Negotiating the Option Pool

Many people think a high(er) valuation is the Holy Grail.  Those people are (often) wrong.  In pursuit of a high(er) valuation, founders often unwittingly give up valuable ownership percentage points by agreeing to a needlessly large option plan reserve.  If you are reviewing a term sheet, the “pool” can be a critical negotiating point, and could be the link to obtaining a higher price per share for your company and you may be better off at a lower valuation with a smaller pool than at a higher valuation and a larger pool.

First, let’s understand what the “pool” represents in the eyes of the mainstream investor funding a private company: The pool typically represents the % of the post-closing fully-diluted capitalization of the company available for future employee option grants.  You may wonder why the post-closing percentage has anything to do with your ownership.  Most investors require that the full amount of this “post-closing” percentage be deemed to be part of the pre-closing capitalization for purposes of calculating their price per share, which means it only dilutes existing holders, not the new shares.

With that in mind, let’s take a look at a quick (very simplified) example: Let’s say you’re a pre-funded company with 10M shares of common stock outstanding, options to purchase 1M shares outstanding, and an available pool of 1M shares, and the investors are putting in just $1M of new cash.  The table below demonstrates the relative outcomes where the only differences are the pre-money valuation and the percentage allocated to the available pool:

Of course, the math will vary in each deal (and many investors are expecting a fixed percent of the post, so the investment amount may differ based upon valuation).  However, the size of the option pool is one of the most important factors affecting your ownership percentage.

How can you help your cause?  Consider building out an option budget, based upon post-closing percentages, that shows what hires you need to make over the next 12-18 months to meet the operating plan you have presented to investors.   This exercise will usually yield a credible pool that is frequently lower than the abstract percentage pool investors “think” they need for a given stage company.  For example, an investor may think a 20% pool is “standard” for a Series A company, based on their experiences with other startups.  However, your plan may require you to make fewer and/or “lower level” hires that will only require you to make grants equal to 10% of the capitalization.  Even at the same valuation, a lower pool means more percentage points stay in your pocket for now.

If you can convince the investors that 10% is really all you need, you just saved 10% for yourself, which may result in your being able to reasonably accept a lower valuation that comes with fewer strings attached.