Whenever a startup raises money, one aspect of the conversation is around employee stock option plans and equity. Investors want to know that the company has equity set aside for employees while founders often want to delay their ownership dilution until they know they’re going to hire new employees and need to allocate new equity grants.
When raising money, investors will often require an increase in the size of the stock option pool to ensure there’s equity for new hires that are part of the funding plan. Only, some investors aren’t clear upfront whether the dilution for this additional option pool comes from the existing shareholders prior to financing or if it’ll come post financing and be shared across the new and old investors. The option pool shuffle is when new investors ask for an increase in option pool size, recommend a target size (e.g. add 15% of the company of the option pool), and then make the existing shareholders take the dilution for this increase (effectively reducing the pre-money valuation).
Entrepreneurs should think through their hiring plans and only increase the option pool based on their projected needs (e.g. add 10% of the company to the option pool instead of 15%). When lower than what the investor requests, the pre-money valuation effectively increases, and if the option pool is increased in the future, everyone shares in the dilution.
Increasing the option pool size and requiring it prior to funding is normal and shuffles the dilution to the existing shareholders. The key is to make the increase in size reasonable and to calculate that dilution when thinking about the effective pre-money valuation for the round.
What else? What are some more thoughts on the option pool shuffle?