Startups commonly offer options to motivate and retain key team members. When a company sets up an employee share option scheme or plan (an ESOP or ESS), the options are over shares that the startup has not yet issued.
What is an Option Pool?
An option pool is a ‘pool’ of equity that the company has set aside to issue to new hires under an ESOP or ESS as a means of incentivising new hires. They represent a ‘pool’ of shares that have not yet been issued but will be issued as and when new hires come on board. It is expressed as a percentage of the total issued share capital of the company.
Even though the ‘pool’ has not been issued, when investors calculate the pre-money valuation of the company, they treat the option pool as if it has all been issued. This is known as the ‘fully diluted’ capital of the company. In other words, when the capital of the company when all options (and other instruments convertible into shares (for example, convertible notes)) are exercised.
During an investment round, the question arises as to who should pay for the option pool.
Who is Paying for the Shuffle?
The term ‘option pool shuffle’ is used to describe the situation where an investor wants the company to increase the size of the option pool but wants the existing shareholders to pay by ensuring that the pre-money valuation of the company captures the increase.
The investor wants to ‘shuffle’ who pays for the option pool from a post-money valuation (in which case the investor will pay for some of the increase) to a pre-money valuation (where only the existing shareholders will pay for the increase).
For example, let’s say that the pre-money valuation of the company is $5 million with a 10% option pool. This means that the value of the option pool is $500,000. If the investor wants the company to increase the option pool to 20%, this would mean that the value of the option pool rises to $1 million with the existing shareholders paying for this increase by dilution of their existing interests. This would also mean that the pre-money valuation of the company is reduced.
If the investor is looking for a 50% share in the company, it doesn’t make sense for that investor to be diluted immediately after its investment through the increase in the option pool from 10% to 20%. So, the investor requires that the cost of the option pool increase is ‘shuffled’ from the post-money calculation to the pre-money. This results in the existing shareholders paying for that increase before the investor’s investment – i.e. on a pre-money valuation basis.
Let’s look at a worked example assuming a $5 million pre-money valuation, a new investment of $5 million and an option pool increase from 10% to 20%.
Without Option Pool Shuffle
Note that actual percentages will be different because the option pool is 20% of the total share capital of the company after the options are exercised.
Post-money valuation: $10 million
Founder interest: 40%
Investor interest: 40%
Option pool: 20%
With Option Pool Shuffle
Post-money valuation: $10 million
Founder interest: 30%
Investor interest: 50%
Option pool: 20%
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Key Takeaways
If you, as a founder, want to ensure that you own a certain percentage of the company post-investment, make sure you negotiate a higher pre-money valuation to cover the cost of the option pool shuffle. Or, negotiate the option pool shuffle out of the term sheet.
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If you have any questions or need assistance negotiating your term sheet, get in touch with our specialist startup lawyers on 1300 544 755.
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