The option pool shuffle

An investor offers $2M at an $8M pre-money valuation. You have 6,000,000 shares, so you think that the price is $8M ÷ 6,000,000 = $1.33 a share. Then the term sheet comes, and the price is $1.00. Nobody changed the valuation. One sentence about the option pool removed 33 cents from each of your shares. In 2007, the blog Venture Hacks called this the “option pool shuffle”.

Predict first

In this deal, the investor gets 20% of the company, and the term sheet adds a new option pool equal to 20% of the post-money. What percentage do the founders own after the round?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

What an option pool is

An option pool is a set of shares that the company keeps for future grants to employees, advisors, and directors. An employee gets a stock option, a right to buy shares at a fixed price. Each grant comes from the pool. The part that the company did not grant yet is the unissued option pool.

The pool counts in the fully diluted shares, before anyone gets a grant. Thus a pool dilutes the holders on the day that the company makes it, not on the day of each grant.

Investors want a pool for a clear reason. The company must hire after the round, and new employees want equity. If the company makes the pool after the round, the pool dilutes the new investors. If the company makes it before the round, it does not. The NVCA model term sheet gives the usual words:

“…a fully-diluted pre-money valuation of $[___] (which pre-money valuation shall include an [unallocated and uncommitted] employee option pool representing []% of the fully-diluted post-money capitalization).”

Read that sentence slowly. The pool is a percentage of the post-money, but it sits inside the pre-money.

Where the pool goes sets who pays

Compare the two places with the Venture Hacks numbers. The pre-money valuation is $8M, the new money is $2M, the founders hold 6,000,000 shares, and the pool is 20% of the post-money.

	Pre-money pool	Post-money pool
Price per share	$1.00	$1.33
Founders	60%	64%
Option pool	20%	20%
New investors	20%	16%

In the pre-money, the pool dilutes only the founders. The investors get exactly $2M ÷ $10M = 20%. In the post-money, the pool dilutes everyone, the investors too. Thus investors usually put the pool in the pre-money. A post-money option pool is rare. Venture Hacks wrote that it tried to get post-money pools for founders, and that the attempts did not succeed.

The math of the shuffle

The fastest method uses dollars, not shares. The pool is a percentage of the post-money, so you can find its value first.

Worked example · step 1 of 6

Find the real price

1
Find the post-money valuation
The post-money valuation is the pre-money valuation plus the new money.
```
Post-money = $8M + $2M = $10M
```

The effective pre-money valuation

The effective pre-money valuation is the pre-money value that the holders before the round actually get:

Effective pre-money
  = Headline pre-money
    − Value of the new pool shares
  = $8M − $2M
  = $6M

With no pool before the round, the value of the new pool is the pool percentage × the post-money. Thus each point of pool costs the holders before the round 1% of the post-money valuation. In this deal, each point is $100,000.

The pool also uses a larger part of the pre-money than its label shows. It is 20% of the post-money, but $2M ÷ $8M = 25% of the pre-money. Venture Hacks gives one more cost. If a buyer purchases the company before the next round, nobody gets the unissued pool shares. Their value goes to all holders, the investors too, but only the holders before the round paid for them.

Move the pool between the pre-money and the post-money, and change its size. The effective pre-money shows in red when the pool removes value from the holders before the round.

Calculator

Size the new option pool, then move it between the pre-money and the post-money. Watch who pays for it.

Where the term sheet puts the new pool

Pool after the round, % of post-money20%

Pre-money valuation$8M

New money

Founders' shares

Unissued pool today (shares)

Price per share: $1.00; Headline: $8M ÷ 6,000,000 = $1.3333
Effective pre-money: $6M; Headline: $8M
Founders own: 60%; 64% with the pool in the post-money

Ownership after the round, pool in the pre-money

Founders
Option pool
New investors

The headline pre-money is $8M, but the new pool takes $2M of it, which is 25%. Thus the shares that exist today get $1.00 each, not $1.3333: an effective pre-money of $6M.

The new investors still get 20%. The founders pay for all the new pool shares and own 60%, 4 points less than with the pool in the post-money.

Work it out

A term sheet offers $4M at a $16M pre-money valuation, with a new pool equal to 10% of the post-money. The company has no pool today. What is the effective pre-money valuation?

When you have a pool today

Most companies have some unissued options before a round. The term sheet target includes those options, so only the increase, the pool top-up, costs the holders before the round. The dollar method of the previous section does not work here, because the old pool shares also change value with the price. Use the share count:

Post-money shares
  = (Shares today − Unissued pool)
    ÷ (Pre ÷ Post − Pool target)
New pool shares
  = Pool target × Post-money shares
    − Unissued pool

Here, Pre ÷ Post is the pre-money valuation ÷ the post-money valuation. The formula comes from two facts. The shares before the new money are pre-money ÷ post-money of all shares after the round. The pool after the round is the pool target × all shares. Subtract the second fact from the first, and only the post-money shares are unknown.

Work it out

Ada and Ben hold 9,000,000 shares, and Northwind has 1,000,000 unissued options. The term sheet gives $2M at an $8M pre-money valuation, with a pool of 20% of the post-money. How many new pool shares does the round add?

The holders before the round are not always only the founders. When SAFEs convert in the same round, the SAFE holders pay for a part of the pool too. The YC post-money SAFE does not include the pool top-up of the round in its share count, so that increase dilutes the SAFE holders. The full Series A example shows this step by step.

Negotiate the pool with a hiring plan

The pool size is a negotiation. Westaway says that seed and Series A term sheets usually set the pool at 10%, 15%, or 20% of the post-money. The hiring plan sets which one. Venture Hacks and Westaway give the same advice: calculate the pool from a hiring plan.

To size the pool from a hiring plan, do these steps:

List each hire that you plan before the next round.
Give each hire a grant, as a percentage of the fully diluted shares after the round.
Add the grants.
Propose the total as the pool target. The unissued options that you have today count toward it, so the round adds only the difference.
Show the plan to the lead investor as the reason for that size.

Here is Northwind’s plan. The grant sizes in it are examples, not market data. The lesson on sizing grants gives market data, and the option pool planner adds up a plan for you.

Hire	Grant
First engineer	2.0%
Second engineer	1.5%
Head of sales	1.5%
Designer	1.0%
Two more engineers	1.0% each
Total	8.0%

The plan uses 8%, and the term sheet said 20%. Northwind proposes 8%, and the two sides agree on 10%. Put a 10% pool into the Venture Hacks deal: the price is $1.17 and the effective pre-money is $7M. That is 17% more for each share than with the 20% pool.

Make the plan go only to the next round. In each new priced round, the new investors set a pool target again, and the plan for that round starts then.

Questions about the pool

Before you sign, find the answer to each of these questions in the term sheet:

Is the new pool in the pre-money or in the post-money?
Is the target a percentage of the post-money fully diluted shares?
Does the target count the unissued options that you have today?
Do options that you promised to new hires, but did not grant yet, count against the pool? These are promised options.
Which hires does the pool pay for, and until which round?

Question 4 is important for SAFEs too. The YC post-money SAFE counts promised options in its share count. The pool top-up of the round stays out of that count, but only while the promised options are not more than the old pool. When you know the answers, put the numbers into the calculator in this lesson and find your real price.

Quiz · question 1 of 5

Test what you learned

A term sheet gives $2M at an $8M pre-money valuation. The company has 6,000,000 shares and no pool. It must add a pool of 20% of the post-money in the pre-money. What is the effective pre-money valuation?