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Employee Stock Pool Size for New Co in the Renewable Chemistry Sector

Atul  Madahar's Profile

Dear Proformative Friends and Neighbors, Thank you for your responses to my previous questions... very, very helpful. My current firm is considering forming a new company to address a large business opportunity/emerging market with our core technology. To date we have been a consultancy and technology licensing business for renewable plastic feedstocks. The new company will be a subsidiary of the previous consultancy. Although our core technology is proven over some twenty years, this new venture will be a complete change to the traditional business. We will now 'own' and 'operate' several industrial scale specialize chemical plants via joint-ventures, both as minority and majority owners. The new venture will need to attract: - $100-$200M in equity financing over 5-10 years from a range of investors - Top caliber management team, including all CXXs, and board - Top engineering and operating professionals Although the technology risk is small, there could be substantial financing risk, interest rate risk, international exposure and all the other factors that impact a growth stage venture. Knowing all this, and the studies/responses that have been cited elsewhere on Performative, what are the range of employee option pool sizes for this type of technology company/business sector? I think for venture backed technology firms, it’s typically a 20% option pool at the formation of the firm. Also, how should the value of the options be set given the firm is in formation? Should the full option pool be created now at whatever par value the current shares are set at? Thank you for your insights,

Answers

Topic Expert
Kent Thomas
Title: Founder
Company: Advanced CFO Solutions
(Founder, Advanced CFO Solutions) |

Atul,

There is no magic number for the appropriate size of an option pool. You are correct that the typical venture capital financing will target a range of 15% to 20% of the fully diluted shares of the business but that is not a hard and fast rule and assumes a business with founders who already have significant ownership holdings. In your case, the pool may need to be larger since there are no individual founders already in place. I recommend to you, as I do to most clients, that you build a pool from the ground up based on the key employees who need to be attracted to the business and the # of shares / % ownership that is typical for each position.

Regarding valuing the options that are granted, you will need to complete internally or contract for a valuation that complies with IRS Code section 409(a). This valuation will establish the value or strike price of the common shares for which options will be granted. There are many firms who can complete such a valuation to comply with the code. I don't believe that you can assume the value of the business is zero or simply the par value of the shares since your business will be contributing technology, contacts and a good deal of knowledge - there is clearly some value or you wouldn't be interested in starting this business.

Good Luck!

Anonymous
(CFO/Board Advisor) |

Here are a few things to consider before setting up the Option Plan/Pool:

1. Kent is correct, 20% will not be enough, as there is no "CEO/Founder" and all other CXO's need to be hired. Assuming all CXO's, including the CEO, will need a minimum of 15%, that would only leave 5% for all other hires, which most likely isn't adequate. As such, you may need to consider a pool size of 10% - 15% for all non-CXO's, and 15% for CXO's. I would follow Kent's advice and build the pool from the ground up.

2. Since there appears to be substantial future dilution, via additional equity requirements over the next 5 - 10 years, you may want to consider adding an "evergreen" feature to the Option Plan so the number of shares reserved for grant under the Plan will increase automatically, based on either time or formula. This will save a lot of trouble in the future should the shares reserved for grant need to be increased.

3. Kent's comment above, concerning 409(a) valuations, is correct for IRS purposes. That said, I recommend that you review with your auditors whether these valuations will be adequate for GAAP purposes. I have had experience, with Big 4 auditors, where they would not accept the 409(a) valuation for GAAP. Accordingly, this created a lot of confusion (and hard feelings) between client and auditor. Also, be prepared to do these valuations multiple times each year, if necessary, even though the IRS requirement provides a safe harbor of only once a year. Neither GAAP, nor the SEC, provide any such safe harbor.

4. Now is the time to think through how frequently Options will be Granted, e.g. only upon hire; on hire and new grants annually during compensation reviews; on promotion; etc.

5. Define the basic vesting schedule. Also, define the acceleration of vesting, if any, upon a change of control. Since there appears to be significant future dilution, I would pay particular attention to the definition of a "change in control". Your lawyers, and financial advisors can assist you with this.

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