The best strategy for not having to fire your co-founders is to not bring them on board in the first place.
One of the most common early-stage startup mistakes is building a weak founding teams. Since a good team is often the closest you can get to a good business plan, this one anti-pattern is the cause of many company failures. Before we dig into why this happens so frequently and what entrepreneurs can do about it, I want to share one of the formative stories from my early days as a VC.
An entrepreneur who should have fired his co-founders
Many years ago, I met a 20-something technical founder who had recently left graduate school with interesting technology in the enterprise search and knowledge management market. Beyond his compelling personality and the technology, he had an impressive approach that allowed him to deliver benefits to users without prior user setup or explicit user actions, using desktop and email client integration. To use a current analogy, it was like Xobni but better.
A week later, he came to Polaris with his founding team. He had three co-founders. They all had grey hair and so-so backgrounds. Over the course of an hour, I learned one of the three was a relative who, after hearing about the idea, pushed himself onto the team as “the business guy” and then promptly brought in a couple of former co-workers as co-founders. The net effect was that a backable founder had become essentially unfundable. I passed on the deal. As expected, the company went nowhere. I am friends with the founder and would like to back him some day.
This is an extreme example, but it underscores the randomness by which founding teams are created. Three disclaimers before we dive into the issues:
I’m not advocating that an entrepreneur goes it alone. Much has been written about the costs and benefits of partners when starting a company. I’m advocating for more thoughtfulness about the building of a founding team and more creativity around how to make progress with limited resources. See Venture Hacks’ post on How to pick a co-founder.
I’m not advocating that what’s best for the company in an abstract sense should trump personal relationships or commitments that have been made. I am advocating for greater care in making commitments and more openness around the balance between business and personal spheres.
I’m focusing specifically on founding teams here, but many of the lessons apply equally well to hiring in very early stage companies (before product/market fit has been proven).
How weak teams get built
Arrogance and ignorance, in small doses, are powerful tools that help entrepreneurs focus and execute against overwhelming odds. In larger doses they make a dangerous poison that kills startups. In most cases, they are the root cause behind weak founding teams.
It’s no secret that startup business plans tend to evolve over time, sometimes substantially. Yet, at any given point along that evolutionary path, many entrepreneurs are over-confident that, this time, the plan will succeed. Then they look at the founding team and, if they think they are missing a key role, they may bring a co-founder on board. This process repeats itself up to the point where either the company converges to what it will likely end up doing in the next few months or the founding team gets to a size that makes additions practically impossible.
I recently met an entrepreneur who started working on a consumer social media idea about a year ago. Thinking he was building a small dot-com, he brought on a college buddy who had done Amazon Web Services work as a chief technical officer (CTO). In a few months, the idea shifted toward working with agencies. He brought in a VP of marketing from the agency space, because he was confident that was where the opportunity was. After a few more months, the team realized there was only a services business in the agency space. Now they are pivoting towards expert identification/collaboration in enterprises, and neither his CTO nor his VPM is right for the team.
The entrepreneur in this example is a smart guy. But he didn’t have enough experience to understand what would be required for a co-founder role over the early evolutionary path of the company. He didn’t fully appreciate the opportunity cost of making these early hires given his limited recruiting network and the pre-product, pre-funding stage of the company. Further, he did not know how to evaluate a VP of marketing. He ended up with a communications-oriented exec who — beyond lacking understanding of the enterprise domain — is not very helpful in general with product marketing issues. This is how ignorance hurts.
What VCs think about bad co-founders
Keep in mind that when you recruit or you pitch investors, they don’t get the benefit of the history that might explain your decisions. Let’s imagine what goes on in a VC’s head:
“Shoot, this is a backable entrepreneur and the idea may have legs but the two other founders are B players and a poor fit for the company at this point. I could talk to the lead founder, but I don’t know about the personal relationships on the team and this can backfire. Also, I don’t want word getting out that I break founding teams. This can hurt my dealflow. Anyway, the CEO showed poor judgment in bringing these people on board. Also, there is still a lot of recruiting work to do whether the team changes happen before or after an investment. Frustrating… this could have been a good seed deal. Now it’s too complicated. I’ll pass using some polite non-reason.”
