring plan can help you negotiate the size of the option pool. You can use online resources to find typical ranges for equity percentages and total them to determine how many options you'll need for new hires. If the total is lower than the proposed option pool, you can likely negotiate it down.

You can use our free Excel model to take your hiring plan and attach the shares you'll need for each new employee. This will help you present a solid case to your venture capitalists (VCs) to reduce the size of the option pool.

A lower valuation can also benefit your startup. If your VCs insist on a pre-investment option pool, you might be able to ask for a higher company valuation. Conversely, you might be able to reduce the size of your valuation and push the option pool to after the investment.

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Pre-Money Returns for Investors

Credit: youtube.com, Understanding the Option Pool in Venture Capital Funding

The option pool shuffle is a clever tactic that benefits investors in three key ways. It only dilutes common stockholders, not preferred shareholders.

A smaller option pool seems less daunting, but it actually eats into the pre-money more than it appears. In our example, the new option pool is 20% of the post-money, but 25% of the pre-money.

If you sell your company before a Series B, all un-issued and un-vested options are cancelled, reversing the initial dilution. This benefits all classes of stock proportionally, even though common stockholders initially paid for the dilution.

You can negotiate with your VC investors by asking for a higher company valuation if they insist on a pre-investment option pool. This can help reduce the impact of the option pool on your company.

Funding Your Startup

You've got a solid hiring plan in place, and you're ready to negotiate the size of your option pool. The first step is to understand that the venture capitalist's default option pool size is usually a generic amount, such as 10%, 15%, or 20%. These numbers are not tailored to your specific startup needs.

Credit: youtube.com, Understanding the Option Pool in Venture Capital Funding

To negotiate a smaller option pool, you need to have excellent financial projections that include a hiring plan. This will help you estimate how many options new hires will need, and you can present that to the VC. You can use online resources to find typical ranges for option grants in Silicon Valley.

A strong hiring plan can help you show the VC how many options you'll actually need, and then negotiate down the pool to that amount. If your hiring plan shows that you'll need fewer options than the default pool size, you can likely negotiate a smaller pool.

Here are some reasonable responses from VCs when asked why they want a certain option pool size:

  • "That should cover us for the next 12-18 months."
  • "That should cover us until the next financing."
  • "It's standard", is not a reasonable answer.

By creating a hiring plan and presenting it to your investors, you can reduce the option pool from 20% to 10%, increasing the company's effective valuation.

Colleen Boyer

Lead Assigning Editor

Colleen Boyer is a seasoned Assigning Editor with a keen eye for compelling storytelling. With a background in journalism and a passion for complex ideas, she has built a reputation for overseeing high-quality content across a range of subjects. Her expertise spans the realm of finance, with a particular focus on Investment Theory.