VC Structures: share options in venture capital deals

Author

DSWAngels

18 May 2020

This is the second in our short series from DSW Angels on what your choices are in structuring a venture deal, whether as investor or founder.

This edition looks at the benefits of creating a cohesive team around the founder or founders, how they should be rewarded, and who pays the cost.

 Investors back teams

Investors like to back a team, not a lone wolf. That’s not to underplay the value of the founders – there are usually one or two key individuals who are fundamental to any scale-up company. But these individuals can’t do everything, they’re not experts in all fields, and generally decisions are best made when founders’ gut-instincts are challenged and refined. Further, founders sometimes go off the boil, get sick, or are overtaken by events – a team is needed to keep the show on the road.

Figuring out the cost of motivating the team

Cash will probably be tight, so big salaries are out. The challenge of delivering the company’s mission and the associated company culture should be part of the package that secures a properly incentivised team. So, the final part of that package needs to be equity.

How much? And to who? (maybe that should be “to whom” should Jacob Rees-Mogg be reading VC blogs too).

Allocations will depend on the importance of the role and the capability of the individual. These may be unknowns at investment – so an estimated pool is required, considering existing options and current roles alongside expected future hires. How much the allocation for new options should be depends mainly on who is already in post and how much equity they already have.

To give an example at one extreme, a business 100% owned by a sole founder CEO is likely to need to put aside meaningful allocations for (say) the CTO and CMO as well as senior management, plus non-executive and/or adviser support. This isn’t going to entirely replicate the cap-table of a business set up by two or three founders with equal shares right at the start, but the pool needs to be big enough for senior hires to have a sense of ownership.

How much in total? As a starting point, maybe 5% to 10% for each of the late-joiner founders, plus an allocation for everyone else – you can easily get up to 30% or more. If that sounds a lot, then put it in context. The founder still has 70% of the equity – a lot more than if the company had been founded by a team of two or three – and with a company that is a much more attractive venture capital investment.

For companies with a wider spread of share-holding founders and key staff, the option pool will be lower, but it’s rare that it comes to less than 10% in early-stage scale-ups.

It makes sense to schedule out all the team members and new hires required to deliver the investment plan, then allocate a figure to each. You might be surprised at the total.

Sharing out the equity is not a cost of finance

Often, a founder (and especially a sole founder) sees the requirement to set aside options or equity as a cost of the finance. It’s not. It’s a cost of building a sustainable business. This is an important incentive for all businesses – early stage or mature, VC backed or not.

Crunchbase estimated last year that on exit, the largest tech companies had median founder stakes diluted down to about 15%, with non-founder management holding nearly 30%, the rest held by VCs and angel investors. That leaves the original founders with about one third of the total management share. These are the most successful tech businesses – it pays to share.

Who bears the cost?

The answer to this is quite simple: the incumbent shareholders. We offer based on the fully-diluted position based on a sensible option pool for future hires. After that, we suffer dilution alongside all other shareholders for options allocated over and above the pool.

To quantify the effect on a founder, consider the following simple example:

share options in venture capital deals

Whether this funding offer works depends on whether the founders get their heads round why a 15% option pool represents 25% of the current issued share capital, and whether they accept that the option pool is a cost of building a great business, and not a cost of the funding.

And lastly – details matter

It is crucial to keep a detailed log of the cap table and any changes to it as share options are granted – you don’t want to be arguing who owns what at exit.

Get a lawyer to produce an option grant letter which will contain all the detail required: what happens in a leaver scenario, when can the options be exercised and at what cost? Pricing is an important issue for tax – if in doubt, get some advice.

Lastly, ensure options are granted on a “number of shares” basis rather than a percentage to ensure dilution is suffered equally amongst shareholders.

Round-up

If I was to boil the above down into a single message, it would be that the individuals within the team who are key in driving equity value must be appropriately enfranchised with equity.

Share and succeed!

Next week we will be looking at one of the really thorny issues in VC investing – leaver terms – why we use them and why they are good not only for the company but also for founders.

 

David Smith

Partner, DSW Angels LLP

david@dsw-angels.com

share options in venture capital deals

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