Agile founding teams
There is a principle in agile development that centers on minimizing wasted effort. One of the cornerstone strategies — supposedly one of Toyota’s rules, too — is to delay decisions until the last responsible moment. Because the future is uncertain, the idea is to make decisions with the most information.The emphasis is on “responsible,” because a lot of procrastination is bad too.
Last week, I wrote about how to raise money without lying to investors with this same principle. The logic also applies to building strong founding teams. Because you don’t know what your startup will end up doing, it can be a big mistake to hire the best people for thispoint in the company’s life.
I am an entrepreneur, and I have team-building problems:
I am not exactly sure what my company will do.
I have limited resources and can’t have many people on my team.
My recruiting network is limited.
My company, especially pre-product and pre-funding, may not be very attractive.
I may not be the best person to evaluate people in _______ and _______.
Ten rules for building agile founding teams
Here are some specific strategies for building founding teams. There are no silver bullets. Some of the advice is contradictory and situation-specific. Caveat entrepreneur.
Network, network, network. Learn how to learn through people. It’s the fastest way to understand a new domain. Value negative feedback. It often carries more information than a pat on the back. Expand your recruiting network, so you get access to better talent.
Set clear expectations. When getting involved with someone, establish the right psychological contract from the beginning. Talk about what might happen if there is a pivot in an unexpected direction.
Go easy on titles. Don’t give out big titles unless you have to and, even then, question why you have to. You can always “upgrade” someone’s title later if they perform well. They’ll appreciate it. On the flip side, big titles can cause many problems when you recruit or raise money.
Structure agreements well. Founders should have vesting schedules with some up-front acceleration. In some cases, you can bestow founding status without giving founding equity with accelerated vesting.
Be honest with and about your team. Get in the habit of discussing team fit with the business plan in an open, non-threatening manner.When you talk to experienced investors or advisors, be honest about the limitations of your team. Most likely they see any warts just as well or better than you, and you can only win by showing you have a firm grip on reality.
Hire generalists early. Hire specialists later.
Hire full-timers reluctantly. You can only have a few of them in the early days, whether they are co-founders or not. Be picky. Don’t fall for the chimera of “If only I hire a __________, then I can _________.” This may be true, but only if the person you hire is perceived to be good and does a good job. The perception of the quality of your team is as important as reality for recruiting and fundraising.
Find experienced part-timers. Sometimes you can get a lot of value out of very experienced people even if they only spend a few hours, or a day, each week with you. The key is to do this over a period of time and build context. Over time, experienced part-time employees can help in the process of building the company. They can help make many decisions — for example, around team-building, financing and the business plan — as opposed to any one decision. This is how I work with startups through FastIgnite. Depending on the situation, I’m an active advisor or co-founder and/or acting CTO. Other people, like Andy Palmer, take on a board or acting CEO role.
Find the right investors. Seek investors who pride themselves on their recruiting abilities and have a track record of helping startups build teams. These investors may see the holes in your team as an opportunity instead of a problem, as long as they feel confident the company is a good recruiting target. Some firms have internal recruiting teams led by experienced former executive recruiters. Examples include Benchmark (David Beirne) and Polaris (Peter Flint). Others, such as General Catalyst and Founders Fund, favor partners who are former entrepreneurs with deep networks and team-building experience.
Fire your co-founders. If you are behind the 8-ball and see your team as a key constraint, you should do something about it. Don’t wait for an investor or someone else to do it for you. The non-CEO co-founders can fire their CEO co-founder, too (or change their role and level of responsibility). This happened at a social commerce startup in the Bay Area I liked. The CEO came up with the idea (kudos to him) but he had enterprise background and provided little value-add. His two co-founders were responsible for most of the progress. It took them too long to reshuffle things. By that point, they’d made a bad impression in front of too many investors. The team fell apart eventually.
