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Jon Bradshaw & Peter Harris

Welcome to another episode of , where hosts and delve into the intricacies of the startup world. In this episode, the hosts share their thoughts on a unique strategy to network within the startup ecosystem, emphasizing the importance of delegation for seasoned professionals. They discuss the challenges and benefits of empowering an admin to connect with key players, creating a ripple effect that streamlines networking efforts.

What Is An Option Pool?

Welcome to another episode of Venture Capital podcast, where hosts John Bradshaw and Peter Harris delve into the intricacies of the startup world. In this episode, the hosts share their thoughts on a unique strategy to network within the startup ecosystem, emphasizing the importance of delegation for seasoned professionals. They discuss the challenges and benefits of empowering an admin to connect with key players, creating a ripple effect that streamlines networking efforts.

The hosts also issue a disclaimer, making it clear that their discussions are not legal, financial, or investment advice. They then transition to a comprehensive exploration of a critical yet often misunderstood topic: option pools. Focusing on the dynamics of options, the hosts break down the concept, its role in compensation, and the tax advantages associated with using options to reward employees in startup environments.

Moving forward, the hosts address various aspects of option pools, including their size, negotiation during fundraising rounds, and the percentages allocated to different stakeholders. They demystify the complexities surrounding stock options for employees, shedding light on the percentage range based on roles, company stages, and other factors.

As the conversation unfolds, the hosts touch upon vesting schedules and their significance, stressing the importance of having a structured plan in place. They share insights into common pitfalls and misunderstandings related to stock options, guiding listeners on the intricacies of exercising, pricing, and potential risks involved.

The episode reaches its climax as the hosts shift gears to discuss option pool refreshes, explaining when and why companies choose to replenish their option pools. Finally, the hosts cap off the episode with a fascinating exploration of how exits, whether through IPOs or acquisitions, impact individuals holding stock options. They navigate through automatic conversions, exercising options, and the potential financial outcomes for employees during exit events.

Tune in for a deep dive into the often-overlooked world of option pools and gain valuable insights into navigating the startup landscape. Remember, this is not financial advice, but a candid conversation from industry experts. Subscribe to Venture Capital for more episodes and stay informed about the ever-evolving startup ecosystem.

