Employee Share Option Plans are often used to motivate staff of tech companies. When capital raises occur, who gets diluted? Investors or Optionholders? – we work through the instance of the option shuffle below.
What exactly is an Option Pool?
An option pool is a ‘pool’ of stock that a business sets aside to offer to new recruits under an ESOP or ESS as a way to incentivize new hires. They reflect a ‘pool’ of shares that have not been issued yet but will be issued in the future as fresh employees are made. It is expressed as a percentage of the company’s total issued share capital.
Even if the ‘pool’ has not been issued, investors treat it as if it has been issued in its entirety for calculating the company’s pre-money valuation. This is referred to as the company’s ‘completely diluted’ capital. In other words, when all options (and other convertible instruments, for example, convertible notes) are exercised.
During an investment round, the topic of who should bear the cost of the option pool emerges.
Who is Covering the Cost of the Shuffle?
The term ‘option pool shuffle’ refers to a situation in which one investor wishes for the firm to raise the size of the option pool but wishes for existing shareholders to pay for the increase by ensuring that the company’s pre-money valuation reflects the increase.
The investor wishes to ‘shuffle’ who pays for the option pool, from a post-money valuation to a pre-money valuation (in which case the investor will bear a portion of the increase, where only the existing shareholders will pay for the increase).
For instance, suppose the company’s pre-money valuation is $5 million with a 10% option pool. This suggests that the option pool has a value of $500,000. If the investor requests that the corporation extend the option pool to 20%, the option pool’s value would increase to $1 million, with existing shareholders paying for the increase through dilution of their existing stakes. This would also imply a decrease in the company’s pre-money valuation.
If an investor is seeking a 50% stake in the company, it makes no sense for that investor to be diluted soon after investing by increasing the option pool from 10% to 20%. Thus, the investor requests that the cost of the option pool expansion be’shuffled’ from the post-money to the pre-money computation. As a result, current shareholders bear the cost of the increase prior to the investor’s contribution — on a pre-money value basis.
Consider the following worked example, which assumes a $5 million pre-money value, a new investment of $5 million, and an increase in the option pool from 10% to 20%.
Without Option Pool Shuffle
You should know that the actual percentages will be different because after the options are exercised, the option pool is 20% of the total share capital of the company. This means that the actual percentages will be different.
- A post-money value of $10 million.
- Founders own 40% of the company.
- Interest from investors: 40%
- The options pool: 20% of them
With Option Pool Shuffle
A post-money value of $10 million.
- The founder owns 30% of the company.
- 50 percent of investors want to buy.
- The options pool: 20% of them
Key Takeaways
In order to make sure you own some of the company after an investor buys in, make sure you get a higher pre-money valuation. This will cover the cost of rearranging the option pool for the investors. There are two ways to get the option pool shuffle out of the term sheet.
Establishing ESOP’s and partaking in option pool shuffling are one of many intricacies requiring accounting attention. Here at Fullstack, we’re always happy to advise – reach out to us for a free consultation to support your startup journey.