If you successfully apply these strategies, you stand a better chance of going after the right people at the right time and bringing top talent on board.
Note: This offer letter includes the follow disclaimer from Wilson Sonsini.
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[Click And Type Date]
[Click and Type Employee]
Dear [Click and Type Employee]:
I am pleased to offer you a position with COMPANY NAME (the “Company”), as its [Click And Type Position]. If you decide to join us, you will receive a monthly salary of $[Click And Type Amount], which will be paid semi monthly in accordance with the Company’s normal payroll procedures. As an employee, you will also be eligible to receive certain employee benefits including [list employee benefits here or “The details of these employee benefits are explained in Exhibit A.”] You should note that the Company may modify job titles, salaries and benefits from time to time as it deems necessary.
***Optional—Vesting Schedule May Differ Too***In addition, if you decide to join the Company, it will be recommended at the first meeting of the Company’s Board of Directors following your start date that the Company grant you an option to purchase [Click And Type Amount] shares of the Company’s Common Stock at a price per share equal to the fair market value per share of the Common Stock on the date of grant, as determined by the Company’s Board of Directors. [Confirm Vesting Schedule] 25% of the shares subject to the option shall vest 12 months after the date your vesting begins subject to your continuing employment with the Company, and no shares shall vest before such date. The remaining shares shall vest monthly over the next 36 months in equal monthly amounts subject to your continuing employment with the Company. This option grant shall be subject to the terms and conditions of the Company’s Stock Option Plan and Stock Option Agreement, including vesting requirements. No right to any stock is earned or accrued until such time that vesting occurs, nor does the grant confer any right to continue vesting or employment.
***Optional***Also, we are offering you reimbursement of relocation expenses for your move from ____________ to ________________, up to a maximum reimbursement of $[amount]. The items for which we offer reimbursement are __________, __________, and __________. (Example: one trip for you and your spouse to do a home search, shipment of household goods, etc.) We will only reimburse for reasonable expenditures which are supported by valid receipts provided promptly to the Company.
The Company is excited about your joining and looks forward to a beneficial and productive relationship. Nevertheless, you should be aware that your employment with the Company is for no specified period and constitutes at-will employment. As a result, you are free to resign at any time, for any reason or for no reason. Similarly, the Company is free to conclude its employment relationship with you at any time, with or without cause, and with or without notice. We request that, in the event of resignation, you give the Company at least two weeks notice.
The Company reserves the right to conduct background investigations and/or reference checks on all of its potential employees. Your job offer, therefore, is contingent upon a clearance of such a background investigation and/or reference check, if any.
For purposes of federal immigration law, you will be required to provide to the Company documentary evidence of your identity and eligibility for employment in the United States. Such documentation must be provided to us within three (3) business days of your date of hire, or our employment relationship with you may be terminated.
We also ask that, if you have not already done so, you disclose to the Company any and all agreements relating to your prior employment that may affect your eligibility to be employed by the Company or limit the manner in which you may be employed. It is the Company’s understanding that any such agreements will not prevent you from performing the duties of your position and you represent that such is the case. Moreover, you agree that, during the term of your employment with the Company, you will not engage in any other employment, occupation, consulting or other business activity directly related to the business in which the Company is now involved or becomes involved during the term of your employment, nor will you engage in any other activities that conflict with your obligations to the Company. Similarly, you agree not to bring any third party confidential information to the Company, including that of your former employer, and that in performing your duties for the Company you will not in any way utilize any such information.
As a Company employee, you will be expected to abide by the Company’s rules and standards. Specifically, you will be required to sign an acknowledgment that you have read and that you understand the Company’s rules of conduct which are included in the Company Handbook. [If Handbook has not yet been adopted add “which the Company will soon complete and distribute.”]
