I read an interesting article on the Seeing Both Sides blog last week which addressed valuation terms considered by private equity investors when negotiating deals. The article primarily addresses how an entrepreneur’s misunderstanding of valuation terms could harm the entrepreneur’s ultimate equity position following the equity raise.Among other topics addressed, the article discusses the impact of management option pools on business valuations as considered by venture capitalists or other private equity investors. Here is an excerpt:
Another term that impacts the price is the size of the option pool. Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business. These new hires typically receive stock options, and the issuance of those stock options dilute the other investors. In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment. In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team. In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires.
This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.
The moral of the story here is that entrepreneurs seeking to raise funds should not get lost in pre-money valuations. Rather, they need to consider the entire impact of the deal terms on their ultimate equity position. The entrepreneur in the above example obviously did not get the better deal because he was hung up on the pre-money valuation.This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.
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Alerding Castor Hewitt is an Indianapolis law firm focusing on business law, information technology law (including SaaS law and legal technology consulting), private equity consulting, probate and business litigation.
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