Without sounding too much like a finance textbook, an option is a contract that allows the owner of the option to purchase a common share of a company at some point in the future for a pre-determined price.
There are two important terms to know:
1.) Options Granted – these are options already awarded to employees and others
2.) Options in Pool Available for Grant – these are options that remain in the option pool and are available to be awarded in the future
Why do VC’s care about options? We want the team at the startup to be highly incentivized to make the company succeed. Also, it’s an important part of the compensation package for new hires.
From a modeling perspective, at Canaan we treat options as if they were shares.
Options “Baked” into the Pre-Money
When funding a new round, options can either be issued immediately prior to the round or created in the round itself. In most cases, new investors will ask that a certain sized option pool (usually 5-15%, depending on stage) be created before an investment occurs. When the options are issued immediately before the round, the founders and existing investors feel all of the dilution associated with the option pool creation. This approach is the most common and is called having the options “baked into the pre-money.”
Options Created in the Round
In some cases, new investors allow the options to be created as part of the round, which is less ideal for the new investors because they also experience the dilution associated with the option pool creation. This approach is much less common and is often used out of necessity. For example, sometimes a company’s founders already have so little ownership, that an option pool created in the pre-money would dilute them to nearly 0% ownership. In this case, it makes sense to create the options in the round.
Check out the attached worksheet that highlights how option modeling works when the options are “baked” into the pre-money valuation vs. when they are created in the round. Notice that the dilution is felt by the founders (75% ownership à 65% ownership) the most when the options are “baked” into the pre. But don’t stress out – these options are given back to employees over time so it’s not as bad as you may think.