As a condition of your employment, you are also required to sign and comply with an At-Will Employment, Confidential Information, Invention Assignment and Arbitration Agreement which requires, among other provisions, the assignment of patent rights to any invention made during your employment at the Company, and non disclosure of Company proprietary information. In the event of any dispute or claim relating to or arising out of our employment relationship, you and the Company agree that (i) any and all disputes between you and the Company shall be fully and finally resolved by binding arbitration, (ii) you are waiving any and all rights to a jury trial but all court remedies will be available in arbitration, (iii) all disputes shall be resolved by a neutral arbitrator who shall issue a written opinion, (iv) the arbitration shall provide for adequate discovery, and (v) the Company shall pay all but the first $125 of the arbitration fees. Please note that we must receive your signed Agreement before your first day of employment.
To accept the Company’s offer, please sign and date this letter in the space provided below. A duplicate original is enclosed for your records. If you accept our offer, your first day of employment will be [Click And Type Date]. This letter, along with any agreements relating to proprietary rights between you and the Company, set forth the terms of your employment with the Company and supersede any prior representations or agreements including, but not limited to, any representations made during your recruitment, interviews or pre employment negotiations, whether written or oral. This letter, including, but not limited to, its at-will employment provision, may not be modified or amended except by a written agreement signed by the President of the Company and you. This offer of employment will terminate if it is not accepted, signed and returned by [Click And Type Date].
We look forward to your favorable reply and to working with you at COMPANY.
[Click And Type Name]
[Click And Type Title]
“If you decide to join the Company, it will be recommended at the first meeting of the Company’s Board of Directors following your start date that the Company grant you an option to purchase X shares of the Company’s Common Stock at a price per share equal to the fair market value per share of the Common Stock on the date of grant, as determined by the Company’s Board of Directors.”
You don’t get your options until the board grants them at the next board meeting. But they should start vesting on your start date.
The strike price is equal to the fair market value as of the grant date (sometime after the next board meeting). But that probably won’t be higher than the FMV as of your first day of work.
“This option grant shall be subject to the terms and conditions of the Company’s Stock Option Plan and Stock Option Agreement.”
These are big documents that you’re agreeing to without seeing. If you’re concerned, request copies before you sign your employment offer.
“Moreover, you agree that, during the term of your employment with the Company, you will not engage in any other employment, occupation, consulting or other business activity directly related to the business in which the Company is now involved or becomes involved during the term of your employment, nor will you engage in any other activities that conflict with your obligations to the Company.”
The company isn’t forbidding you to work on your own business on the side.
Get a lawyer to advise you on what you need to do to own your side business. At a minimum, work on the side business on your own time and don’t use anything owned by the company.
“As a condition of your employment, you are also required to sign and comply with an Invention Assignment Agreement (enclosed) which requires, among other provisions, the assignment of patent rights to any invention made during your employment at the Company.”
These Invention Assignment Agreements always seem too far-reaching but they’re rarely negotiated, especially if they’re coming from one of the major Silicon Valley law firms.
The Invention Assignment Agreement usually asks employees to carve out the IP they developed before joining the company by listing it in an exhibit. If you’ve developed a lot of IP that is relevant to the business, you might want to ask the company to list its IP instead of, or in addition to, yours.
At-Will Employment and Sundry Items
“You should be aware that your employment with the Company is for no specified period and constitutes at-will employment. As a result, you are free to resign at any time, for any reason or for no reason. Similarly, the Company is free to conclude its employment relationship with you at any time, with or without cause, and with or without notice.”
This is an offer letter, not a 5-year contract with the Chicago Bulls.
“You should note that the Company may modify job titles, salaries and benefits from time to time as it deems necessary.”
You have no job security.
“This offer of employment will terminate if it is not accepted, signed and returned by such-and-such date.”
This offer expires soon.
“This letter, along with any agreements relating to proprietary rights between you and the Company, set forth the terms of your employment with the Company and supersede any prior representations or agreements including, but not limited to, any representations made during your recruitment, interviews or pre-employment negotiations, whether written or oral.”
If it isn’t in this agreement, it isn’t happening, even if we told you it was.
Related: I have a job offer at a startup, am I getting a good deal? Part 1 and Part 2.
