✋ Hello there! Thanks so much for giving Term Sheet Pitfalls a shot! If you’re receiving this, you’re a founder, operator, investor, or friend who we think would enjoy this newsletter. If you missed our last few posts, you can find them here:

• What’s a term sheet anyways?

• The Art of Startup Valuation

If you were forwarded this newsletter, subscribe HERE

Our commitment to you: brief, simple, valuable content that will empower you to get smarter on VC term sheets and fundraising strategy.

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

We recommend replying with a “hi” in order to ensure that future posts don’t end up in spam world or unsubscribing at the bottom at your preference (no hard feelings).

What are stock options?

Stock options are incentives granted to employees, advisors, and consultants. Some employees joining a VC-backed startup typically receive an option grant, which allows them to acquire company common shares in the future at a certain price by “exercising” the options. In doing so, the founders of the company are attempting to motivate/retain the employee with the potential of a cash reward, assuming the company performs well in the future and grows its valuation beyond where the option is originally priced when issued to the employee. We will discuss share classes in the future, but for now think of common shares as those that go to founders and employees and preferred shares as those that are acquired by investors.

Stock options are allocated from an equity incentive pool (sometimes called an option pool), which is an amount of common stock primarily reserved in the cap table for future employees (in certain cases, options can be pulled out of the option pool for existing employees/founders as well). Typical options agreements include the number of options granted (the number of shares that can be purchased), the vesting schedule, the strike price, and the clawback provisions. When employees are granted options, they are banking on their ability to purchase (“exercise”) their vested options in the future at the strike price and sell them at a higher price if the company experiences a liquidity event (typically an exit), reaping the profits (aka the “spread”).

What is vesting? At what pace do options vest at after they are granted?

Vesting: is the process of gaining ownership over granted stock options. Typically, the process of gaining ownership is tied to a vesting schedule or a defined event that triggers ownership.

The most common vesting schedule is the following: 25% of an employee’s stock vests on the one-year anniversary of their hire (aka the “one-year cliff vest”), and the remaining 75% vests in equal monthly increments over the next three years (aka “step vesting”). It’s a total of four-year vest but with the requirement to make it at least one full year to vest the first 25%.

Example: Chuck is granted 2,500 options at a new AI-legal startup with a standard vesting schedule on 1/1/2025.

• If Chuck terminates his employment or is terminatedon 11/29/2025, he vests 0 options

• If Chuck terminates his employment or is terminated on 1/2/2026, he vests 2,500 x 25% = ~625 options

• If Chuck terminates his employment or is terminated on 6/30/2027, he vests 2,500 x 62.5% = ~1,562 options

•  If Chuck terminates his employment or is terminated any time after 12/31/2028, he vests all his options

Employees that leave a company (voluntarily or not) are typically required to exercise (aka buy shares at the strike price) their options within 90 days or they will forfeit them (this period is referred to as the PTE or post-termination exercise period). Even if the PTE period is longer, it is important to exercise within 90 days since after this incentive stock options lose their favorable tax treatment.

In 2021, Carta data showed that ~90% of the stock options of terminated employees had a less than 95 day post-termination exercise period; however, this provision is more commonly reconsidered by companies these days.

Companies are staying private (or “not acquired”) far longer than they used (i.e., Stripe). A company that goes public after ten years creates a challenging cash situation for an early employee who joined at inception and leaves after four years. After departing, he or she has 90 days to come up with cash needed to exercise the vested options. As most employees accept a relatively lower cash salary in lieu of the upside associated with their equity options, coming up with cash isn’t always easy. If the company was hypothetically public when the employee needed to exercise their options, the employee could sell some of their shares in the market and then use the cash proceeds to pay for the remaining exercise costs.

