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📢 Why Do VC Firms Want an Option Pool Before the Funding Round?
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?
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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📢 Featured Article: Lessons from the Dot-Com Era for Generative AI Hype
With daily news on AI startups raising millions of dollars even without a product or well-established team - this leads most of us to think that Gen-AI is all about the hype and this hype will burst someday.
While searching about what the Doc-Com era looks like and learning something about this Gen-AI hype, I came across an article where the author draws parallels between the current hype surrounding Generative AI and the dot-com era of the late 1990s. Here is the summary of that article:
Rapid Commoditization: The early proliferation of web browsers and servers in the dot-com era to the current landscape of Generative AI. They suggest that, while building top-class Language Models (LLMs) is currently complex and expensive, the progress in open-source LLMs hints at a potential future of commoditization, particularly for simpler tech elements.
Incumbents vs. Disruptors: The established players in the dot-com era initially thrived due to their distribution but were later overtaken by more innovative newcomers. Similarly, today's tech giants like Microsoft, Google, and Amazon are pushing Generative AI products, but the author predicts that smaller, more innovative disruptors may emerge in the long run.
Startup Survival: Drawing from the history of dot-com startups, many early pioneers did not survive, while the second wave of companies, like Google and Netflix, achieved long-term success. This phenomenon is attributed to distorted incentives and a learning effect. The article advises Generative AI startups to focus on long-term goals and real merits.
"Roll Your Own" Pitfall: Comparing the dot-com era's tendency to build custom web content management systems to the current trend of DIY Generative AI solutions. They predict that organizations will eventually turn to professional solutions and startups to meet their needs, highlighting the opportunity for startups to solve challenging problems in the tech stack.
If you want to read the full article - here is the link.
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