6. How much money do you have in the bank right now? How long will it last?
Investors call this runway.
If you’re making an essential contribution to the business, you should have a job as long as the company has runway.
Whether you’re essential depends on what the business needs today; e.g. assistants, recruiters, and salesman might not be essential if the company hasn’t finished building a product yet.
7. What was the company’s post-money valuation in the last round?
Let’s say the company’s post-money valuation in the last round was $10M. If the company is acquired for $100M, the acquisition value of your options should increase roughly 10x, assuming the company didn’t incur any dilution after the last round.
8. What are the investor’s preferences?
If the acquisition price isn’t greater than the investor’s preferences, the common stockholders won’t see a penny when the company is sold.
So don’t join a company with $100M in preferences unless you expect the business to sell for a lot more than $100M.
9. Who is on the board and whom do they represent?
Besides the CEO, the board has the greatest opportunity to increase or destroy the value of the company’s shares.
10. Would I hire the CEO and board to increase the value of my options?
The CEO and the board can easily destroy the value of your options through incompetence and/or greed. You need to ask yourself:
Would I hire the CEO and board to increase the value of my options? Identifying great people is an aesthetic skill, like seeing the beauty in a painting. Most of us don’t have this skill. And those of us who do still get it wrong a lot. Get help from someone who knows how to identify great people.
Do I trust the CEO and board to treat my options like their own? Don’t join the company if you don’t trust the CEO and board to avoid opportunities to treat their stock better than yours.
“Let’s work out the major points and we’ll give you a written offer. We don’t want to start things off on the wrong foot with an offer that is way off the mark.”
2. How does my compensation compare to my peers in the company?
Some companies pay more, some companies pay less, but an offer is fair if your compensation is in line with you peers’.
Your total compensation consists of salary, options, vesting, cliff, acceleration, bonuses, and severance. And a peer is someone who (1) joined the company at roughly the same time as you did (e.g. halfway between the Series A and Series B) and (2) has roughly the same title you do.
Most employees have a 4-year vesting schedule with a 1-year cliff, no acceleration, no bonuses, and no severance. The exceptions are for Vice-Presidents and higher (and founders).
By the way, your cliff may be longer than the company’s runway, but c’est la vie.
3. What are my options worth?
First you have to know how many options you have and how they vest. Let’s say you have 1000 options and they vest over 4 years. So you get 250 options a year for 4 years.
Now you have to guess what an acquirer would pay for your shares. Let’s call this the acquisition share price. Setting the acquisition share price to the preferred share price of the last round is a good start—let’s say it was $1/share.
Now multiply your options (1000) by the acquisition share price ($1) to calculate the acquisition value of your options: $1000. Since the options vest over 4 years, the annualized acquisition value is $250/year. And while the acquisition value of your options might be $1000 today, you’re naturally hoping that the company’s acquisition share price increases over time.
If the company has gained a lot of value since the last round, you might set the acquisition share price higher than the preferred share price. If the company has not has not done well since the last round, you might set it lower. Either way, you will have to ask the company for the preferred share price in the last round. Or if someone has offered to buy the company for $50M since the last round, I might use $50M to calculate an acquisition share price.
Finally, you will have to pay for your options—they’re not free. Options have a strike price—that’s what you pay for your options. Sometimes it’s much lower than the acquisition share price and can be ignored. Sometimes it’s high and can’t be ignored—high strike prices are becoming more common due to high-valuation rounds (Facebook), founder cash-outs, and high 409A valuations.
Most people think this number is important—it’s not. You care about the value of your options, not your percentage of the company. Your percentage will decline over time but the value of your options will hopefully increase.
This is for advanced Venture Hackers only. Don’t do this without an accountant and/or lawyer.
Exercise your options early if you want to start the clock on capital gains tax eligibility for your stock. Startup pros usually exercise their options early to lower the expected value of the taxes on their stock. In certain cases, you will pay less taxes in an acquisition or IPO if you exercise your options early.
