This post is a continuation of the Series A discussion that covers everything a founder should know before raising their Series A. If you missed the first two posts, you can find them here.
These next couple of posts will focus on the key economic terms that you should know about in a term sheet. In this post we will be discussing the price and the option pool.
Price:
The Price term is exactly what it sounds like; it is the value of your company. It is measured in price per share but mainly discussed as the total number that your startup is worth. When it comes to price it is important to note that it is represented in two different terms; pre-money and post-money. VC’s use these two different terms when discussing the valuation of your startup so it is important that you know the difference between them. To put it simply, pre-money is the value of your startup before investment, and post-money is the value of your startup after investment. It is important to note that investors almost always talk in terms of post-money. For example, if an investor says they will invest $5mm at a $20mm valuation, what this means is they value your company at $15mm pre-money and their $5mm investment will bring the post-money valuation of the company to $20mm. A bit of practical advice, if you are in negotiations with an investor and you are unsure of which term they are using when talking about price, just ask them; it never hurts to get clarification.
Option Pool:
The Option Pool is the number of shares reserved for employees. The standard size of the employee pool is anywhere between 10%-20% of the fully diluted stock. At your Series A round, investors will demand that an option pool be created. This makes a lot of sense as you will need to retain talent with stock grants and options since you will be unable to pay them competitive market rates. However, be careful as this demand can turn into another form of price control from the investor. The option pool affects your startup’s valuation because it is included in the calculation of the pre-money valuation of your startup. What this ends up doing is diluting the founders. For example, let’s say you have negotiated a $2mm investment for your startup at a $5mm pre-money valuation. The investors have requested a 20% option pool. Due to how the option pool is calculated into the pre-money valuation, instead of being valued at $5mm, your startup really has an effective valuation of $4mm ($5mm pre-money valuation – $1mm option pool amount (.20 x $5mm) = $4mm). It is important when negotiating the option pool to present a defined hiring plan to justify an option pool on the lower end of the above range. If the investor is dead set on having a certain percentage being allocated to the option pool, then argue for a higher pre-money valuation so you don’t greatly feel the effects of the option pool dilution.
As always, it is important that you discuss any terms in a term sheet with an attorney who handles these matters. In my next post, we will continue the conversation around important economic terms in a term sheet by discussing the liquidation preference.