How Do Pre/Post money Valuation and Option Pool Work?
This Friday -> Venture Deals by Brad Feld and Jason Mendelson Pt.3 [2 min reading]
Hey, it’s Fede!
I didn’t expect to receive so much interest in the technical chapters of this book. Let's find out a bit more about pre/post-money valuation and the option pool.
Let’s stick with “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist” plus some extra input!
Let’s keep it super easy: the pre-money valuation is the startup valuation before a new investment. This number sets the starting point to calculate the investor’s ownership percentage.
Please, don’t confuse pre-money with post-money valuation!
The post-money valuation includes the new investment and this is something to keep in mind because it determines the percentage of shares investors will hold after the round.
Let’s make it more clear with an example:
If founders originally owned 100% of the startup pre-investment, after the investment, the investor would own CHF 5 million / CHF 15 million = 33% of the startup, and the founders' ownership would be diluted to 67%.
Insight: In this book, they emphasize that founders should be careful to chase super high pre-money valuations without considering the long-term implications. A high pre-money valuation can set tough expectations for future rounds if growth doesn’t match it. Keep in mind these points:
Future Rounds: High initial valuations set tough expectations for future funding. If growth doesn’t match, raising funds at the same or higher valuation becomes difficult, leading to potential down rounds that can hurt hype, reputation, and morale.
Investor Expectations: High valuations signal rapid growth. Missing these projections can create tension and complicate future negotiations.
Dilution: While higher valuations mean less immediate dilution, they often come with stricter terms or larger option pools that can reduce founder equity over time.
Side note: I’m writing from Switzerland, where CHF (Swiss Francs) is the currency. For international readers, CHF is valued slightly higher than USD.
An option pool is a % of equity set aside for future employees. Investors often insist on creating or expanding the option pool before their investment, which reduces the founder’s ownership rather than theirs.
The option pool is closely linked to the ESOP (Employee Stock Ownership Plan), which is the actual plan that dictates how the option pool is distributed, vested, and managed. While the option pool sets aside equity, the ESOP ensures these shares are used effectively to attract and retain employees.
Tip: Negotiate to keep the option pool as small as possible while still providing flexibility for new hires. A typical pool is around 15-25% of equity.
Say you negotiate a CHF 10 million pre-money valuation and agree to a 15% option pool. If an investor contributes CHF 5 million, the post-money valuation becomes CHF 15 million. However, if the option pool is calculated pre-money, in general, it means that 15% of the post-money valuation (CHF 15 million) is allocated to the option pool, impacting the founders’ shares more significantly. This effectively reduces founder ownership, as the pool is created from their equity rather than the investor’s.
In this scenario, the investor’s CHF 5 million contribution secures them 33% ownership of the company (CHF 5M/CHF 15M), while the 15% option pool comes out of the founders’ shares. This leaves the founders with 52% ownership.
See you next Friday,
Federico Lorenzon