Anatomy of a Term Sheet 2 – Pre-Money Valuation and the Option Pool

Welcome to Anatomy of a Term Sheet Part Two.

In the first part, we looked at the introductory language and some of the basic offering terms in the model term sheet of the National Venture Capital Association, which you can find here.

Today we are going to look at two remaining basic offering terms – price per share, and pre-money valuation. The pre-money valuation term raises a very important issue for founders, involving the employee option pool and the dilutive effect this term will have. So join me as we dig in… 

The first term to examine in this part is:

Price Per Share: $[________] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

This is the price that the VC investors will be paying for each share of preferred stock. If there are angel investors who put in money through a convertible note, they will probably be paying a lower price per share when converting the loan to equity, due to price discount and valuation cap terms in the convertible note financing.

The next term, which is a crucial one to understand, involves pre-money valuation and the employee option pool:

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization). 

The pre-money valuation is the valuation immediately prior to the VC investment, and the post-money valuation is the pre-money valuation plus the amount of the investment. So, if the pre-money valuation is $4 million, and the VC is investing $2 million, the post-money valuation is $6 million.

Note the use of the term “fully-diluted” in connection with the pre-money valuation, post-money valuation, and post-money capitalization. “Fully-diluted” means the highest potential amount of common stock that could be outstanding, regardless of vesting and assuming that all options and other securities (such as convertible notes) are converted into common stock.

The inclusion of the employee option pool in the post-money valuation and capitalization has the effect of diluting the founders’ share of the startup, without diluting the VC investors’ share. To see how this works, let’s return to the scenario just described, where the pre-money valuation is $4 million, the VC investment is $2 million, and the post-money valuation is therefore $6 million.

Assume there are two founders, each with 50% of the stock pre-money, and there is no option pool. Thus, prior to the VC investment, the founders owned 100% of the company, collectively. After the investment, if there is still no option pool, the VC fund will own 33% ($2 million divided by $6 million) and the founders’ stake will be reduced to 66%.

As a practical matter, however, the VC will require the startup to set up an employee stock option plan and set aside an option pool for the employees. Startup companies are typically short of cash, and the stock option plan is an important tool for attracting and retaining talented employees, and giving them an opportunity to share in the increasing valuation of the startup.

When the VC uses the above language to require an option pool, it is taking that option pool out of the founders’ share, further diluting the founders, but not diluting the VC. To determine the price per share, the post-money valuation is divided by the fully-diluted number of shares outstanding, plus all the shares or options that will be issued in the future as part of the option pool.

Let’s take a second look, assuming the option pool is 20% of the fully-diluted post-money capitalization (20% is a fairly common size for option pools). Now the cofounders only own 46% of the post-money company (66% minus 20%), while the VC investor still owns 33%. The founders’ share of the company has been diluted, but the VC’s share has not. The founders’ ownership has decreased by 30%, all due to that “post-money capitalization” language.

What can the founders do to avoid or mitigate the dilution that is caused by the option pool? As a practical matter, a startup will not be able to have the VC’s remove the option pool requirement, and that isn’t a good idea anyway. As I mentioned before, stock options are an important tool for attracting and retaining good employees, especially when the company is cash-poor. Stock options are desirable, it’s the dilution of the founders that is problematic. Unfortunately, founders also will not be able to get the VC’s to share in the dilution alongside the founders. The VC’s have the upper hand here, because they have the money. There are a few partial remedies that are possible.

The first remedy is to negotiate for a higher pre-money valuation, to compensate at least in part for the option pool dilution. Going back to the previous example, let’s suppose the pre-money is $5 million, with the VC’s investing $2 million. The post-money is now $7 million. The VC’s share of the post-money capitalization is 29%. The founders’ share is now 51% (taking into account the 20% option pool), which is better than the 46% share when the pre-money was $4 million.

A second remedy is to try to reduce the size of the option pool as much as possible. If your startup already has an executive team in place, you might be able to get away with a 10% option pool; you don’t need the extra options to entice a CEO or other top executives.

A third remedy is to already have the option plan and pool in place before going to the VC investors. Whether this is possible will depend on where the startup is in its development process, as well as the finances of the startup. Setting up a stock option plan will cost about $1500 to $2000 (maybe more, maybe less), and if the startup has money available from an angel investment, it may be a good use of funds. The stock option plan will make it easier for the startup to attract employees at this stage, allowing it to stretch its funds a bit further. And if the plan is already in place, the VC’s may not push as hard on the size of the option pool.

Hopefully this helps to explain a fairly complex yet common issue that arises when negotiating with VC investors. Next time, I will write about the alternative provisions for dividends.

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