Two sides of an often contentious issue

13 May Two sides of an often contentious issue

Posted at 08:42h in Commentary, Entrepreneurs, Venture Capital by

The Issue: Who gets diluted by the employee incentive pool?
Typically, once an entrepreneur and prospective investor decide they want to make a deal, they negotiate a valuation. Once they’ve agreed on the valuation, they work out a variety of other key terms for the investment. One of those terms is usually a carve out of shares to be reserved for future employee equity incentives – the “pool.” This might be as much as 20% (sometime even more) of the fully-diluted equity. Entrepreneurs are often surprised when the employee pool dilutes them, but not the investor.
By way of example, suppose the entrepreneur and investor agree on a $1 million investment for 1,000,000 shares representing 50% of the post financing equity, with (so the entrepreneur figures) 50% left for the entrepreneur. A simple $1 million pre-money, $2 million post-money valuation. But then the investor points out the need for an employee pool, and the entrepreneur, realizing he’ll need to be able to offer key employees some equity incentives, agrees. In our hypothetical let’s assume the two parties agree that a pool of 20% of the post-financing equity (in this case, 400,000 shares) is the right number. Where do those 400,000 shares come from?
In practice – and much to the dismay of many entrepreneurs – the investor will insist that the entrepreneur bear all of the dilution attributable to the pool. Using our example, the post-money equity would be 50% for the investor, 20% for the pool, and now just 30% for the entrepreneur.
The Angry Entrepreneur.
Talk about a bait and switch! First you chisel me down on the price and then, when I’ve given you half my company and we’ve got a “deal” you come back later and say, “oh, and by the way, we’re taking all of the employee pool out of your piece of the company.” Now, it seems to me when “we” – you’re always telling me we’re partners, right? – agree that we need to set aside some equity for an employee pool “we” should at least share the pain. By what possible logic should I should foot the entire bill?!?
The Angry Investor.
Let me guess. This is your first time, right? I guess I knew that, but still….
Get with the program. When we negotiated the valuation we agreed that I would invest $1 million in exchange for 50% of the fully-diluted equity. For me, that meant that, if nothing else, I would own ½ the company when the deal closed. When we later agreed that the company should reserve 20% of it’s equity for future employees, that had nothing to do with our previous agreement. The bottom line is that I agreed to buy ½ of the company for $1 million. How we carve up the other ½ of the company, well, like the chicken providing the eggs at breakfast, I’m interested. Like the pig providing the bacon, you’re committed. Live and learn, I guess. Oh, and by the way, maybe the arrangement will make you a little more careful when you hand out equity incentives.
What’s your take?
So, who is right? Should the entrepreneur suffer all of the dilution of the pool? Your opinion may not change the world, but we’d like to hear it.
Other columns by Paul A. Jones

Paul Jones is president of the Council for Innovation, the Entrepreneur in Residence at the College of Business at the University of Wisconsin-Oshkosh, and a recovering Silicon Valley lawyer with substantial experience as an angel and institutional venture capital investor and venture-backed entrepreneur. The views expressed herein are his own.