Who to dilute when creating the option pool?

June 3rd, 2015

I offered a cofounder X% in a pre-seed business. The lawyers advised us to create an option pool, so I had them draft up the paperwork. The partner was unhappy with the results because creating a 10% pool diluted him proportionately.

Should all of the shares of the option pool come out of the CEO and majority shareholder, or should the dilution be applied evenly?

Chris Murphy Director of Corporate and Legal Affairs at E2open

June 3rd, 2015

Proportionally. The partner should understand this, and also understand this is standard and fair, and also that future investments will dilute proportionally as well (unless you really want to hamstring your business).

That all said, you can of course choose to make the partner whole for this round, but that is not sustainable as the company evolves and the partner needs to understand that is (usually) going to be better to have a smaller part of a much bigger pie in the end, and that is why folks accept dilution.

To me, this is an essential concept to get straight on between the founders now, or this will not work out well in the long run.

Marc Rowen

June 3rd, 2015

Normally, founders (and other employees) would get diluted proportionally.

From your post, it seems like it might be that the option pool was getting created at the same time as you're bringing on your cofounder. I could see there being some ambiguity in that case, similar to pre-money and post in a funding event.

Michael Barnathan

June 3rd, 2015

People will always respond better to getting less than they expected when they also know you're getting less in proportion. Unequal dilution just looks (and probably is) unfair.

Michael Barnathan

June 3rd, 2015

When one person is diluted, everyone should be diluted. Make sure founders (and others who are getting paid primarily in equity) know that they'll be diluted as the business grows.

As for smaller piece of bigger pie, run the numbers and keep in mind that you can build multiple 7-figure businesses in the time it'll take you to build one 8 or 9 figure one. I'm not sold on the notion that building a big company is always more profitable for the founders.

Rob G

June 3rd, 2015

Everyone should be in the same boat - everyone gets diluted, otherwise this will be a continual source of debate and friction. The exception of course is investors who almost always get preferred stock, liquidation preferences, etc. and they will want to top up the options pool (and likely increase it to more like 15-20%) before they invest... so they don't get diluted :)

Stephen Cataldo

June 3rd, 2015

I think we'd need more details about the agreement before giving real advice. Especially when someone who focuses on startups and business deals makes a deal with a tech person whose job is not supposed to be the minutia of equity arrangements, what you implied/said may well not have been the standard, and you shouldn't expect a tech partner for example not to be pissed that 10% ownership is already less than 10% when no investment money has arrived and nothing interesting has happened.

Here are two scenarios that both fit the question, which feels closer?
1) A founder with an idea and some initial work brings me and someone else into a room. I shake hands that I'll have 10% of the company for the work I'm about to do. The founder and the next person talk, they also agree to 10%, and the founder tells me I now have 9%.
2) I have 10% of a company, an investor buys a portion of the company, so my slice is reduced, of course.

Michael Weickert ♦ Strategic & Entrepreneurial Executive ♦ Trail-blazing leadership in biotech, medical device & pharmaceutical business

June 3rd, 2015

You technically can do it either way until you have investors but by FAR the most conventional and usually appropriate approach is diluting everyone proportionally. Dilution taken only by a subset of shareholders should only happen for a VERY good reason and the precedence could be dangerous. Re-assessing everyone's equity before investments are made could result in someone receiving extra shares making them whole in terms of percent ownership of the company but that should be only for a very good reason such as a critical role played, major contribution made, etc. justifying that percentage of ownership.

Investors will also want an option pool set up prior to their investment so the pool does not dilute them so this pays off - which I presume is why your lawyers advised it.

Lastly, a cofounder that concerned about a 10% dilution for an option pool is probably going to have a lot more issues in the future and needs some mentoring from an experienced entrepreneur.

Neil Gordon Board Member, Corporate Finance Advisor and Strategy Consultant

June 3rd, 2015

The partner is unhappy because instead of X% of the company, it's X% - the dilution of the option pool. It's not about right or wrong, it's about expectations, reasonable or otherwise.

I've long advised clients to express ownership in terms of shares or units, and not percentages.

Be as gentle as you can in explaining why dilution is shared equally, absent a clear agreement to the contrary.

David Schwartz Multi-Platform (Desktop+Mobile) Rapid Prototyping + Dev, Tool Dev

June 3rd, 2015

I really like the approach given in Slicing Pie when it comes to tracking early-stage equity allocations.