There is an old Opening adage that says: Cash is king. I’m no longer sure that’s true.
In today’s cash-rich environment, options are more valuable than cash. The founders have many guides on how to raise money, but not enough has been written about how to protect your startup’s pool of options. As a founder, recruiting talent is the most important factor for success. In turn, managing your pool of options may be the most effective action you can take to ensure that you can recruit and retain talent.
That said, managing your pool of options is not an easy task. However, with a little foresight and planning, it is possible to take advantage of certain tools at your disposal and avoid common mistakes.
In this piece, I’ll cover:
- Option pool mechanics across multiple funding rounds.
- Common pitfalls that trip founders along the way.
- What you can do to protect your set of options or correct course if you made mistakes in the beginning.
A minicase study of option group mechanics
Let’s run through a quick case study that lays the groundwork before diving deeper. In this example, there are three matching co-founders who decide to quit their jobs to become startup founders.
Knowing they need to hire talent, the trio goes live with a 10% pick pool at the start. They then improvise enough money in angel, pre-seed and seed rounds (with a cumulative dilution of 25% in those rounds) to achieve a product-market fit (PMF). With PMF in the bag, they generate Series A, resulting in an additional 25% dilution.
The easiest way to ensure you don’t run out of options too quickly is to simply start with a larger group.
After hiring a few C-suite executives, they are now running out of options. Therefore, in Series B, the company performs a 5% option pool pre-money reload, in addition to giving up 20% in capital related to the new cash injection. When the Series C and D rounds arrive at 15% and 10% dilutions, the company has taken a big step and has an initial public offering imminent in the works. Success!
For simplicity, I’ll assume a few things that don’t normally happen, but that will make illustrating the math here a bit easier:
- No investor participates in your apportionment after your initial investment.
- Half of the available pool is allocated to new hires and / or used for upgrades each round.
Obviously, every situation is unique and your mileage may vary. But this is a fairly close proxy to what happens to many startups in practice. Here’s what the pool of options available will look like over time throughout the rounds:
Be aware of how quickly the pool thins, especially in the beginning. At first, 10% seems like a lot, but it’s hard to make the first hires when you have nothing to show the world and no cash to pay salaries. Additionally, the first few rounds not only dilute your capital as a founder, but dilute everyone’s, including your pool of options (both allocated and unallocated). By the time the company increases its Series B, the available pool is already less than 1.5%.