Many companies offer a “cashless exercise option.” In this case, the employee can surrender some shares to the company in lieu of paying out of pocket for the exercise price. Even so you will be taxed by the IRS on the difference between the fair market value of the stock and the exercise price. Surprise, the IRS only accepts cash. This entire dynamic is sometimes referred to as the “success disaster.” Employees run the risk of being harmed financially for building a succeeding business that has grown in value significantly. This dynamic undermines the cash-equity dilemma that many startup employees face (the risk of taking lower cash compensation for stock, as most startups fail).

Some startups are now giving employees all the way up to ten years to decide on whether to exercise options or not, which is perfectly legal, but has further tax implications. We could release an entire post on the tax implications of exercising options but instead recommend this tremendous overview from the Carta team. Scott Kupor’s Secrets of Sand Hill Road also provides a great overview of this topic.

Four Unique Vesting Scenarios:

1️⃣ Founder vesting: this can be a contentious topic. A founder may have been working on a company or idea for years before he or she engaged with a lawyer to incorporate the company and raise VC for the first time. Thus, it’s not unreasonable that a founder would expect full vesting credit for the time he or she put in… on the other hand the VC is investing on their belief in the founder and wants the founder to be incentivized (by vesting more ownership) for as long as possible. While there’s no right or wrong answer, the VC can typically get comfortable if there is some material amount of vesting to occur in the future even if a chunk is vested up front before the official close of the VC round. For example, a founder might close a pre-seed with 85% ownership and 8,500 shares. The VC might get comfortable with the founder vesting 2,125 shares immediately (~25%) with rest to vest over 4 years. This can obviously be very frustrating for a founder and is certainly a downside of raising outside capital. That said, some VCs get comfortable not requiring a re-vest or additional vesting in a competitive round.

It’s important to note that founder stock is typically subjected to additional vesting only once, at the time of the first VC round. Of course, founders can “re-up” later, taking from the option pool typically pending board approval.

2️⃣ Vesting following an acquisition: imagine that as a founder or employee you are halfway through vesting a granted options package and the company is acquired. Stock option agreements typically define what is called a “trigger” clause. Single-trigger states that only one event must occur to accelerate the vesting of your equity (an acquisition). If the company is acquired, you gain complete ownership over all your options. Double-trigger (more common than single trigger) requires two events to occur to accelerate the completion of your vesting. The first trigger is the acquisition, and the second trigger is the founder or employee getting terminated by the acquirer without cause or good reason in a specified period (typically one year). 99% of terminations in California are without cause. As such, if the acquirer wants to retain the founder or employee, the acquirer can do so while not having to worry about his or her options fully vesting (i.e., employee gets fully vested and says “bye” at closing of the acquisition). If the acquirer wants to terminate the employee or founder (maybe due to synergy implementation), he or she is accelerated (seems fair).

Founders and employees who are fully vested can have their vesting schedule reset in an acquisition or future funding round (with the consent of the employee or founder). Specifically, founders/employees can be given new stock that vests over time in acquisitions or new funding rounds.

Note: in certain cases, companies may include clawback provisions in stock option agreements. These provisions give the company the right to buy back vested shares at the original issue price or at fair market value after dismissing an employee under defined circumstances (leaving for a competitor, severe misconduct, etc).

3️⃣ Vesting following an IPO: no expiration ➡️ in the case of an IPO, typically options do not expire and continue being vested. The IPO is not an “exit” in this case for founders or employees.

4️⃣ Unallocated options from option pool / cancelled options: if a company is set to be acquired and there are unallocated options sitting in the option pool (or options that were not yet vested after an employee leaves), these options do not dilute shareholders. They effectively do not exist, and for purposes of determining percentage owned, they are allocated across the cap table on a pro rata basis. So, if a shareholder owns 10% of the company, they will be given 10% of the unallocated options, technically increasing their ownership.

What is a strike price in the context of options? How is it determined?

