Valuation and Option Pool. One of the more contentious things in the negotiation between an entrepreneur and a VC over a financing, particularly an early stage financing, is the inclusion of an option pool in the pre-money valuation. As my friend Mark Pincus likes to say, "it's just another way to lower the price". I'll accept that critique. And take it one step further. The option pool is absolutely a piece of the price negotiation. But it is a very important one as I'll explain. But first, let me lay out a few things for those who aren't well versed in these matters. The pre-money valuation is the value of the company before the money comes in.
But to the entrepreneur it might be a lot more dilutive due to the inclusion of the option pool in the pre-money valuation. In the case of the $5mm post money valuation, that means there needs to be $750,000 worth of options in the pre-money valuation. I am sure I lost a few of you on all of that math. I'll wrap with a true story about this provision. Comparing term sheets « HighContrast. Comparing term sheets Jeff Bussgang did a guest post on PEHub on the topic of how entrepreneurs should look at and compare competing term sheets. Jeff correctly points out that the pre-money valuation of the company is not what entrepreneurs should focus on exclusively because the pre-money includes an option pool, which is under board control.
Instead, he suggests that entrepreneurs should look at “the promote” which is the ownership of the founders * the post money as an indication of how good a deal they got. In his example he compares a 6 on 7 offer with a 20% pool with a 6 on 9 offer with a 30% pool. The promote in the first case is $4.4M (34% of 13M post) and in the second it is $4.5M (30% of $15M post). This all makes sense–focusing on ownership as opposed to pre-money valuation is important but I disagree that “the promote” is the key financial metric to focus on when comparing term sheets. Typically, if things go OK, that’s ownership-at-exit * exit-value. Like this: Inc. – True Pre-Money. One of the common areas of misunderstanding, and therefore conflict, in financing negotiations has to do with the relationship between the pre-money valuation and the option pool. Investors want the company to have an adequate option pool for future hiring and it is customary to include the pool in the pre-money valuation.
Some entrepreneurs see this as nothing more than a veiled attempt at lowering the value of the company. Well, yes and no. No in that investor aren’t actually lowering the value of the company as the option pool is net new–it comes on top of what they value the company at. Yes in that investors wouldn’t be willing to do a deal at the same pre-money valuation without the option pool. Fred Wilson has a good introductory post on options and valuation, which prompted me to put together this simple valuation calculator. First, the math, which assumes this is the first round of financing. Deal engineering. Follow @simeons to get notified about new tools for entrepreneurs. Spreadsheet programs. Entrepreneur Corner Roundup: Firing your customers and looking b. A Year of Heavy Losses - Interactive Graphic.