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As we saw in the pricing discussion above, the difference between a calculation based on issued and outstanding shares versus fully diluted shares can be significant. The option pool is typically the biggest component of the difference between issued and outstanding and fully diluted shares, and so the size of that option pool tends to get a lot of scrutiny at the time of any investment.
As a company hires employees, it issues grants of options on the stock that is reserved for the stock option pool, thereby slowly depleting that pool. It is common that a company has to top up its stock option pool several times as it grows from no employees to dozens, to hundreds, to potentially thousands. It increases the pool by allocating shares from the company’s authorized stock. When the company adds more shares to the option pool, it dilutes all the existing stockholders (when using the fully diluted ownership calculation). It is a round of dilution without directly bringing in any money (the way a stock sale to investors does). So companies aren’t anxious to top up the pool by themselves.
Savvy investors know that the company should have a healthy stock option pool so it can motivate the new employees it wants to hire with the money it is raising. So as part of almost any priced investment round there is a discussion about how big the pool should be and who is going to take the dilution hit. New investors want to allocate additional shares to the pool in a way that dilutes the existing equity holders before the new investors come in. The company would prefer if the option pool were topped up after the new money came in, as the dilution to the founders and prior investors would be less because the new investors would be sharing in that dilution.
exampleBelow is an example of how Figure A2 would change if the Round 2 investors had insisted that they are buying 20% for their $750K, and they still agree to the $3M pre-money, but now they also insist that the stock option pool be topped up to 15%. If you look back to Figure A2, you will see that the stock option pool is down to 6.43% post investment if it is not addressed. Because the investors have established their 20% post investment ownership (on a fully diluted basis) as part of their investment terms, the full burden of the dilution in this case is borne by the founders and existing investors (and existing employees). The founders go from 55.65% ownership post investment to 49.17%. A big difference. The investors for their part get more shares, 473,942 more, because they require 20% of a larger total of fully diluted shares now.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 57.84% | 49.17% |
| Employees | 345,000 | 2.00% | 1.70% |
| Round 1 Investors | 2,875,000 | 16.63% | 14.14% |
| Round 2 Investors | 4,067,692 | 23.53% | 20.00% |
| Issued and Outstanding | 17,270,000 | 100.00% | |
| Option Pool | 3,050,000 | 15.00% | |
| Total Fully Diluted | 20,337,692 | 100.00% |
Because the investors are now buying more shares for their $750K, the price per share goes down. Another way to think about this is that the investors insisted that the option pool be topped up before they invested. Topping it up required more shares. The option pool prior to the investment had to be increased to 18.75%, so that after the dilution of that option pool by the 20% ownership stake from Round 2, it would be 15%. The price per share in this example is
This is what the investors are paying divided by the number of shares they are receiving; or, using our standard formula of the pre-money valuation divided by the number of fully diluted shares immediately before they invest (after the top up):
The good news is, despite all the dilution suffered by the founders and the Round 1 investors by the savvy Round 2 investors, the price per share has more than doubled from $.087 at Round 1 to $.184 at Round 2. This is a function of the company hitting its milestones and driving up the pre-money valuation.
As an investor, you would like the company to top up the option pool before you invest. We hope that with this understanding of the impact on founders and the prior investors (which may include you or your fellow angels), you will appreciate why the existing stockholders want the new investors to share the burden of increasing the option pool.