I was recently asked by an entrepreneur, “What happens to the leftover option pool after an acquisition?”
In short, the shares get a disappearing act.
Not so fast, though! Where those shares magically disappear to is the key to all this. In most cases, the unused shares are redistributed to all shareholders proportionate to their ownership. So for example, if you are a founder in Company XYZ with a 10 percent equity stake, and the leftover option pool is 10 percent, your cut would be 1 percent, bringing your total to 11 percent. Which leads us to the problem…
The founders are the ones who stand to get screwed the most by this tricky math.
When entrepreneurs raise funds, the employee option pool is always established at a pre-money valuation, which means the shares come out of the founders’ portion of the pie. If no arrangements were made in the term sheet, the founders’ shares not only get diluted, but they never get undiluted ever again once the company is sold.
Remember: all unused shares in the option pool get REDISTRIBUTED EVENLY to all shareholders. So basically, your extra 1 percent means that the remaining 9 percent will fatten the pockets of your investors. 9 percent is HUGE, especially if your company gets acquired for a handsome sum.
Even worse, you stand to be more diluted if you raise multiple rounds of funding because all new raises generally require a restocking of the option pool in order to satisfy newer hires.
The simple solution would be to keep the employee option pool as small as possible. VC’s tend to want bigger ones because of what we stated above.
The other solution would be to install clauses in the term sheet that clearly state that all leftover shares will be returned to the founder(s) upon any acquisition.
But say you didn’t do that. Well, you still have some recourse if you happen to have a few friends on the Board. When a company is about to be acquired, the Board can vote on and pass a resolution that determines how the leftover shares will be distributed. Time to cozy up to a few board members!
Just remember, your VC can be your best friend and a silent enemy at the same time!
Image credit: CC by Porto Bay Trade