Why Do VC Firms Want an Option Pool Before the VC Round?

• I have been interacting with so many founders at events or during pitch sessions , one thing that I observed in most of the founders get confused when VCs say they will invest some amount at pre-money. Let’s take an example.

• “When a VC says they will invest $10 million pre-money” — it means $10 million inclusive of any ESOP the startup will be set aside for future employees.

• At the same moment, they always have a query about why it’s not exclusive and why investors saying it’s inclusive. So If you are a founder it’s really important for you to understand the math behind it.

• So let’s deep dive into it — Why do VC Firms Want an Option Pool Before the VC Round?

• Let’s do simple mathematics to understand this. We will take the two scenarios of the founder considering the option pool before & after VC round. This will help you to get a better idea.

Suppose — Founder A and Founder B started a Business with the following shares.

• Founder A and Founder B have some shares in their company. Founder A has 10,000 shares, and Founder B has 5,000 shares.

• To find out how many shares there are in total, we add Founder A's shares and Founder B's shares: 10,000 + 5,000 = 15,000 shares in total.

• They also want to set aside some shares for something called an "Option Pool." This is like a special group of shares for their employees or other people who help the company.

• They decide that 15% of all the shares will be in the Option Pool. So, they need to calculate how many new shares to add to the Option Pool.

• To find the number of new shares for the Option Pool, they use this formula:

(Total Number of Shares * Percentage for Option Pool) / (1 - Percentage for Option Pool)

In their case, it's: (15,000 * 15%) / (1 - 15%) = 2,647 new shares for the Option Pool.

Now, they add these new shares to the total shares: 15,000 (old shares) + 2,647 (new shares) = 17,647 shares in total after setting up the Option Pool.

So, there are 17,647 shares in the company after they've decided to create the Option Pool and added new shares for it.

• Now a VC Firm is investing= $2m

• Let’s say the Pre-money valuation of the company is $8m

• Post-money valuation= $2m+ $8m= $10m

• Dilution= $2m/ $10m= 20%

• Number of new shares to be issued for VC Firm / (Number of New shares to be issued for VC Firm+ Total number of shares after Option Pool)= 20%

• Number of new shares to be issued for VC Firm= ( 17,647*20%)/ (1–20%)= 4,412

• Total number of shares after VC round= 17,647+ 4,412= 22,059

Final Ownership Structure:

• Founder A= 10,000/ 22,059= 45.33%
• Founder B= 5,000/22,059= 22.67%
• Option Pool= 2,647/ 22,059= 12%
• VC Firm= 4,412/ 22,059= 20%

Now Consider a Second Scenario: Founders create a 15% Option Pool after VC Round

• Number of shares with Founder A = 10,000

• Number of shares with Founder B = 5,000

• Total number of shares= 10,000+5,000= 15,000

• Option Pool= 15% (Founder Considering option pool before vc round)

• Number of new shares for Option Pool/ (Number of New shares for Option Pool+ Total Number of old shares)= 15%

• Number of new shares to be issued for Option Pool= (15,000*15%)/ (1–15%)= 2,647

• Total number of shares after Option Pool= 15,000+2,647= 17,647

• Now a VC Firm is investing= $2m

• Let’s say the Pre-money valuation of the company is $8m

• Post-money valuation= $2m+ $8m= $10m

• Dilution= $2m/ $10m= 20%

• Number of new shares to be issued for VC Firm / (Number of New shares to be issued for VC Firm+ Total number of shares after Option Pool)= 20%

• Number of new shares to be issued for VC Firm= ( 17,647*20%)/ (1–20%)= 4,412

• Total number of shares after VC round= 17,647+ 4,412= 22,059

Final Ownership Structure:

• Founder A= 10,000/ 22,059= 45.33%
• Founder B= 5,000/22,059= 22.67%
• Option Pool= 2,647/ 22,059= 12%
• VC Firm= 4,412/ 22,059= 20%

Now Consider a Second Scenario: Founders create a 15% Option Pool after VC Round

• Number of shares with Founder A= 10,000

• Number of shares with Founder B= 5,000

• Total number of shares= 10,000+5,000= 15,000

• VC Firm wants 20% ownership

• New shares to be issued for VC Firm= (15,000*20%)/(1–20%)= 3,750

• Total number of shares after VC round= 15,000+ 3,750= 18,750

• Next, the Company creates a 15% Option Pool (As the founder considering the option pool after VC funding)

• New shares to be issued for Option Pool= (18,750*15%)/ (1–15%)= 3,309

• Total number of shares after Option Pool= 18,750+ 3,309= 22059

Final Ownership Structure:

• Founder A= 10,000/ 22,059= 45.33%
• Founder B= 5,000/ 22,059= 22.67%%
• Option Pool= 3,309/ 22,059= 15%
• VC Firm= 3,750/ 22,059= 17%

If you compare the Second Scenario with the First Scenario, you will find that

• VC Firm’s ownership has been reduced from 20% to 17%
• Both Founders’ ownerships are unchanged
• The Option Pool has been increased from 12% to 15%

And that’s why VC Firms prefer an Option Pool before the Investment.

That’s It. I hope this helps you to get an idea — Why do VC Firms Want an Option Pool Before the VC Round