Strike Price: the predetermined price an employee pays to exercise (aka purchase) their stock options and turn their stock options into actual shares of the company owned outright. Tax regulations (IRS Section 409a) require options grants to have a strike price equal to or above the fair market value of the underlying company stock on the date that the option is granted. A 409A valuation almost always requires a third-party provider as it’s best practice to engage an independent, qualified, appraiser. With that said, startups often want to incentivize their employees with an attractive strike price. From our experience, while founders may push to boost their valuation in a negotiation with a VC, they aim to diminish their 409A fair market valuation by providing less optimistic forecast assumptions, etc. A lower 409A valuation resulting in a lower allocated strike price increases the chances that an employee is “in the money” when they go to exercise their vested options in the future.

What should employees look for when they are considering an options package?

1️⃣ Ownership %: Most employees overfocus on the number of shares that they are getting. Understanding what % of company ownership you are theoretically getting on a fully diluted basis is step one. Ultimately you want to forecast what your ownership would look like at exit versus the valuation you believe the company can achieve at exit. For example, let’s say there are 800,000 founder shares, 100,000 unallocated options, and 100,000 preferred VC shares before I join a startup as COO. Granted 25,000 options out of the unallocated pool, I am essentially getting the opportunity to acquire 2.5% ownership if I stay at the company through my vesting period irrespective of where the company is valued today. If I believe the company will complete two more future financings (selling 20% stakes to VCs, which will dilute me) and will be acquired for $1Bn in a bull case, I can equate the value of my options before paying the strike price as = $1,000,000,000 x (2.5% x (1-20%) x (1-20%)) = $16,000,000 (not bad!)

2️⃣ Strike Price: a lower strike price is typically better for employees (but of course, this is relative to number of fully-diluted shares). Ultimately, employees will have to buy their options at the defined strike price to sell them during a liquidity opportunity. Thus, a lower strike price increases the potential profit margin an employee can capture. Nonetheless, as we mentioned earlier, the strike price is determined by a regulated 409A valuation. Where the strike price lands is largely out of the control of the employee receiving the options package… by the way, if a company issues options at a certain strike price followed by a down round (companies valuation drops), the company can reprice the options for the employees. This essentially cancels existing options and issues new ones at a lower strike price to mitigate the negative impact on employees’ equity stakes during a down round. In the example above let’s say the most recent pre-money valuation was $25M pre, representing a PPS of $25. Let’s say the determined fair market value is nearly in line with the most recent PPS of $25. I could forecast my theoretical take home before taxes ➡️ Strike Price of $25 x 25,000 vested shares = a cost of $625,000. $16,000,000 – $625,000 = $15,375,000 in pre-tax income from the exit

3️⃣ Vesting Schedule: anything outside the normal one year cliff and three year stepped vesting should be flagged and discussed, especially if less favorable as an employee.

4️⃣ Restrictions on Stock Sales: we will talk more about ROFR and buy-back provisions in the future, but tldr, it shouldn’t be hard to sell your exercised options when you have the opportunity. Sale restrictions make this more difficult and reduce the value assets such as options and RSUs.

The Impact of Options on Startup Valuation and Ownership Dilution

Now that we’ve introduced the typical terminology associated with stock options, it’s important to address how the allocation of options impacts company valuation and shareholder dilution. For founders and early stage investors this is likely the most important section of this post.

While intuitively both VCs and founders want to ensure that the company has a sufficiently sized option pool to pull from for future hiring needs, a bigger pool isn’t necessarily better for founders or existing shareholders. Even though a large option pool will make it easier to grant strong options packages, any increases to the option pool can lower the effective pre-money valuation and drive dilutionary effects for existing shareholders.

