Where the pool is topped up decides who pays for it. Four lines of cap table arithmetic, and why the higher headline valuation can be the worse offer.
When a term sheet requires the option pool to be topped up inside the pre-money, the effective pre-money is the headline minus the post-money value of the pool. A 15 per cent pool on an 8.0 million pre-money and 2.0 million round leaves an effective pre-money of 6.5 million, a share price 14.5 per cent lower, and founders holding 59.87 per cent instead of 61.98 per cent if the pool were created after the round.
Worked in full in The Venture Capital Associate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
This is the option pool shuffle. It is not a trick so much as a convention, and every seed and Series A term sheet makes a choice about it. The arithmetic takes four lines, and anyone reading a term sheet or a cap table should run it before comparing two offers on their headline valuations.
| Input | Value |
|---|---|
| Headline pre-money valuation | 8,000,000 |
| New investment | 2,000,000 |
| Post-money valuation | 10,000,000 |
| Founders' shares | 7,000,000 |
| Angels' shares | 600,000 |
| Existing unallocated pool | 400,000 |
| Fully diluted shares before the round | 8,000,000 |
| Unallocated pool required after the round | 15% |
The investor wants 20 per cent for 2.0 million, and wants 15 per cent of the post-round company sitting in an unallocated pool. The founders and angels keep what is left, 65 per cent, and it is their 7,600,000 shares that fix the size of the company:
In Excel: =(Founders+Angels)/(1-Inv/Post-PoolPct) for N, then
=Post/N for the price.
The effective pre-money is what the round actually pays for the shares that existed before it, net of the pool: 0.8553 × 7,600,000 = 6.5 million. The short form is the one to remember: effective pre-money = headline pre-money − pool % × post-money, so 8.0 − 15% × 10.0 = 6.5.
If the pool is topped up after the investor comes in, the price is set on the existing 8,000,000 shares: 8,000,000 / 8,000,000 = 1.0000 a share, and the investor buys 2,000,000 shares. The pool is then enlarged so that it is 15 per cent of the total, which needs 1,294,118 new shares, and everyone is diluted by it, the investor included.
| Holder | Pool in pre-money | Pool after the round | No top-up |
|---|---|---|---|
| Founders | 59.87% | 61.98% | 70.00% |
| Angels | 5.13% | 5.31% | 6.0% |
| New investor | 20.00% | 17.71% | 20.00% |
| Unallocated pool | 15.00% | 15.00% | 4.0% |
| Price per share | 0.8553 | 1.0000 | 1.0000 |
| Total shares | 11,692,308 | 11,294,118 | 10,000,000 |
Read the investor row. Put the pool after the round and the investor ends at 17.71 per cent, not the 20 per cent it paid for. That is why investors insist on the pre-money convention: it makes the pool dilute only the existing holders. The founders' cost is 2.11 points of the company, and the price discount is 14.5 per cent.
The angels pay too. Their 600,000 shares fall from 6.0 per cent with no top-up to 5.13 per cent with the pool in the pre-money, against 5.31 per cent if the pool came after the round. Anyone who holds shares before the round, including employees with vested options and earlier investors, shares the cost in proportion. It is the founders who notice, because their stake is the largest, but a seed fund that holds through the Series A is on the same side of the table.
| Pool required | Effective pre-money | Price per share | Founders, pool in pre | Founders, pool after | Gap |
|---|---|---|---|---|---|
| 10% | 7.00m | 0.9211 | 64.47% | 65.62% | 1.15 pts |
| 15% | 6.50m | 0.8553 | 59.87% | 61.98% | 2.11 pts |
| 20% | 6.00m | 0.7895 | 55.26% | 58.33% | 3.07 pts |
Each 5 points of pool takes 0.5 million off the effective pre-money. If the hiring plan for the next eighteen months needs only 10 per cent, a 15 per cent pool costs the founders 4.61 points of ownership, and the unused options stay in the pool to dilute everyone at the next round. The negotiation that matters is rarely the headline valuation; it is the size of the pool, justified hire by hire.
To deliver a true 8.0 million pre-money with a 15 per cent pool inside it, the headline would have to be 9.76 million: (8.0 + 15% × 2.0) / (1 − 15%). The gap between the two headlines, 1.76 million, is the post-money value of the pool that the existing holders fund.
Comparing term sheets on headline pre-money. An offer at 8.0 million with a 10 per cent pool has an effective pre-money of 7.00 million; an offer at 8.5 million with a 20 per cent pool has 8.5 − 20% × 10.5 = 6.4 million. The higher headline is the worse deal. The second mistake is counting the existing unallocated pool as if it were founders' equity: the 400,000 unissued options at 5 per cent of the pre-round company are already part of the shuffle, and the top-up only needs to cover the difference.
The cap table and the conversion, headline against reality, is one of the working documents on the companion page of The Venture Capital Associate, with the free workbooks for its cases. For the preference stack that sits on top of these percentages at exit, see when non-participating preferred converts.
It is the practice of requiring the employee option pool to be created or enlarged before the new money comes in, so that it is counted in the pre-money valuation. Only existing holders are diluted by it. On an illustrative 8.0 million pre-money with a 15 per cent pool and a 2.0 million round, the price per share falls from 1.0000 to 0.8553.
Subtract the post-money value of the unallocated option pool from the headline pre-money. With a 15 per cent pool and a 10.0 million post-money, 1.5 million comes off an 8.0 million headline, leaving 6.5 million. It is the price the round actually pays for the shares that existed before it.
No. An illustrative offer at 8.0 million with a 10 per cent pool has an effective pre-money of 7.00 million, while one at 8.5 million with a 20 per cent pool has only 6.4 million. Founders should compare offers on effective pre-money and on their fully diluted ownership after the round.
This article is one calculation from The Venture Capital Associate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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