INVESTORS REAP WINDFALLS FROM THE TREATMENT OF OPTION POOLS

Last week I met with representatives of a technology client contemplating a Series A venture capital financing. In discussing the company’s cap structure, they asked me how big the stock option pool should be. Like a lot of clients, they wanted to make sure that the stock option pool is sufficient to compensate their employees. In their view, the bigger the option pool, the better.
The benefits of equity compensation are obvious to most readers. But there is a hidden downside to having an oversized option pool. In a typical VC transaction, a larger option pool results in the issuance of more shares to the investor. The formulas that determine how many shares are issued to an investor assume that every option reserved for issuance in an option pool will be issued, and that every option or warrant that has been issued will be exercised.

These assumptions rarely prove to be true. A company may not issue all options contemplated by the pool. And even if all options are issued, they probably won’t all be exercised; employees quit or are terminated prior to vesting or without exercising. Arguably, a formula that grants the investor a percentage of all shares that have been issued or might be issued usually overstates the number of shares that should be issued. This means that the founders keep a smaller percentage of their company’s equity.
To address this windfall, the company could seek provisions that count only issued and outstanding options in determining the number of shares issuable to the investor. Even if the issuer cannot prevail on these provisions, it can exercise restraint in issuing options and it can push back on demands for an oversized option pool.

How Sausage is Made
This blog posting will demonstrate how this windfall occurs. Warning: The analysis that follows may not be interesting to you unless your company is planning to issue stock or make an investment. My feelings won’t be hurt if you stop reading here.
The calculation of the number of shares to be issued to an investor begins with the “pre-money valuation” (the valuation of the company before an investment is made). A higher valuation means that the investor’s percentage of the company’s equity will be lower. This means that the founders can keep more. (On the other hand, the Facebook IPO is one example of the negative effect of pricing your stock too high.)
It shouldn’t be surprising that the company and its prospective investors often disagree about the “pre-money valuation.” This disagreement is exacerbated when the company lacks a financial track record, or a history of profits or even revenues. In a subsequent blog posting I will address the topic of valuation. But for now, let’s assume that the company and the investors can reach agreement on the pre-money valuation.

The following is the formula for determining the investor’s percentage interest (that is, the investor’s percentage of the company’s stock):
Percentage Interest = Amount of Investment divided by (Amount of Investment plus the Pre-Money Valuation).
If for example a company desires to raise $5 million, a $5 million pre-money valuation will result in the investor’s receipt of a 50% interest ($5 million divided by $10 million). This means that the investor will receive the percentage of all of the company’s stock determined using the above formula. (Although venture capitalists typically receive preferred stock that is convertible into common stock, for simplicity let’s look at the numbers as if the preferred stock had been converted.)
Stock options and the stock option pool are almost as important as valuation in determining what the founders are able to keep after the investment. The number of shares of stock issuable to the investor is determined on a fully diluted basis. That is, all shares that are issuable upon the exercise of options and the conversion of convertible preferred stock and debt must be included in determining the number. If in the above example the investor is to have a 50% interest, the number of conversion shares must equal 50% of the issued and outstanding shares of all common stock (including conversion shares), on a fully diluted, as converted basis.

To determine the number of conversion shares to which the investor is entitled, the company must calculate the total number of shares of common stock, assuming that all holders of warrants and options exercised their rights. In the 50% example above, if the company had 1 million outstanding shares of common stock, and warrants and options for another 500,000 shares, 1.5 million shares would be deemed issued. To receive a 50% interest, the investor would require preferred stock convertible into 1.5 million shares of common stock. While this is 50% of all shares on an as-converted basis, it would actually represent 60% of the outstanding shares at issuance. (1.5 million shares out of 2.5 million issued.)
In most cases the investor doesn’t object to the fact that an issuer has outstanding options and warrants; they have already been taken into account in determining how many shares the investor receives. But VCs (and other sophisticated investors) are even more aggressive. They often encourage the company to accommodate future issuances of stock options by reserving a percentage of its shares for an employee stock option pool, typically 15% to 20% of its common stock. This appears to favor the company by acknowledging the necessity of employee stock options; the company won’t have to seek the investor’s approval every time it wants to issue stock options. But in reality this is a mechanism for increasing the number of shares issuable to the investor, thereby increasing the investor’s percentage of outstanding stock.

To illustrate, let’s say that, in the example above, the company were required to reserve an option pool of 500,000 shares. The investor would receive 2 million conversion shares (50% of the sum of (i) the investor’s 2 million conversion shares plus (ii) 1 million outstanding shares plus (iii) 500,000 existing options and warrants plus (iv) the 500,000 reserved and unissued employee stock options). Now the investor holds two-thirds of the outstanding shares (2 million out of 3 million).
If all of the reserved options are issued to employees, and all of those options and the previously issued option and warrants are exercised, the investor would end up with 50% in the long run (without giving effect to any future investments). But that almost never happens. It is highly likely that some or all of the employee stock options may never be issued and even the issued options may not vest or may be forfeited, even if “in the money.” For example, if only 250,000 (of the 500,000) options are issued and outstanding as of liquidation, the venture capitalist has received a windfall of 250,000 more conversion shares than it would have.

To address this windfall, the company could seek provisions that count only issued and outstanding options in determining the number of shares issued on conversion of the investor’s preferred stock. I have had some success with this. But, not surprisingly, most sophisticated investors will argue strenuously against these techniques. The issuer may not be able to prevail on these provisions, but it can exercise some control over the number of options and warrants that it issues and it can push back on demands for an oversized option pool.