VCs and option pools: Now you’re swimming in the deep end

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks:  My co-founder and I have been talking to some VC firms on Sand Hill Road, and I think we’re pretty close to getting at least one term sheet.  I read your post a few weeks ago about how one of the common mistakes startups make dealing with VC’s is focusing too much on valuation.  You also mentioned there are other important terms that affect the economics of a financing, including the size of the option pool.  Can you please explain that?  Our company never issued any options – and my co-founder and I each own 50 percent of the shares.  Will the VC firms require an option pool? And, if so, how will that affect us?

Answer: The issuance of stock options by startups is quite common, because it gives key employees an opportunity to benefit directly from any increase in the company’s value, but doesn’t require any cash outlays by the company.  That makes them an important tool to attract talented staffers.

Accordingly, the VC firms will likely require your company to establish a large pool of unallocated options for future employees.  In fact, you will probably see language in the term sheet similar to this (with the blanks filled-in): “The price per share is based upon a fully-diluted pre-money valuation of $_________ and a fully-diluted post-money valuation of $________ (including an employee pool representing __% of the fully-diluted post-money capitalization).”

The pre-money valuation (or “pre”) is the value of the company prior to the VC investment (I cover it in more depth in this previous column), and the post-money valuation is equal to the pre plus the amount of the investment.

For example, if you and the VC negotiate a pre of $6 million, and the VC has agreed to invest $2 million, then the post-money valuation would be $8 million.  Accordingly, absent an employee option pool, the VC would own 25 percent of your company post-money  ($2 million divided by $8 million), and you and your co-founder would own 75 percent.

It’s the parenthetical language – “including an employee pool representing __% of the fully-diluted post-money capitalization” – that many entrepreneurs do not understand. Unfortunately, that clause can substantially dilute their share, but not the VC’s.  (Note that it’s a little confusing in the term sheet because the dilution results from the way the price per share of the company is calculated.)

Most venture capitalists utilize an unusual methodology for calculating the price per share of a company after the determination of its pre-money valuation.  Here’s how it works: the post-money valuation is divided by the “fully diluted” number of shares outstanding (in other words, the total number of shares, options and warrants that have been issued by the company), plus all of the shares or options that will be issued in the future as part of the employee pool.

So, if we stick with the example above, if the employee pool were 20 percent of the fully-diluted post-money capitalization (which is fairly typical, though sometimes higher), you and your co-founder would only own 55 percent of the company post-money (75 percent minus 20 percent). The VC would still own 25 percent and 20 percent would allocated to the employee pool.

The founders, as you see, shoulder all of the dilution. The 20 percent employee pool is calculated as if the VC’s shares of preferred stock have already been issued to the VC.

It actually can get worse. If your company were sold prior to a Series B financing, all of the unissued and unvested options would be cancelled, and the VC would share the additional sale proceeds proportionally with you and your co-founder – even though those options came out of your pocket.

Ultimately, it’s evidence of the “golden rule”: He who has the gold makes the rules.

The bottom line is that you need to fully understand the economics of a VC financing, which include liquidation preferences and the option pool.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.