Navigating the Delicate World of Non-Arms Length Transactions.
Keys to Securing The Funding You Need to Scale.
Most of you will know of the possible contentious effects of a “pre-money” vs. “post-money” offering between entrepreneur’s and investors during negotiations of a financing round. As you also know, a strong way to motivate already talented employees and executive personnel early on is to provide them with options to purchase shares in the company at a future date. This motivation is self-evident: give me a chance to participate in the profits of the company I’m working hard to help you build, and I’ll just work harder, because I know that the harder I work, the higher the probability of success and, hence, my personal payoff.
Both investors and entrepreneurs know this, and so the option pool becomes a negotiating tactic that investors know how to utilize.
Understanding that it is investors who own the money (and possible other valuable resources) lends an understanding to the strength of the investors’ position entering into the financing round negotiations.
You as the entrepreneur also want to establish an option pool, first, because of the obvious motivations it elicits in team members, and, second, because it has become a necessary component in compensation packages around the start-up and emerging company ecosystem.
So in the process of the negotiating stage, the investors come to you with a funding package. Prior to speaking with them, word was that your start-up was worth $1 Million (the “pre-money” valuation), and you’re asking for funding of $1 Million. The investors agree to this, but stipulate that they want to insert an option pool equal to 5% of the post-money fully diluted valuation.
Why is this a dangerous option? The answer is best explained by an example:
Let’s assume that, prior to these talks, there are 100,000 shares outstanding. You as the originator own 70% of those shares, with the others owned evenly by each of your 2 business partners. The value per share is therefore $1 Million / 100,000 = $10 per share, and your value is $700,000
If you allow this pre-money option pool, then the Company’s “effective” pre-money valuation is reduced to $900,000 ($1 Million - $100,000 options)
What is the post-money fully diluted valuation?
$900,000 effective valuation + $1 Million cash + 100,000 new options = $2 Million.
Note that $100,000 in new options is equal to 5% of the post money fully diluted valuation, or $900,000 pre-money effective valuation plus $1 Million additional funding plus $100,000 in new options. To determine the post-money value of the shares, the value of the option pool must be included in the equation to determine per share value:
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What is the post-money value per share?
$1 Million pre-valuation / (100,000 shares plus 100,000 options) = $5 / share
What??? You say!!
A 5% option pool in the “pre-money” valuation would instantaneously dilute your initial ownership in the $1 Million pre-money valuation to $350,000($1 Million / 200,000 = $5.00 per share * 70,000 shares). This makes a substantial difference in the amount of money you walk away with, and it’s important therefore to recognize the issues on the table prior to entering into a negotiation phase.
Yes, you need an option pool, not only because it motivates the right people and can facilitate your overall goals to grow the company, but because without it it’s hard to retain good talent
Rarely will you see investors request an option pool as low as 5% (more common are option pools between 10% and 15% of the pre- or post-money valuation). I’ve maintained a 5% pool in the example, however, to keep the numbers relatively stable and reflective of the actual effects you’ll see in practice.
Slipping the option pool in the pre-money valuation is what effectively puts value in the pockets of investors. There are ways to deal with this potentially combustible issue:
- Negotiate the option pool in the post-money valuation
Whenever you provide option pools, the value of the previously issued shares is at risk of dilution. However, the potential erosion will be less if the value of the option pool is based on the post-money rather than the pre-money valuation because the option pool, or the 5% in the example above, will be based on a higher valuation (post-money). Entrepreneurs need to know the possible dilutive results before entering into funding negotiations so that they know what they’re possibly heading into.
In cases where the funding comes with business expertise, then the dilutive ramifications of the funding may be tolerable, especially if options have been set aside previously for future utilization. However, these are points that need to be negotiated, and we look to industry practices and relevant transactions to determine reasonable option pool levels. Ultimately, the smaller the option pool, the better off you the entrepreneur are. The investors, however, will be going for as high an option pool as possible, so middle ground needs to be established in order to move forward in the negotiations.
- Come to the table with option pool needs.
When you can tell investors and stakeholders what your option pool needs are and why you need them, and then wrap this reasoning within the context of keeping team players motivated to facilitate company growth, then efforts by investors to enlarge the pool can come off as self-aggrandizing and selfish. Determine quantitatively what the option needs are, and the detrimental effects of going beyond these parameters, and you’ll have an assertive argument to keep the option pool down.
Of course, the investors are the ones with the money, and if you need it and they’re the only funding option on the table, your negotiating leverage can dissipate. Each issue is unique, and the negotiations are executed within the parameters that they’re played out in.
Option pools are an important and vital component in the establishment of your team. Normally options given to team members range from 5-10% for the CEO, and reducing down the scale to.2-.3% for junior managers.
During the 1990’s we saw MBA graduates from top-tier schools marching off to Silicon Valley with nothing but the promise of big things ahead and millions of options - yet minimal salary - on their contracts. Times have definitely changed, yet the power of option pools remains intact. It’s the responsibility of entrepreneurs and investors alike to utilize this component of compensation to drive success within the company.
Nicholas Kilpatrick is a partner at Burgess Kilpatrick an accounting firm in Vancouver, B.C. He specializes in the firm’s strategic consulting and forecasting practice. Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebok.com/BugessKilpatrick for more information on our firm.
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