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Episode Transcript

Peter: I was thinking about this on my drive home today.
Jon: Okay.
Peter: I should tell me what you think of this idea. I should get an ad. Men whose job it is to. I'm going to take everybody on near like a AI-Utah list, for example. Yeah. I reach out to all of them and invite them to lunch. Right. And then I'm going to ask them, like, how I can be helpful and I'll take some notes on that.
Peter: And then also, like, who can they introduce me to? That's somebody that they like hugely respect, right? So then that all goes back to my ad men. And my ad men then uses that to set up, like, the next appointments and meetings for me.
Jon: Okay. Do it. I'm at a point in my career that I don't start anything new. If I can't delegate and train someone how to do the spot.
Peter: Nine out my.
Jon: I know my focus for my next ten years should not be what can I do myself and muscle my way through. But who can I bring in and have them do it and they can't? It's a no go.
Peter: It's a no go. Smart. I should get.
Jon: Heart to heart. It's a very hard brain transition.
Peter: It is. Well, part of it is I'm a perfectionist, and people just don't do things as well as I do.
Jon: Okay.
Peter: But I read somebody said this the other day. Maybe it was like Cody Sanchez or somebody. I don't know. But. But they were like. They were like, if you fall into that trap, what you need to realize is that, like, let's say you find somebody and they can only do things like 75% as good as you can. The answer is you hire two of them and now you're getting 150% of the value of what you could do.
Jon: I don't think that.
Peter: I don't think it scales quite that well. But it was an interesting idea. And I was like, that's pretty fair.
Jon: Texting the founder now that you told me to.
Peter: I told them to what?
Jon: Well, you just brought this up, so it's like, I get involved with that individual.
Peter: Take like, go grab lunch or something nice. Nice.
Jon: All right. So for this episode, just for a disclaimer, this is not legal advice is not financial advice. We're not your accountants. We're not your financial planners or investment advice. But what? So what kind of spurred this topic? We're going to talk about what is an optional pool. But specifically, I think options, whether you're an employee at a nonpublic company or you're a start up, is probably one of the least understood topics.
Jon: I think one of the caveats I want to do a quick sidestep before we get into what an option pool is, is Well, I don't know. So it's if when you join a company, if you if you if the value of the options were zero, would you still take the offer? That's generally my advice for anything option related.
Jon: I want to go just.
Peter: Because you have no faith in the success of startups.
Jon: No, I have faith in the success of startups.
Peter: You just don't think that their equity is going to be worth anything.
Jon: I know any company that gets more than a million in revenue, one out of ten may provide some type of outcome or dividend right? So doesn't matter how good the team is, it could be market like a lot about startups is market timing. It doesn't matter to the greatest team in the world. Part of its time means part of it serendipitous.
Jon: It's a lot of work, a lot of work, and I think people constantly underestimate it or they see successful founders and think, I could do that. I don't think they realize how much muscling through problems you have to do. Again and again and again, it never really gets easier. And if you are successful, the challenges, your problems are and your work environments are always changing.
Jon: And so you have to be dynamic to solve all of these different types of curveballs that come your way. It's not how I get better at this. Now it's get 2% better. You're constantly facing different things. Anyways, let's talk about option pools. What is an option for Peter? Let's see. How will you understand this topic?
Peter: All right. And option Pool is a series of options that are set aside for employees and founders to receive as compensation. You know, part of their overall compensation. what is an option? An option is a contract, right? To buy something in the future at a predetermined price, at a price that is typically predetermined today. So, for example, I could come to your house and I could say, I'm going to give you an option.
Peter: I'm going to I'm going to sell you and see. So, for example, I could come to your house and I could buy from you an option to buy your house. Right. I give you five grand, let's say, and then I say, okay, I have the option to buy your house for $200,000. Let's say right fast, whatever it's worth today.
Peter: Fast forward a couple of years. Your house is now worth 300,000. I now come to you and I say, Hey, remember that contract? The option to buy? I'm going to buy it for 200,000. And then I immediately go and sell it on the open market for 300,000. And I got $100,000 gain. Right. And I paid you $5,000 for that contract.
Peter: So that's the basics of like an options contract when it comes to start ups. And a companies companies will issue options. These options contracts to employees. And they basically say, okay, today the company is valued at like $10 million, which equates to a share price of X, right? So maybe it's a dollar per share. And then, you know, later on the company goes public or it gets acquired or whatever.