Use an accountant or lawyer. Don’t sue us if this blows up in your face.
Mike Cassidy‘s talk on building companies fast is a must-read for all entrepreneurs:
(The slides are here if you don’t see them embedded above.)
Mike founded Stylus Innovation (sold 2 years after launch for $13M), Direct Hit (sold 500 days after launch for $500M), and Xfire (sold 2 years after launch for $110M). Mike is currently the CEO of travel guide and tour review site Ruba.
“Nearly 100% of the investors interviewed believe that they add value to their portfolio companies. Unfortunately… only 45% of the entrepreneurs interviewed indicated that they believe that was the case.”
“Investors provide leads to a significant subset of hired executives (an average of 18% of executive hires). However, they trail both the non-CEO members of the management team (who referred, on average, 29% of executive hires) and CEOs (36%).
“The major exceptions were for the CEO and CFO positions, for which the percentages [for investor leads] jumped to 28% and 30%.”
Translation: investors refer 18% of hired executives, employees refers 65%, and “other sources” refer the remaining 17%.
Hire investors for money-add and employees for value-add.
This data is consistent with our advice: hire investors for their money-add. Investors do add value, but you should assume their primary contribution will be money. Most of your value-add will come from employees, not investors.
Find an investor who will make an investment decision quickly, who is humble and trustworthy, who will treat you like a peer, who shares your vision, and is betting on you, not the market. If you’re lucky enough to find more than one of these investors, you can start thinking about which one will add the most value.
Ignore the averages: How will your investors help you?
Finally, this survey is really interesting, but it measures averages. You don’t care how the average investor helps the average entrepreneur. You care about how your investor will help you. And the only way to figure that out is by referencing your investors.
We’re looking for a one (wo)man developer army who wants to work with Venture Hacks to build our next product. It’s in a $25 billion market filled with lame products and unsatisfied customers. This is a founder-level role for the right person.
We’re also offering a $1000 referral bounty if we hire someone you refer.
Naval and I have started companies like Epinions and Songbird where we’ve raised $100M+ from investors like Sequoia. Read our full bios for the whole story.
Now, we’ve gone crazy for helping entrepreneurs build their businesses. You already know about our first product: Term Sheet Hacks. The hacks will keep coming—unsolicited reviews from the founders of Flixster and ‘Hot or Not’ call the hacks “much needed” and “fantastic”.
The next Venture Hacks product is going to serve a $25 billion market and make it even easier for entrepreneurs to raise money. It’s going to be a lot of fun to build it and take over the universe (or something smaller like a galaxy).
Contribution: Work with us to build a great user experience and back-end. Social software experience is a plus. Full-time or consulting works for us. Develop with whatever tools and language you think are best for the project.
Compensation: Salary is above market and stock is way above market. This is a founder-level role for the right person.
Contact: Send links to your best work to firstname.lastname@example.org. Please include one or two sentences that describe why you have a high level of ability.
Summary: Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.
If you don’t keep your eyes on the option pool while you’re negotiating valuation, your investors will have you playing (and losing) a game that we like to call:
Option Pool Shuffle
You have successfully negotiated a $2M investment on a $8M pre-money valuation by pitting the famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has created $8M of value.
Your teammates ask what their shares are worth. You explain that the company currently has 6M shares outstanding so the investors must be valuing the company’s stock at $1.33/share:
$8M pre-money ÷ 6M existing shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00… this must be a mistake! Reading on, the term sheet states, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”
You call your lawyer: “What the fuck?!”
As your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?”
If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost you millions of dollars of effective valuation. Don’t lose this game.
The option pool lowers your effective valuation.
Your investors offered you a $8M pre-money valuation. What they really meant was,
“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call their sum your $8M ‘pre-money valuation’.”
For all of you MIT and IIT students out there:
$6M effective valuation + $2M new options + $2M cash = $10M post
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.33/share to $1.00/share:
$8M pre ÷ (6M existing shares + 2M new options) = $1/share.
Update: Check out our $9 cap table which calculates the effect of the option pool shuffle on your effective valuation.