This can be illustrated through a simple example and guided simulation

Example:

•  Imagine a seed VC who intends to acquire 25% of a startup irrespective of valuation; however, the VC demands that before he purchases his ownership and the financing is completed, there is a 10% unissued option pool put in place

• Prior to the financing, the founders own 7M shares of common stock while existing employees own 1M shares of common stock

• The term sheet is written in standard fashion so that the option pool first comes from the pre-money so that existing shareholders are diluted prior to the financing (not the seed VC)

• Therefore, we can calculate that after the round closes, founders and employees will be left with ➡️ 100% - 25% (seed investor) – 10% (new option pool) = 65% ownership

• If 8M shares represent 65% ownership post close, then:

  • Post-money, the total # of shares on a fully diluted basis = 8M / 0.65 = 12,307,692

  • Seed investor gets 12,307,692 x 25% = 3,076, 923 shares

  • Option pool is allocated 12,307,692 x 10% = 1,230,769 shares

• Given the option pool must be allocated pre-money, we calculate that:

  •  The option pool is 13.3% of the pre-money shares:

    • 1,230,769 / (1,230,769 + 8,000,000) = 13.3%

•  There is a ton of dilution absorbed by the founders/employees before the financing, effectively dropping the pre-money valuation.

Option Pool Simulation - Watch Video

How can founders attempt to fight against option pool dilution?

The option pool allocation discussion typically comes up during the same time as the price negotiation since it ultimately can have a direct impact on the effective pre-money valuation. Sometimes you will see a paragraph like the below separated out in the term sheet:

“Prior to the closing of the financing, the company will reserve shares of its common stock so that x% of its fully diluted capital stock following the issuance of seed preferred is available for future issuances to directors, employees, etc. The term “employee pool” shall include both shares reserved for issuance as stated above, as well as current options outstanding, which aggregate amount is x% of the company’s fully diluted capital stock following the issuance of its seed preferred.”

As exemplified, the combination of a new round of financing combined with the allocation of an unissued option pool prior to the financing can be quite dilutive and impactful on price. In short, changing the option pool is often “equivalent” to changing the pre-money valuation.

The founder(s) can try to combat a VCs option pool proposal by:

1️⃣ Fighting the pool size. Perhaps the company doesn’t need as large of an unallocated pool for future hiring as the VC has proposed. A founder can come with a detailed hiring forecast and demonstrate that they only need, for example, a 5% pool, as opposed to the proposed 10-20%. There is no defined standard for the appropriate pool size, but Chuck and Daniel most commonly see 10% for Series A stage companies. In certain cases, a founder may also negotiate the pool down and offer the VC what is called “anti-dilution” protection. This ensures that if the pool does increase in the future, the VC gets to avoid any associated dilution. The preferred path for founders, though, is to decrease the allocated pool without providing this future protections.

2️⃣ Accepting the pool proposal but negotiating the pre-money valuation up to offset the effective dilution of the pool.

3️⃣ Convincing the VC that the pool should be added to the deal following the closing of the financing on a post-money basis, which will result in the same pre-money valuation but a higher post-money valuation with everyone sharing in the dilution.

4️⃣ Holding on to (as opposed to allocating to employees) as much of the pool as possible following the close of the round. Obviously, founders will need to provide incentivizing option packages for employees; however, as discussed, left over options at exit are allocated pro rata to existing shareholders. Therefore, leaving them unallocated allows shareholders to boost their ownership and offset some of the dilution that occurred when the pool was formed in the first place.

To conclude, VCs requesting to include a ~10% option pool that comes from the pre-money is a pretty standard negotiating starting point (especially at the Series A phase). Even if that large of an option pool isn’t needed today, it’s a strategy that a VC will use to avoid future dilution if increasing the option pool to hire and incentivize talent becomes necessary at any point following their investment.

Restricted Stock and RSUs:

Restricted Stock: Most employees like to receive options because there is no taxable income on receipt of those options. However, some employees, especially at very early stage companies, may prefer to receive actual stock (restricted stock). In that case, they have taxable income equal to the value of the stock received. The same vesting conditions apply, but unlike options, restricted stock is granted without a strike price.

