The “Option Pool Shuffle”, the “Promote”, and Other Fundraising/Equity Issues Entrepreneurs Need To Know

I came across a few blog posts recently that I thought were pretty useful pieces of advice for entrepreneurs on the fundraising, VC negotiation, and equity allocation side of things.  Lots has been written on these issues in a variety of places, but these are a few I thought I’d share.  Of course most of these are only relevant if you are going to take outside funding; I’m a big proponent of bootstrapping as long as you can.

As always, the best advice seems to be “do your homework”, and “get a good lawyer”.  I’m an ex-lawyer myself, and am familiar with a lot of deal structures and negotiating issues, but unless you’re a specialist in VC-specific topics or have been exposed to a lot of VC deals, you can get tripped up on stuff like this when negotiating with VCs/investors.

The “Option Pool Shuffle”

This is the phrase Nivi and Naval use in their great post on VentureHacks.  They essentially point out that during a fundraising negotiation (e.g., for a Series A round), VCs will by default count the allocation for option grants to future employees against the founders and not against themselves or pro rata between the founders and VCs.  This reduces the founders’ effective valuation (they work through an example with numbers).

This option pool shuffle also has other inherent benefits for the VC.  For example, the option pool only dilutes common and not preferred (which is what VCs hold), but upon an exit the cancellation of un-issued and un-vested options creates reverse dilution that benefits everyone (common and preferred) even though only the common (i.e. the founders) paid for that dilutive option grant in the first place. Sneaky Sneaky.

As the VentureHacks post points out, the trick is to be aware of this issue going in, ensure as small an option pool as is reasonable, and to keep your eye not just on the pre-money valuation overall but on the founders’ actual effective valuation, aka “the promote”.

The “Promote”

Jeff Bussgang at Flybridge characterized the effective valuation addressed above as “the promote” in this post on his Seeing Both Sides blog.  He provides an example in which he was competing against another VC for a deal.  He offered “6 on 7” ($7MM pre-money valuation with $6MM new money from the VC) with a 20% option pool, and a competitor offered “6 on 9” but inserted a larger 30% option pool. 

The founders accepted the competing offer, focusing on the higher pre-money valuation ($9MM vs. $7MM).  But the founders’ value in dollar terms that they will carry forward after the financing (what he calls the “promote”) was almost identical in both cases.  As he says:

In my example of the “6 on 7” deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation.  In other words, they have a $4.4 million “promote” in exchange for their founding contributions.  Note that in the “6 on 9” deal, the founding team had a nearly identical promote:  30% of a $15 million post-money valuation, or $4.5 million.  In other words, my offer wasn’t different than the competing offer, it just had a smaller pre and a smaller option pool.  

Founders should certainly focus on maximizing their valuation as an important criteria, but if the “promote” is pretty close, then at the margin they should prefer whichever investor is the better fit for their startup (in fact this should almost always be the most important criteria).

Other Issues

Some other interesting posts on fundraising and options issues are shown below:

How to make a cap table:  

http://venturehacks.com/articles/cap-table 

Options info for people considering joining a startup: 

http://infochachkie.com/options (seven questions you should ask before joining a startup)

http://www.quora.com/What-information-about-stock-options-should-I-expect-when-considering-an-offer-from-a-startup

http://www.tonywright.com/2008/a-newbies-guide-to-startup-compensation-or-stock-options-will-make-me-rich/

Founder vesting:

http://cdixon.org/2009/04/21/founder-vesting 

Allocation of equity among founders:

http://answers.onstartups.com/questions/6949/forming-a-new-software-startup-how-do-i-allocate-ownership-fairly/23326#23326