Peter: And now the company is worth $100 million. What happens is the founder or the employee that received those options can go and they can exercise them wherein they pay the dollar per share for the option and to buy one share of stock, and then they immediately sell that share of stock for the $10 that it's now worth. And they pocket the difference of $9 per share.
Peter: And, and so that's how startups are able to compensate employees. And the reason that they do it this way, there are a bunch of reasons, but like one of the big reasons is that it can be like a tax efficient way to provide the equity to employees. Because if I go to you and I say, okay, I'm just going to give you straight equity, then you will have to pay taxes on the that equity, Right.
Peter: And even though it's you're not actually getting cash in this case. So like if I give you a $100,000 worth of equity in the company, you now have to pay taxes on that $100,000 worth of equity, which could be, you know, depending on what tax bracket you're in, like $50,000. And so it's just not like super taxed advantaged.
Peter: Whereas if I give you options, those options are worth like just like in my prior example with the house, right? I pay $5,000 for that option. That's what the options worth. If I gave you the the option, it's worth 5000 now you're only paying taxes on the 5000 instead of, you know, the 100,000 or the 200,000 or whatever it might be in an equity.
Peter: So, yeah, that's one of the reasons there are a lot of other reasons as well as to why they'll do them. But at the end of the day, it's a way to provide some additional compensation and incentive to employees so that they, they feel like they have some upside, they feel like there's good alignment, they feel like they're owners in the business.
Jon: Okay. So my understanding from deals that I've seen is option pools are typically about 10% and it's usually done prior.
Peter: To 10 to 15%.
Jon: Okay.
Peter: And what do you mean they're done prior?
Jon: Well, it depends. I think if if a if a founder wants to get away with 10%, I think they usually put the option pool together before they start fundraising. And then they tell the the the VC firm that, hey, the option pool has already been created, It's at 10%.
Peter: Well, okay, so what happens is there's two ways to negotiate this. One is that it comes out of, it effectively well, they'll say that it comes out of the post money. But in reality what's happening is it's actually coming out of the the pre money out of the founder shares. That is the like market standard today. because what happens is let's say you have like a 10% option pool and you you have the VCs going to put in $1,000,000 and buy 10% of the company.
Peter: So that would result in a $8 million pre money because it's $8 million pre plus the million dollars from the VC plus the 10% option pool. So the 10% option pool pushes down the valuation from 9 to 8 million. In that case, sometimes founders will argue and negotiate to have the option pool come out of the VCs pocket too.
Peter: So then in that case what happens is let's say the VC still invests $1,000,000 at a $9 million valuation, pretty money. And then the POST-MONEY is $10 million, and then they add on the 10% option pool, in which case the VC gives up. $100,000 of the value of their position and the founders give up $900,000 of their position to create this 10% option pool.
Jon: My understanding is that most option pools 85 to 90% are done as part of the pre money versus the post. Would you agree with that?
Peter: in that what you're saying is like 85% of the time that the option pool is taken out of like the founder or the founders.
Jon: And not the VCs.
Peter: And not the VCs. That's right.
Jon: Yep. Who typically get stock options. And what are current stock options for, you know, like employ ten plus board members, advisors.
Peter: In terms of percentages, I mean, it really depends on like the stage of the company and the the, the, the position.
Jon: Okay.
Peter: So I would say generally like once a company is like pretty well established, you know, we're just talking like series C stage, know senior executives are probably pulling in somewhere in the like 1% range, 1 to 2% of options or of owner implied ownership in the company advisors. I mean that can be a little bit all over the place, but typically less than half a percent.
Peter: independent board members usually said at about 1% is kind of the market rate. but like if you're, if you're employee number one, you might be getting like a quarter percent of the company, half percent of the company somewhere in there. And then, you know, most employees, you know, to your point, like they're getting 10%, there's a 10% option pool.
Peter: So, you know, they're going to what happens typically that what I see is a company will raise a series A they'll have a 10 to 15% option pool of that option pool, like a big chunk of it will go to the senior management and then an equal percentage of that will be spread out amongst like all the additional employees that they have.
Peter: And when they raise their series B, they'll have allocated, you know, ten of the 15% right. And then they refreshed the option pool. It's another like 10% to bring the total option pool size to like that 10% or 15%, whatever it is they're targeting. so I know it's just, it just really varies. but generally what I would see is that if you were, let's say you were a developer and you make $150,000 a year and you decide to join a startup, you're probably going to make somewhere like 120 and then get another like 30 to $40000 worth of options.