RSUs: Employees of VC-backed startups that are in the late stage of their life cycle often get Restricted Stock Units (RSUs) as opposed to options. In the simplest terms, RSUs refer to an agreement by a company to issue employees shares on a future date. One RSU is the right to get one common share. RSUs, like options, are also subject to a time-based vesting schedule and can be trigger based; however, RSUs don’t have a strike price and are instead released directly to the recipient after vesting without any need to “exercise” or buy them. RSUs can come in the form of cash or stock. RSUs are kind of like a bonus and can be through of us equity or cash compensation. From our perspective, RSUs are better than options for employees because they don’t require exercising a strike price and offer certainty/stability; however, early stage companies with fluctuating prices per share throughout their life cycle will rarely issue RSUs.

FTI on RSUs: RSUs are not actual stock in the company as is the case with restricted stock. You can think of RSUs like an unfunded promise to give you a specific number of shares in the future as you meet the vesting schedule. Unlike restricted stock awards, RSUs typically do not offer shareholder voting rights or dividends unless your company’s plan allows them. Because of the flexibility RSUs give to employers, RSUs are more commonly used than restricted stock awards

Warrants

Another economic term you may encounter during a financing is warrants. Startups sometimes utilize warrants as a supplementary funding option. A warrant is similar to a stock option. When issued/contracted, it gives the warrant holder the right to buy a certain number of shares of the company’s common or preferred stock at a predefined price over a specified period. For example, a 5-year warrant for 50,000 seed preferred shares at $1 per share anytime in the next 5 years (even if the price per share of the company sits well above $1). Once a warrant owner exercises the warrant, he or she receives official shares in the company (not unlike an option). Warrants also can come with a vesting schedule, but they don’t have to. Warrants are often used in combination with other securities or transactions, providing an additional incentive to contracting parties. For example, a warrant issued in conjunction with a convertible note, a bank loan, or a commercial agreement with a vendor.

Unlike options, warrants are typically issued to investors. They can also be issued to suppliers, customers, and so on. A core difference between options and warrants is that companies that issue warrants are not accountable for following 409a regulation. Companies can set any exercise price. As such, warrants are commonly granted a nominal rate at which the exercise price is as low as a penny per share. This sweetens the deal for the VC. The VC is essentially getting the right to acquire nearly free future shares, rewarding the VC with more potential upside for the risk the VC is taking by participating in the financing.

Let’s harp on this last point because it’s maybe the most important take away on the topic of warrants:

1️⃣ Warrants in practice are really a way for an investor to effectively lower the effective valuation for the company… with further dilutionary impact in store for existing shareholders. The calculation of the pre-money valuation typically does not include the potential dilution from new warrants that will be granted in the current financing; however, new investors will require that a company’s fully diluted cap table includes all existing options AND warrants outstanding prior to their new investment.

So as a founder, by granting warrants, you are setting yourself up for more dilution in the future!

Remember, Price Per Share = Pre-Money Valuation / Fully Diluted Shares Outstanding

If the Fully Diluted Share Count is higher due to warrant grants, the Price Per Share goes down and new investors can purchase more shares on the same investment basis, effectively dropping the pre-money valuation and increasing the dilution existing shareholders will experience at the close of the financing.

See below in practice: as displayed, the PPS is $0.09 lower when historically granted warrants are considered in the existing share count (effectively dropping the pre-money valuation to $14.3M). As a result, the seed investor acquires an additional ~133,333 shares with the same $5M investment in case 1. Furthermore, the founders/employees experience more dilution.

2️⃣ Warrants (especially in early stage VC) can create a lot of annoying complexity and accounting headaches long term. If the investor is adamant about pushing warrants, it may make sense to simply drop the pre-money valuation and eliminate the warrants accordingly. Occasionally, founders might prefer to keep the warrants so they can inflate the headline valuation (#rocket) since (as previously mentioned) the warrant value is rarely calculated as part of the valuation (see example above in which pre-money in both cases is technically $15M despite different PPS).