The option pool shuffle
Part 2 of why starting (or joining) a start-up will not make you rich: VCs and the option pool shuffle
Previously in “Start-ups will not make you rich” we outlined the economic pitfalls of starting your own start-up, joining a start-up as a founding team member or early employee. If you’re considering starting your own company or joining one as an early employee, it’s imperative that you frame a potential unicorn exit on the probability of it actually occurring plus the opportunity cost of the income associated with your current employer. Below is the article for reference.
As web3 and emerging technology enthusiasts, our belief is the next generation of wealth creation will be at the intersection of finance and technology.
This is why it is so important for founders to understand financing terms proposed by venture capitalists. Investors are not altruistic, kind, generous souls. Investors are free-market capitalists funded by LPs who demand a return commensurate to their risk. As such, VCs structure term sheets with provisions and preferences that are advantageous to them, not to the founder and certainly not to the employees. Today we are going to cover a very common, and very special provision, known in the venture community as the “option pool shuffle”.
Term sheets usually frame the pre-money valuation price per share with language like...
“..the price per share of the seed round is based on a pre-money valuation of $6,000,000, including an available option pool of 10% of the post-money fully diluted capital of the Company.”
The aforementioned sentence means that the investor wants 10% of the company, once the round is closed, to be in an option pool that has not been granted to anyone.
Option pools are incentives for start-ups to recruit exceptional talent, and pay them less than the market rate, with the belief that there will be a massive exit event at some point in the distant future which will create generational wealth. Below is a snippet of the upsell you will hear if you’re interviewing for a start-up as an early employee.
“Please join us. We are revolutionizing the _____ industry! I can’t offer you the same salary as BigTech Co, but join us with 50% pay cut and i’ll reward you with 100,000 options. When we IPO for $100 billion dollars you’ll be rich!” - Start-up founder at Uber for Cats
We now know that this statement is not true. Founding team members and early employees generally lose money. We’ve reviewed it here for those who are interested, but the creation of the option pool also dilutes founders while preserving the equity of the VC. Here is how.
Example - raising $2 million with a pre-money valuation of $6 million
If the founding team has 10 million shares. The founder has 80% and other “founding team members” in the aggregate have 2 million shares or 20%. An investor from BigVCCo offers to invest $2 million with a $6 million pre-money valuation:
The founder gets diluted from 80% to 60%
The founding team gets diluted from $20% to 15%
The VC owns 25%
~3.3 million new shares are created @ $.60/per share
The founder becomes an instant millionaire! Amazing.
The math and cap table are depicted below:
But now the VC says:
“I want 10% of the company, once the round is closed, to be in an option pool that has not been granted to anyone”.
From the perspective of the founder, it sounds like more shares are going to be issued to accommodate the 10% option pool. Although this might not be ideal, at least everyone, including the investors, will get diluted proportionally to the number of shares owned.
Compare to the original cap table outlined in Table 1:
An additional ~1.4 million shares were issued - the 10% allocated to the newly formed option pool
The founder’s % ownership decreased from 60% to 54%
The founding team’s % ownership decreased from 15% to 13.5%
The VC’s % ownership decreased from 25% to 22.5%
The pre-money valuation increased from $6 million to ~$6.8 million
Investors hate this. More specifically: they hate the last 2 bullet points.
The VC who led this round wants to own 25% of the company until the next round of financing and they want it at a $6 million pre-money valuation. So what does an astute venture capitalist do?
The option pool shuffle.
The option pool is “shuffled” such that the pre-money valuation is inclusive of the 10% post-money money option pool. This is what the VC means when they state that: “…the price per share of the seed round is based on a pre-money valuation of $6,000,000, including an available option pool of 10% of the post-money fully diluted capital of the Company.”
Tactically it means the founders get diluted twice, first by the option pool shuffle, and second as a result of the newly issued shares from the actual funding round. Why would the VC do this? To preserve their % ownership, of course.
We can examine the math below:
A 13% pre-money option pool is created
After financing closes the 13% option is diluted to 10%
The founder’s post-money % ownership decreases from 60% (table 1) to 54% (table 2) to 52%
The founding team’s post-money % ownership decreases from 15% (table 1) to 13.5% (table 2) to 12%
The price-per-share decreases from $.60 cents to $.52 cents
…And the altruistic VC from BigVCCo? His % ownership remains unchanged at 25%. Money leaves the founders pocket right into the VC’s Gucci wallet.
This also introduces a secondary point of contention, the VC doesn’t actually think the founder’s company is worth $6 million. What they’re really saying is…
“We think your company is worth ~$5.18 million. But let’s create ~$820,000 worth of new options, add that to the value of your company, and call the sum a $6 million ‘pre-money valuation’”.
Provisions, liquidation preferences, option pools, etc should be analyzed by quantifying the impact of each item at their predicted exit price. This eliminates the raw emotion and qualitative language related to it being a “good” or “bad” offer. Getting a term sheet is a huge milestone that most people will never get to experience, and it should be celebrated. It means someone believes enough in your vision to give you money. We should not take this for granted.
If you’re a founder and you fail to at least understand these special provisions and their downstream implication to future fundraising or liquidation events, it may cost you and your employees millions. So slow down, read the term sheet, ask your network (i’m also happy to review) and remember that VCs always get paid first.
Unless you crush it with a $100 billion AirBnB IPO or $20 billion Adobe acquisition (Figma) these provisions, preferences, and many rounds of dilutions are why starting your own company or working at a start-up will not make you rich.
So please make sure you enjoy whatever it is you’re doing!
October 31st, 2022
San Francisco, CA
Article cover generated by DALL-E - “An oil pastel painting of venture capitalists taking over a company and firing everyone”
Frontrun predicts the future of money and technology.
meme of the week - “that look when you realise it’s time to update your CV”