What benefit (besides happy employees) is there to issuing an all-employee option pool from a Series A before a Series B? What's the downside (besides founder dilution)? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by David S. Rose, Founder of 6 startups, angel investor in 100+, on Quora:

Employee stock compensation doesn't work the way that many seem to think.

Preferred Stock (Series A, B, etc.) is issued only to investors, because it provides for a priority cash payout equivalent to the invested capital.

Employees receive Incentive Stock Options to purchase shares of Common Stock. Because all Common stock is equal, regardless of when it was added to the Option Pool, there is no relation between options and series of preferred stock. Instead, the only thing that differentiates options issued to Employee #1 from those issued to Employee #1000 is the strike price: the price at which the employee has the option to purchase a share of stock in the future.

For tax reasons, the strike price for all options must be set at the Fair Market Value of a share of the company's Common stock on the date of the grant. Because there is no public market to set the price, the company is required to engage an independent appraiser to provide a 409A Valuation, and that is what determines the strike price.

The only effect of adding shares to the option pool at one time versus another is that an option pool increase affects only the shareholders who were in place before the increase. That's why every investment term sheet will require an addition to the option pool before calculating the valuation at which the new investor is investing.

For example, let's say that a company had no existing option pool and raises a Series A as its first round of capital, of $100,000 at a pre-money valuation of $900,000 (what the company is worth before their investment) and therefore a $1,000,000 post-money valuation (the value the company had prior to their investment, plus their $100,000 which is now in the company's bank account.

Because it's planning to be a high-growth company, everyone understands that all employees are going to need to have stock options included as part of their compensation package. So the investors insist on the creation of a 20% option pool...that is, setting aside 20% of the value of the company to be used as a pool of shares on which employees, current and future, will be granted options.

Now, what you would think they would do is to say "ok, here's our investment, and since we agree that the company is worth $1 million, we'll set aside $200,000 of it for the option pool. That means you (founders) and we (investors) will own the remaining $800,000 (or 80%), therefore valuing our investor share at [$800,000 * 10%=$80,000] and your founder share at [$800,000 * 90%=$720,000] and the option pool at [$1,000,000 * 20%=$200,000].

But no! What they do instead is say "ok, we agree that the company is worth $900,000 before our investment, but that valuation includes whatever equity you are going to have to provide to your current and future employees from now through whenever you will be able to do your next funding round. So to make that work out the way it should, we want to be sure that after our investment the company will have a 20% unallocated option pool, but that the pool needs to be created in advance, before our investment. As such, that means we are buying a clean 10% of the company for our $100,000 [($900,000+$100,000)*10%], and the since the company we're investing in comes complete with the option pool, that means the future 20% pool (which will be worth $200,000) needs to come completely out of your founder share.

Calculated that way, our ownership will be [($900,000+$100,000)*10%]=$100,000, the option pool will be [($900,000+$100,000)*20%]=$200,000, and your founder share will be worth [($900,000+$100,000) - ($100,00+$200,000)=$700,000.

Because of this industry-standard, investor-friendly calculus, companies always try to minimize the size of the option pool at each round, because the farther out they can push it, the more parties (such as the investors) there will be to share in the dilution. Put another way, where the founders need to take all the dilution before the Series A, when it comes time to the Series B, the dilution will be shared by the Founders, the existing option holders, and the Series A investors. And for the option pool increase at the Series C, the dilution will be shared by the Founders, the existing employee option holders, the Series A investors, and the Series B.

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