The shuffle puts pre-money into your investor’s pocket.
Proper respect must go out to the brainiac who invented the option pool shuffle. Putting the option pool in the pre-money benefits the investors in three different ways!
First, the option pool only dilutes the common stockholders. If it came out of the post-money, the option pool would dilute the common and preferred shareholders proportionally.
Second, the option pool eats into the pre-money more than it would seem. It seems smaller than it is because it is expressed as a percentage of the post-money even though it is allocated from the pre-money. In our example, the new option pool is 20% of the post-money but 25% of the pre-money:
$2M new options ÷ $8M pre-money= 25%.
Third, if you sell the company before the Series B, all un-issued and un-vested options will be cancelled. This reverse dilution benefits all classes of stock proportionally even though the common stock holders paid for all of the initial dilution in the first place! In other words, when you exit, some of your pre-money valuation goes into the investor’s pocket.
More likely, you will raise a Series B before you sell the company. In that case, you and the Series A investors will have to play option pool shuffle against the Series B investors. However, all the unused options that you paid for in the Series A will go into the Series B option pool. This allows your existing investors to avoid playing the game and, once again, avoid dilution at your expense.
Solution: Use a hiring plan to size the option pool.
You can beat the game by creating the smallest option pool possible. First, ask your investors why they think the option pool should be 20% of the post-money. Reasonable responses include
“That should cover us for the next 12-18 months.”
“That should cover us until the next financing.”
“It’s standard,” is not a reasonable answer. (We’ll cover your response in a future hack.)
Next, make a hiring plan for the next 12 months. Add up the options you need to give to the new hires. Almost certainly, the total will be much less than 20% of the post-money. Now present the plan to your investors:
“We only need a 10% option pool to cover us for the next 12 months. By your reasoning we only need to create a 10% option pool.”
Reducing the option pool from 20% to 10% increases the company’s effective valuation from $6M to $7M:
$7M effective valuation + $1M new options + $2M cash = $10M post
70% effective valuation + 10% new options + 20% cash = 100% total
A few hours of work creating a hiring plan increases your share price by 17% to $1.17:
How do you create an option pool from a hiring plan? #
To allocate the option pool from the hiring plan, use these current ranges for option grants in Silicon Valley:
5 – 10
2 – 5
1 – 2
Independent Board Member
0.4 – 1.25
0.5 – 1
5+ years experience Engineer
0.33 – 0.66
Manager or Junior Engineer
0.2 – 0.33
These are rough ranges – not bell curves – for new hires once a company has raised its Series A. Option grants go down as the company gets closer to its Series B, starts making money, and otherwise reduces risk.
The top end of these ranges are for proven elite contributors. Most option grants are near the bottom of the ranges. Many factors affect option allocations including the quality of the existing team, the size of the opportunity, and the experience of the new hire.
If your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.
Bring up your hiring plan before you discuss valuation.
Discuss your hiring plan with your prospective investors before you discuss valuation and the option pool. They may offer the truism that “you can’t hire good people as fast as you think.” You should respond, “Okay, let’s slow down the hiring plan… (and shrink the option pool).”
You have to play option pool shuffle.
The only way to win at option pool shuffle is to not play at all. Put the option pool in the post-money instead of the pre-money. This benefits you and your investors because it aligns your interests with respect to the hiring plan and the size of the option pool.
Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t work.
Your investor’s norm is that the option pool goes in the pre-money. When your opponent has different norms than you do, you either have to attack his norms or ask for an exception based on the facts of your case. Both straits are difficult to navigate.
Instead, skillful negotiators use their opponent’s standards and norms to advance their own arguments. Fancy negotiators call this normative leverage. You apply normative leverage in the option pool shuffle by using a hiring plan to justify a small option pool.
You can’t avoid playing option pool shuffle. But you can track the pre-money as it gets shuffled into the option pool and back into the investor’s pocket, you can prepare a hiring plan before the game starts, and you can keep your eye on the money card.