Peter: And those options are priced based on the price of the company. So what they'll do is they'll hire a valuation firm like here in Utah, their scalar analytics and scalar, or they can hire CADA where where, you know, I'm an investor and those companies do for online evaluations and that's how they price the options. both like what the options are worth as well as what the strike price is.
Peter: And the strike price is, you know, what you pay when you exercise them in order to buy to convert the options into shares.
Jon: Now let's talk about vesting and why it's important. So generally, current current market trends are it's a it's a one year clipped and a four year vesting schedule. Yep. Usually done on a monthly or quarterly basis. What that means is in the first year you get nothing until you complete.
Peter: For one year. Yep.
Jon: And then you would have the right. You don't get your shares or options or member interest, you get the right to purchase those shares at the original strike price.
Peter: Right.
Jon: And then after that it would be your vesting schedule usually.
Peter: Well you would get the options.
Jon: Yeah. You get the options at trial.
Peter: But you don't get the shares.
Jon: Or you get the options. Yet you have the purchase.
Peter: Option is the right to buy right.
Jon: And then typically you have to exercise your option purchase agreement. If you leave the company. Yep. After that period within like a 30, 60, 90 day window. Yep.
Peter: Which can suck. Or you cause. Yeah, cause they could be worth a lot. The people I feel the worse for the people that exercise their options. And then the valuation of the company dips or the company goes out of business because you now just paid taxes on something that was ultimately ended up being worthless. That sucks, but it's a real risk that hurts a lot of people and it's probably hitting a lot of people right now.
Jon: With everything underwater. Yeah.
Peter: Yeah. Here's the danger with those, right? Like, what we just explained is, like, let's say you joined a company in 2021, and they raised at a very high valuation. Well, guess where your strike price is priced and those options back there. And now fast forward, two years are not worth what they were back then, and now they're worth like half that.
Peter: Your options are still priced at the higher valuation, which means they're effectively worthless until the unless the company is able to grow back up to that valuation and above.
Jon: Yeah. One of the reasons why I'd like to talk about why vesting is important. So this is something that just recently happened to us. They said, Hey, I want option or stock, just give me the stock now. It doesn't matter. I don't care if this is your best friend growing up right? Yeah. Life happens, Things change. Let's just say that person is great.
Jon: Like, here's a really good example. Maybe that person dies, two years in cash. At that point, if you don't have a vesting schedule, all of that equity and whatever you said or didn't say verbally to that individual is now beholden to that person's spouse or family or whoever inherits it. Right? Sure. And I think those are things people don't don't talk about a lot.
Jon: Yeah. Or maybe it's a person's spouse and then she marries an attorney. Yeah. And then you're kind of stuck in this weird scenario where this attorney is now jerking your chain. Yeah, it's extremely important to have that in there to make sure that you can control the future of the company. Because the one of the one of the big things I think that people don't think about with vesting is if you want to go fundraise later and let's say this individual dies, you know, like two weeks in, they still have you give 25%.
Jon: They have 25% forever. Yeah. Always do. Vesting.
Peter: Yeah. Vesting matters. And like like if you're going to give equity to somebody in your company and you are worried about that, you know, makes a ton of sense to have buyout agreements in place, sometimes it makes sense to take out insurance, life insurance on each other just have mechanisms in which case and in the event that you're able to unwind the relationship.
Peter: Right. Especially if they get hit by a bus. And now, you know, you don't want to deal with their spouse, but at the same time, like, look, if they've put on a ton of effort and they've effectively earned their shares.
Jon: for sure. Then I'm just saying you.
Peter: Want to treat that as compensation for them. Right.
Jon: One of the very common topics, topics I hear founders doing is they just give shares or hey, let's avoid this. It's less legally complex or complex or different tax incentives. Yeah, there's there's reasons for all that. There's different types of options and vesting schedules and reverse vesting. But have a competent lawyer who goes through that with you and make sure that you're covered because you never know what'll happen.
Jon: And it's easier to give something to someone than to take it away. Yeah, as a company, that's true. I think one of the things that we do in all of our agreements is that we we have a reach purchase agreement that the company at any point can repurchase the shares at a fair market value and the contract and the bylaws state how the fair market value is determined makes sense.
Jon: And that's another way to cover yourself. Sure. Okay. What about optional refreshes? Those are not something that a lot of people talk about. I assume that usually just happens that, you know, if you raise your seed, that happens at a Series A and B and so forth.
Peter: Yeah. I mean, basically you just want to always have options available for new hires and so forth. So whenever a company raises more money, they'll look at what's left in the option pool and to ensure that there's enough there to make the hires that they need to make, they will oftentimes refresh it. They don't have to refresh it every single time.
