US Corporate Law 20 Episodes (11)
The trap in the valuation of startups - the option pool, is there such a big difference between setting up the option pool first and setting up the option pool later?
The trap in the valuation of startups-option pool, there is such a big difference between setting up the option pool first and setting up the option pool later? Valuation clauses in the term sheet | The valuation you see is not the valuation you think | Investors are pitting you! Where are all the options that never run out?
In the last issue we covered a lot of jarring terminology in the Term Sheet. Today we will focus on one of the terms - valuation Pre-money valuation.
The terms of valuation are generally on the first page of the Term Sheet and are very brief. There's just one line, or just one number, and that's the price at which your company is valued. This is the most intuitive clause for entrepreneurs, and it is often a clause that entrepreneurs are really capable of negotiating, and it is often a clause that lawyers cannot help you with. Other clauses are generally left to lawyers because the legal expertise is too strong.
The valuation we are talking about is often pre-money valuation, pre-financing valuation. Because the post-financing valuation is the result of adding the investor's investment amount. Many entrepreneurs will think that the valuation is worth talking about. If I get two Term Sheets, the one with the higher valuation will be better.
However, it should be noted that there is another factor that greatly affects the actual equity of investors is the option pool. A 5-page term sheet, the terms of the option pool tend to appear on the third page of the term sheet and are not as compelling as the terms of valuation. But it has a big impact on the first page valuation pre-money valuation.
Two VCs tell you the same "Pre6 vote 4", that is, the pre-money valuation is 6 million, and in the case of investing 4 million, let's compare the difference between the first and last option pools:
1. If the option pool is set up after the VC comes in, then "Pre6 investment 4" means that the founder's share value is 6 million after financing, accounting for 60%, and the VC's investment value is 4 million accounting for 40%. A 20% option pool is added, that is, the founders and VCs are diluted by 20%. The final ratio is that entrepreneurs account for 48%, VCs account for 32%, and the option pool accounts for 20%.
2. If you want to set aside 20% of the option pool in advance, the 6 million invested by VC will still account for 60% of the post-financing valuation, 20% of which is reserved for the option pool for entrepreneurs. Actually only 40%. Then the final ratio is 40% for entrepreneurs, 40% for VC, and 20% for option pools.
Comparing the two situations, you will find that the proportion of entrepreneurs has shrunk by 8%. And if the ratio of entrepreneurs and VCs is taken out separately, the first option pool is set up later, 48% of entrepreneurs are 32% of VCs, which is 3:2, while the second type of entrepreneurs is 40%, and VCs account for 40%, which is 1:1.
That is to say, as soon as the money comes in, the entrepreneur and the investor are already tied. When another investor comes in in the next round, the entrepreneur becomes a minority shareholder. Of course, our example of VC accounting for 40% is quite extreme. Often one round of investors comes in, which means 10-20%. If you add the reserved option pool, it basically means that after two rounds, the founder will become minority shareholders.
Some entrepreneurs may ask, isn't the option pool issued to their employees? Are the employees not their own? Anyway, employees can't stand on VC's side. However, after the option pool is reserved, 20% will not be issued immediately, but will be issued slowly. And even if the options issued have not been issued for four years, they have not yet become equity, and they have no voting rights. That is to say, this 20% erodes 20% of the founder's voting rights in vain.
Another point is that it is precisely because 20% of the options are issued slowly, and often the result is that when the company exits, that is, when the company is acquired or listed, the equity structure will be reshuffled. Unused option pools will be written off, not returned to the founders. If a 20% option pool is set up, and after 5 years, when the company exits, the remaining 10% has not been issued, then this 10% is also a pit that has been occupied for 5 years in vain, and is taken advantage of by VCs.
Some entrepreneurs often ask, should the option pool be established when the first round of financing comes in? I thought that when I first started a company, I had to set up an option pool. Many startups often say that I want to set a 20% when registering a company, because all the VCs that entrepreneurs hear will tell them that you want to set up an option pool. However, you must know that the option pool is used to motivate employees. Companies often only have founders at the beginning. The founders already have equity incentives and do not need options. That said, you don't actually need an option pool until you hire your first employee. When a startup hires its first employee, it is often after raising the first money, or even the second money. If you set up an option pool early, it means that you have tacitly agreed to give profits to investors, and as you can see from the fourth lecture, setting up an option pool is not a matter of one sentence, but requires a complete set of documents. Spend a small amount of legal fees. If you wait for the VC to come in and then set up, you and the VC will share the legal fee. Even for most entrepreneurs, to get financing from VC, they have to accept the condition of setting up an option pool in advance. After listening to today's content, as an entrepreneur, you must think twice about setting up an option pool. At least try for a little bit.
If today's content is helpful to you, please give me a like, and if you have any related questions, please leave me a message in the comment area.
