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When a VC invests in a company, it is common to also introduce an Option Pool to incentivise the management team and employees. The Option pool will generally equate to 5%-20% of the company.
As part of the VC investment, a pre-money valuation will be agreed between the Founders and the VC. There are two different ways of calculating the dilution effect of the Option Pool on the Pre-Money Valuation:
- VC friendly approach: If the pre-money valuation includes the dilution effect of the new option pool, then that is worse for the Founder and better for the Investors. As the Investors won't be diluted by the new Option Pool. Investors often argue that they want the pre-money valuation to be Fully Diluted, as the reason for including the dilution in the pre-money valuation
- Founder friendly approach: If the pre-money valuation excludes the dilution effect of the new option pool, then it is better for the Founder and worse for the Investors. As both the Investors and the Founders will be diluted by the new Option Pool. Founders should argue that the positive impact from the new Option Pool will benefit the new investors, and so they should also be diluted by the new Option Pool
Both approaches are common, and moving the order of the Option Pool dilution, is known as the "Option Pool Shuffle"
Say A company has 90,000 shares, and wants to (i) allocate 18,000 shares to a VC and (ii) create an Employee Share Option Pool (ESOP) of 10%.
The VC Friendly Approach:
- The ESOP is created first - allocating 10% of the Company. So the ESOP gets 10,000 shares (10,000 / 100,000)
- The VC is allocated its shares - 18,000 shares. The VC ends up with 15.25% of the company (18,000 / 118,000)
- The ESOP ends up with 8.47% of the company (10,000/118,000)
The Founder Friendly Approach:
- The VC is allocated its shares - 18,000 shares
- The ESOP is created. There are now 108,000 shares outstanding, so the ESOP gets 12,000 shares, and has 10% of the company (12,000 / 120,000)
- The VC ends up with 15% of the company. 0.25% less than the VC Friendly Approach
- Ironically, the Founders (existing shareholders) will end up with a smaller shareholding under the Founder Friendly Approach than the VC Friendly Approach, as more new shares will have been issued. But, they are often the recipients of the some of the Option pool, so this may be easily remedied. And more importantly, there are enough shares to allocate to new joiners and rising stars amongst the team
It's easy to model the share option pool using Reportally's cap table builder:
- Add a new equity round for your VC: e.g. Series A
- Add a new share option round
- Better for founder: set the date of the option round after the date of the VC round
- Worse for founder: set the date of the option round before the date of the VC round