Peter: For example, if a company didn't issue that many options, they still have a significant amount in the option pool that an entrepreneur may negotiate to not increase the option pool and say, hey, we have sufficient here, we don't need to take additional dilution.
Jon: Let's talk about the exciting part exits and how it affects people, whether it's an IPO or an acquisition.
Peter: Okay.
Jon: So just make sure we cover the topic. Most people typically in there, the options will automatically convert to stock. In the case of an IPO or an exit, they would automatically be exercised and purchased on behalf of that individual, correct?
Peter: Yeah. Sometimes what they'll do is a cashless exercise wherein you don't actually have to come up with the money to exercise the option. They'll just basically exercise on your behalf and then immediately sell them and then give you the difference. So this oftentimes happens when companies are acquired or go public just because it helps facilitate the whole thing.
Jon: What do you think are the most common misunderstandings or pitfalls in this scenario?
Peter: Well, I think we talked about one earlier, which is not understanding like how options work, not understanding the pricing of options, like a lot of people think like, like I got, you know, $50,000 worth of options, not realizing that like they have a strike price and the strike price is based on where the value of the company is.
Peter: And the company's got to grow a whole bunch more and you're going to have to you know, there's a good chance you may have to fork over some money in order to exercise those options. And like, especially if you leave the company and a lot of people leave companies after a couple of years. So, yeah, I think there there are a bunch of things like that.
Peter: I.
Jon: Just think it's tough that a lot of people who join companies don't have access to the cap tables. Like, yeah, it blows my mind that, that even though like the total number of issue shares or shares outstanding etc..
Peter: Yeah yeah they just know, I got so many units or I got so many options and I don't know. Yeah. To your point, like they don't know the what the current share prices, they don't know how much dilution there is. Every time a company raises more money theoretically like they're getting diluted. more now the way that shows up is really on the share price, but oftentimes employees don't know what the share price is.
Peter: of, you know, based on the, the, the latest round and you could get deceived by looking at it and saying, well, when I joined the company, I got issued options when we were valued at $10 million and then now we're valued at $100 million. So my options must be worth ten X not realizing, well, the company raised $50 million and gave away half the company.
Peter: So in reality your options are probably worth closer to like four X instead of ten. Retsinas Still not a bad place to be, but like not, you know, for as much for there are four is not ten.
Jon: So yeah, you should look at options are when they liquidate, unless you're one of the top five you got to you'll get enough cash to buy a car, maybe a house if you're lucky.
Peter: Yeah I think it depends on how successful the company is and also how generous they are with their stock. Their stock options. Like my friend was at a very successful company and, you know, it was enough for him to pull out enough to buy a house and a couple of cars. And he wasn't like, you know, he was like employee number like 26 or something like that.
Peter: so early, but not.
Jon: After like number of.
Peter: Insanely early. Yeah.
Jon: House couple cars is usually the realm of what your options will end up being worth the worth, if you're lucky. Yeah. All right. Did you know.
Peter: Like, there are some people that are just, like, crazy lucky, like pretty much the first hundred employees at Facebook, Google, Amazon, you know, some of these places where they're all like billionaires or center millionaires.
Jon: It's an outlier, though.
Peter: Yeah. Yeah. Well, welcome to venture.
Jon: That's why VCs have it easy, because every one of those that they think could be a unicorn, they can have a seat at many companies, not just one.
Peter: Yeah, but even so, it's still really hard.
Jon: For sure. For sure. But I think. Is there anything else you want to you want to cover on the option basis now? I think that's just one of the things that too many people don't understand and they get surprised when there is or isn't an exit or when they leave the company, something that forces the the purchase agreement.
Peter: That can be tricky.
Jon: Just be careful. I always like the companies that have the stand up and say, hey, here's where we're at. Here's the number of shares that are issued. Obviously, there's a lot of competition in the share price that's in it. This is how we calculated the share price. So are we moving forward or moving backwards? Yeah.
Peter: I agree that I think companies should be transparent about that stuff.
Jon: You know, too often I don't think they are.
Peter: So I agree.
Jon: No, no. Before you buy, get the information. They don't give you information. Bounce.
Peter: Amen.
Jon: All right. Well, thanks. Make sure you give us a five star review. We could really appreciate it. It's how we keep the lights on and go to venture capital firm WW W dot venture capital law firm to subscribe to us on Instagram, see Peter doing TikTok dances, all those type of things. All right, catch you in the next episode.
Peter: Sia.