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ON-DEMAND INSIGHTS

Impact of Incentive Equity Pools on Startup Fundraising

Posted by Justin McAnaney on December 22, 2022 at 8:46 AM

incentive equity pools startupsSince a startup’s incentive equity pool will interact with and have an impact on the pricing and dilutive effect of its equity fundraising rounds, it is important that founders understand how an incentive equity pool may impact their fundraising efforts. Like founders themselves, investors in early stage companies understand the necessity of using incentive equity to attract and align interests of employees and other service providers with the interests of founders and investors in the long term growth of the company’s value. In fact, if a pool has not previously been established at the time of a startup’s initial priced equity fundraising round, the investors in that round will likely require its creation as a condition of the investment.

For companies that do have a pool established prior to a priced equity round, investors may require an increase in the size of the pool (a “top-up”) so that the proportion of equity available from the pool following completion of the fundraising round is sufficient, in the eyes of the investors, to allow the company to recruit the appropriate range of talented team members and service providers to take the business forward. As a rule of thumb, founders should expect that investors will require an incentive equity pool comprising at least 10% - and up to 20% - of the fully-diluted capitalization of the company, as calculated following the completion of the investment round, depending on the expected hiring needs of the company.

Calculating Investor Price per Share and the Dilutive Effect of the Pool or Top-up

The manner in which the establishment or top-up of a pool is calculated will have a meaningful impact on the price per share paid by the investors in the fundraising round, and on the dilutive impact of the round on founders as the holders of pre-round common stock.

If, as is the market standard, the pool to be established or the top-up of an existing pool is included in the pre-money, fully diluted equity of the corporation, then the share count used to calculate the investor’s price per share is increased by the pool or top-up, and the price per share paid by the investor decreases and the dilutive effect of the round on pre-round holders of common stock increases proportionately.

Alternatively, if the pool to be established or a top-up of an existing pool is not included in the pre-money, fully diluted equity of the corporation, then the share count used to calculate the investor’s price per share is not increased by the pool or top-up and there is no decrease in the price per share paid by the investor or commensurate increase in dilution to the pre-round holders of common stock.

To illustrate the differences in these approaches, below are two simple examples. In each, we start with the same pre-money capitalization referenced in Part 1, and we assume the company is valued at $5,000,000 before the investment round.

Market Standard approach: the pool to be established or the top-up of an existing pool is included in the pre-money, fully diluted equity of the corporation:

Pre-investment company valuation: $5,000,000

Pre-investment equity
: comprised solely of

  • Outstanding Shares: 1,000,000 shares of common stock held by the founders (100%)

Pre-investment, fully-diluted equity for purposes of calculating price per share for new investment 1,250,000 shares comprised of

  • Outstanding Shares: 1,000,000 shares of common stock held by the founders (80%)
  • Pool/Top-up: 250,000 shares of common stock (20%)

Investment Amount: $1,000,000


Investor Price Per Share
: $4 ($5,000,000/1,250,000)


Shares Issued to Investors
: 250,000 ($1,000,000/$4)


Post-investment company valuation:
$6,000,000 ($5,000,000 + $1,000,000)

Post-Investment, fully-diluted equity
: 1,500,000 shares comprised of

  • Founder Shares: 1,000,000 shares (approx. 66% of the fully-diluted equity, which represents $4MM of the post-money value of the company)
  • Investor: 250,000 shares (approx. 17% of the fully-diluted equity, which represents $1MM of the post-money value of the company)
  • Pool: 250,000 shares (approx. 17% of the fully-diluted equity, which represents $1MM of the post-money value of the company)

Alternative approach: the pool to be established or a top-up of an existing pool is not included in the pre-money, fully diluted equity of the corporation and is instead established post-money:

Pre-investment company valuation: $5,000,000

Pre-Investment equity used for purposes of calculating price per share of new investment
:

  • Outstanding Shares: 1,000,000 shares of common stock held by the founders (100%)

Investment Amount: $1,000,000


Investor Price Per Share
: $5 ($5,000,000/1,000,000)


Shares Issued to Investors
: 200,000 ($1,000,000/$5)


Post-investment company valuation:
$6,000,000

Post-investment, fully-diluted equity
: 1,200,000 shares comprised of—

  • Founder Shares: 1,000,000 shares (83% of the fully-diluted equity, which represents $5MM of the post-money value of the company)
  • Investor: 200,000 shares (approx. 17% of the fully-diluted equity, which represents $1MM of the post-money value of the company)

