The Option Pool – Part II

Why designing your option pool is important to your capital raising exercise

When cash is dear at a startup and the key employees are looking for compensation benefits that are attractive enough to want to continue to stay – this is when, you, the founder of the company thinks of the option pool. (An option pool is a share of stock reserved for employees of a private company). As a startup the only thing that differentiates you from others in the space is the people you are able to attract and retain. No wonder then that founders spend an inordinate amount of time figuring out how to design the option pool. The designing element is central in the scheme of things, especially when it comes to valuations at the time of raising capital.

Size does matter
First things first, do not let the investor tell you how big your option pool should be, irrespective of what your company size is. Instead, you must present to the investor a hiring plan, for say, the next 12 months and pre-empt discussions on the size of the option pool. Hiring plans tend to be imaginative at the early stage, but let that not deter you. A simple mental allocation for say direct reportees to the chief-executive and chief-financial officer and so on can be set out and a pool size, determined. Chances are, the resultant number will be smaller than what the investor had in mind and you have now efficiently stymied any reactions on why the option pool size needs to be bigger. Small option pool at a high price is the ideal way to go.

The investor would pitch for a larger pool since the company ought to have a fully equipped team in order to be worthy of investment. If you do not have this already in place, it is the founders’ lapse. In such a case, the investor will insist that the option pool gets culled out of the founders’ stock (pre money). Also consider this logic; if the investor invests in your company and buys stock why would he immediately post such investment agree to a dilution of his capital by contributing to the option pool? These are the two primary reasons why the investors will always argue for the option pool to be cropped out of the founders’ stock.

From a founders’ perspective, you will have to reason that the investor is a partner in the company and should invest in top quality human resources and not just the founders. This is a good reason, but it does not usually win you the arguments regarding the option pool.

Round after round
In each subsequent round of funding this will continue to be reasoned and debated. To assume the first percentages set aside for the pool, will last the lifetime of the company is farfetched, the series B and C funding rounds will require you to hit refresh on the option pool percentages. The series B investors will want the fresh option pool to come out of the stock held by founders and series A investors, series A investors will want it to come out of the series B holders post money stock, so everyone participates in the dilution and the founders at this point are largely unconcerned as long as they have a pool to keep their key resources in place and run the business.

However, it is important to note that the option pool lowers your valuation, here’s how.

Investment amount: US $3 million;
pre money valuation:  US $ 8 million (8M);
Share price: 8M/5M – 1.60 per share

However, the investor tells you that the share is worth 1.30 per share. After a meditative silence you will realise that this is so because the 8M pre-money valuation includes an option pool equal to say 20 per cent of the post money fully diluted capital. This means in the pre money valuation a bunch of stock was allocated towards the pool. What this also means is that the effective valuation of the company is lower than 8M say 5M and the 3M difference is the price for the unallotted option pool. So, pre money valuation 8M ÷ (5M existing shares + let us say 2 M new options) = 1.14 per share.

The case for not putting the option pool in the pre money valuation is well made. The founders now have been diluted, have lost on price per share valuations and if series B occurs before the option pool stock vests then the series B investor term sheet will speak as to all unissued options also being cancelled.

The lone ray of light at the end of a long tunnel is this – listen to the investors concern, design the hiring plan well ahead, create the option pool (No, the investor will not let you put it into post money valuation numbers, no matter what), reiterate why your company is truly different (it works sometimes, go ahead try your luck) and be tuned into the fact that this is but one part of the leverage game with respect to the term sheet.

Note: In India, the Securities and Exchange Board of India has made certain amendments recently to the SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999. This revision is applicable to public limited companies only.

This article first appeared in Smart CEO and was authored by Aarthi Sivanandh.

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