Why Do VC Firms Want an Option Pool Before the VC Round?
Founder's Mistakes Option Pool | Monday's VC Reading | Remote VC Jobs
I have been interacting with so many founders at events or during pitch sessions or finalizing investments in their startups, I observed that almost all founders get confused when VCs say they will invest some amount at pre-money. Let’s take an example.
“When a VC says they will invest $10 million pre-money” - it means $10 million inclusive of any ESOP the startup will be set aside for future employees. At the same moment, they always have a query about why it’s not exclusive and why investors saying it’s inclusive. So If you are a founder or aspiring investor it’s really important for you to understand the math behind it. So let’s deep dive into it - Why do VC Firms Want an Option Pool Before the VC Round?
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Let’s do simple mathematics to understand this. We will take the two scenarios of the founder considering the option pool before & after vc round. This will help you to get a better idea.
First Scenario: Founders create a 15% Option Pool before VC Round
Suppose - Founder A and Founder B started a Business with the following shares.
- Number of shares with Founder A= 10,000
- Number of shares with Founder B= 5,000
- Total number of shares= 10,000+5,000= 15,000
- Option Pool= 15% (Founder Considering option pool before vc round)
- Number of new shares for Option Pool/ (Number of New shares for Option Pool+ Total Number of old shares)= 15%
- Number of new shares to be issued for Option Pool= (15,000*15%)/ (1-15%)= 2,647
- Total number of shares after Option Pool= 15,000+2,647= 17,647
- Now a VC Firm is investing= $2m
- Let’s say the Pre-money valuation of the company= is $8m
- Post-money valuation= $2m+ $8m= $10m
- Dilution= $2m/ $10m= 20%
- Number of new shares to be issued for VC Firm / (Number of New shares to be issued for VC Firm+ Total number of shares after Option Pool)= 20%
- Number of new shares to be issued for VC Firm= ( 17,647*20%)/ (1-20%)= 4,412
- Total number of shares after VC round= 17,647+ 4,412= 22,059
Final Ownership Structure:
- Founder A= 10,000/ 22,059= 45.33%
- Founder B= 5,000/22,059= 22.67%
- Option Pool= 2,647/ 22,059= 12%
- VC Firm= 4,412/ 22,059= 20%
Now Consider a Second Scenario: Founders create a 15% Option Pool after VC Round
- Number of shares with Founder A= 10,000
- Number of shares with Founder B= 5,000
- Total number of shares= 10,000+5,000= 15,000
- VC Firm wants 20% ownership
- New shares to be issued for VC Firm= (15,000*20%)/(1-20%)= 3,750
- Total number of shares after VC round= 15,000+ 3,750= 18,750
- Next, the Company creates a 15% Option Pool (As the founder considering the option pool after VC funding)
- New shares to be issued for Option Pool= (18,750*15%)/ (1-15%)= 3,309
- Total number of shares after Option Pool= 18,750+ 3,309= 22059
Final Ownership Structure:
- Founder A= 10,000/ 22,059= 45.33%
- Founder B= 5,000/ 22,059= 22.67%%
- Option Pool= 3,309/ 22,059= 15%
- VC Firm= 3,750/ 22,059= 17%
If you compare the Second Scenario with the First Scenario, you will find that
- VC Firm’s ownership has been reduced from 20% to 17%
- Both Founders’ ownerships are unchanged
- The Option Pool has been increased from 12% to 15%
And that’s why VC Firms prefer an Option Pool before the Investment.
That’s It. I hope this helps you to get an idea - Why do VC Firms Want an Option Pool Before the VC Round
You can download the Excel sheet of these examples from here - Download here
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