True Pre-Money

One of the common areas of misunderstanding, and therefore conflict, in financing negotiations has to do with the relationship between the pre-money valuation and the option pool.

Investors want the company to have an adequate option pool for future hiring and it is customary to include the pool in the pre-money valuation. Some entrepreneurs see this as nothing more than a veiled attempt at lowering the value of the company. Well, yes and no. No in that investor aren’t actually lowering the value of the company as the option pool is net new–it comes on top of what they value the company at. Yes in that investors wouldn’t be willing to do a deal at the same pre-money valuation without the option pool. Fred Wilson has a good introductory post on options and valuation, which prompted me to put together this simple valuation calculator.

First, the math, which assumes this is the first round of financing.

Post-Money Valuation = Pre-Money Valuation + Investment Amount
Pre-Money Valuation = Founders' Share + Option Pool

In the example above, the deal is “2 on 3 with 20% pool”, which means that the company is worth $2M (the true pre), investors put in $2M and $1M is reserved for the option pool for a post-money valuation of $5M. Investors and founders both own 40% of the company. If there was no option pool, they’d both own 50% and the post-money valuation would be $4M instead of $5M.

Many investors will be happy to invest the same amount of money on a pre-money valuation equal to just the founders’ share without an option pool. Increasing the option pool will dilute both the investor and the founders at the same rate. If the company is aquired, any unused options are typically canceled and this increases everyone’s share. The effect of a founder leaving and the company repurchasing the founder’s unvested shares is similar. In short, changes in the option pool affect everyone the same way.

There are several reasons why investors insist on a sometimes large pool of unissued options:

  • Deal engineering. It’s true, some investors pad the pre-money with a large option pool and try to sell this to entrepreneurs as their company having a higher value. That’s bull and won’t fly in the end. Even if an entrepreneur doesn’t understand what’s going on, the company’s lawyers will be able to point it out. If they didn’t, fire them.
  • Pushing more capital. Sometimes, a large option pool allows an investor to deploy more capital. This works in the case when the investor wants to (a) invest relatively more money into the company and (b) positions that they absolutely must own at least X% of the company. Say, the investor wants 20%. If the company is valued at $10M then the investor would put in $2.5M for a post money of $12.5M ($2.5M / $12.5M = 20%). However, if a 30% option pool is added then the post money will be $20M (the pool will be $6M) and the investor will put in $4M ($1.5M or 60% more than before!). The pre-money would have jumped to $16M. As an entrepreneur, I’d love this. I get more money ($4M as opposed to $2.5M) and I don’t get diluted any further. Well, technically, the true pre-money valuation is a smaller percentage of the total but as long as I don’t waste the option pool, the unused portion will come back.
  • Convenience. It is easier for investors to start owning X% and, with a well-padded option pool, know that their ownership percentage is more likely to go up on exit, when unissued options are canceled, as opposed to down, as the option pool is increased. Also, from a board perspective, it is simply easier to not have to grow the pool every few months.
  • Board dynamics. Increasing the option pool requires board approval and in some cases, depending on the rights of the preferred investors, various shareholder votes. When there are multiple investors and/or classes of preferred shareholders, it may be difficult to grow the option pool even for very legitimate reasons. Investors who want companies to be able to appropriately reward employees and others through equity may want to ensure that the option pool is sufficiently large at the point when they have maximum leverage–during a financing. I experienced this situation with a European investment I made. The partner representing the largest existing European VC had a rather limited notion of how much equity it took to motivate management and employees. I negotiated hard to get the maximum increase in the option pool possible (on top of a valuation we had already agreed upon) because I doubted the company’s ability to increase its pool post financing.

In all but the first case above, the company and the investor are more likely to be aligned than not in wanting a meaningful option pool.

I would strongly caution entrepreneurs to be wary of term sheets which give them high percentage ownership with a very small option pool. The pool would have to grow and the ownership stake of the founders will go down (unless they get reloaded from the pool, which is not very common for founders). Comparing term sheets is very difficult but this is an easy thing to watch out for.

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