Then, once the new pool or top-up is completed post-money (using the same size pool, 250,000 shares, as used in the example above), the post-investment, post-pool, fully-diluted equity will be: 1,450,000 shares compromised of

  • Founder Shares: 1,000,000 shares (approx. 69% of the fully-diluted equity, which represents $4.14MM of the post-money/post-pool value of the company)
  • Investor: 200,000 shares (approx. 14% of the fully-diluted equity, which represents $840K of the post-money/post-pool value of the company)
  • Pool: 250,000 shares (approx. 17% of the fully-diluted equity, which represents approx. $1MM of the post-money/post-pool value of the company)

To summarize, the above examples illustrate how the decision of whether or not to include the pool/top-up in the pre-money, fully-diluted equity has significant consequences for the outcome of the investment round on both founders, as the holders of the pre-round equity, and on the investor.

If the shares in the pool/top-up are included in the pre-money, fully-diluted equity, as is the norm, only the founders will be diluted by the establishment or increase in the pool. The investors’ equity stake does not experience any of such dilution. In the first example, $1MM of the fully-diluted post-money equity value moves from the founder to the pool; whereas the investors retain the entire amount of their $1MM investment in the fully-diluted, post-money equity value.

In contrast, if the pool is excluded from the pre-money, fully-diluted equity and then later established or topped-up in the post-money, both founders and investors are proportionately diluted. In the second example above, both the founders and the investors share the dilutive effect on the value of their equity proportionately to the relative size of their stakes in the company. Finally, it should be noted of course that the size of the pool/top-up, the pre-money valuation of the company and the amount invested will all impact the outcome and extent of the dilution in each case.

Key Considerations for the Negotiation of a Pool in Connection with a Start-Up Fundraising Round

As noted above in the market standard example, the founders are typically expected to bear the dilutive effect of the pool or top-up, which is based on the investors’ presumption that the company already has a team in place which is capable of successfully implementing their business plan, at least until the next round of financing. If this is not to the case, and equity is needed to recruit and incentivize additional team members, investors will expect the additional shares to come from the founder’s holdings, without dilutive effect on the shares acquired by the investors.

Further, when the market standard approach is followed and the pool/top-up is included in the pre-money, fully diluted equity of the company, founders should work with their legal counsel to prepare for their negotiations with investors by compiling details about their existing team and any planned hiring between rounds so as to negotiate as small a pool as possible – i.e. to “right-size” the pool/top-up to what is actually needed to build out the team - rather than simply relying on a round market standard number which may be larger than necessary. Generally, founders should be wary of an investor pushing for a larger pool than is necessary since any unissued options from the pool will carry over into the next round, effectively enabling the investors in a prior round to avoid dilution at the time of the next round simply by having over-allocated to the pool at the time of the earlier round.

Also, if there is an exit before the entire pool is used, reverse dilution will occur in proportion to the then outstanding equity, which means that investors benefit proportionately from the unused pool (effectively transferring value from founder to investor in a manner that was not assumed in establishing the valuation of the company for the fundraising round).

Finally, since the concept of the pre-money pool is tied to a valuation which assumes a fully-formed team, founders may choose to trade a lower valuation for a smaller pool. Before making such a decision, however, founders should consider modeling this out as in the examples above in order to derive a post-money equity and value held by founders and investors. Depending on the specific details, a lower pre-money valuation with a smaller pool may be better or worse for founders than a higher pre-money valuation with a larger pool. Also, it is important to note that the pre-money valuation for a given round will impact the trajectory toward future fundraising rounds.

In conclusion

Founders should avoid any inclination to treat the creation or top-up of an equity pool as a sideline matter or to simply accept the market standard as a rote approach to its creation and size. Instead, the pool should be recognized for what it is and negotiated with legal counsel accordingly - a key element of any fundraising round which directly correlates to the company’s valuation and impacts the dilutive effect of the equity issued in the round. If you have questions about incentive equity plans or general issues relating to startup companies, please contact Justin McAnaney at jmcananey@outsidegc.com.

 

Justin McAnaney is Partner with Outside GC's New York-based team. Justin is a seasoned corporate lawyer and business leader with a twenty-year track record of providing meaningful legal and strategic advice to businesses of all types and sizes. He regularly advises clients on both transactional issues and day-to-day business matters throughout the corporate lifecycle, including assisting start-up companies with arrangements between co-founders and structure and fundraising matters. 

 

Topics: startups, incentive equity pool, startup fundraising

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