Understanding the details of option pools, their effect on valuations and who will benefit from their structure is key. This post will go through a few calculations that can be adapted to your particular use case.
We will go through some scenarios and actionable formulas, and by the end of this post you will have the framework to model option pools in your favor.
Sheryl and Elon are two good friends who decided to co-found a company called SpaceBook (the social network for aspiring communities on Mars). Their initial cap table looks as below, with the total number of shares being 1 million:
Now, they want to raise a seed round. They manage to get a deal with an investor, Peter:
This means that Peter will receive 9.09% of the company. How do we know that?
Now that Sheryl, Elon, and Peter have agreed on the basic deal, they start talking about reserving shares for employees, i.e. creating a stock option pool.
You have two possibilities: a pre-money (aka investor friendly) or a post-money (aka founder friendly) option pool. The naming is a little confusing since different people use the naming pre or post for different purposes, so make sure you know if you are talking about an investor or founder friendly pool. We will explain in more details what each of them means below — for now, read on.
Let’s say we want to create an option pool of 10% (in the fully diluted cap table after the capital increase), i.e. the have to be equal to 10% of the total number of shares after the investment. In this case, the following equation is true:
Simply reshuffling and isolating the terms, we have:
Think thoroughly about this, and once you understand it, you will notice the one important thing we’ll need later on: The depend on the number of Peter’s shares.
Very easy to calculate and understand. The round is done as explained above. Then an option pool of 10% is created, which dilutes everyone. In this case, Peter will end up with less than the planned 9.09%, after the pool is created.
This is tricky to calculate because it involves equations that have to be solved numerically. And it’s founders-unfriendly because only the founders (Sheryl and Elon) get diluted.
In which case would Sheryl and Elon go for a pre-money pool? In the event that Peter, for instance, says “A deal is a deal. With or without the option pool, I want to have my 9.09% for my $500,000 investment as agreed before this whole pool business!”
This means, the shares created for the pool have to be created, so to say, before Peter invests in the company so that he does not get diluted. In other words, the price per share that Peter will pay will diminish:
This again means, that if Peter gets a cheaper price per share, then he will get more shares for his $500,000 investment. An important detail to be noticed here: The number of Peter’s shares depends on the number of shares in the option pool!
At this point you will see that we have a “problem”: The number of shares in the option pool depends on the number of Peter’s shares because it has to represent exactly 10% of the total shares after the capital increase. On the other hand, the number of Peter’s shares also depends on the number of shares in the option pool because his stake also needs to be exactly 9.09% as agreed during the deal. This is why we need to solve this numerically and this is where Ledgy’s round modeling comes in.
As stated above, the post-money is friendlier for the founders. But if your investors insist on a pre-money pool, you can also, for example, model your funding scenarios with a higher company valuation and negotiate in order to reach a win-win situation.
Please reach out if anything’s unclear.
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