I cant stress how important it is to be able to speak the same language as investors and to be able to think along the same lines. On the latter point, Ive briefly written about this topic before here. but I wanted to give a little bit more color on the former topic with a particular concrete example.

The way founders and investors define pre-money valuations, the value of your business prior to a funding round, are far too often misaligned. On average, first time founders typically see valuations in absolute terms. For example, a $2 million pre-money valuation means a pre-financing round value of your start-up of $2 million. This seems logical enough right? But, does this reflect reality? Unfortunately not.

This is because investors almost always include an option pool in a round of financing. In short, option pools are essentially the shares of your start-up that will be allocated to new early hires (e.g. CTO, CMO, CFO). At this point, Im sure you can imagine where the dilution comes from. The shares that will be granted to these key employees will come directly out of the founders stake and not that of the investors. In each financing round, investors like to invest X amount of dollars in exchange for a fixed stake of the business, which typically ranges from 15-25% depending on the stage of investment and the risks involved. If any one investor starts seeking anything north of 25%, this should be a major red flag, but this is besides the point here. At each successive round, investors will seek to replenish and/or increase the size of the option pool available. Its important to fully understand the implications here as it can really dilute your stake and to equip yourself with sound reasons why you dont need such a robust option pool.

VCs have coined a term called the true pre-money valuation, which highlights this very point brought about when option pools are taken out of the founding teams share of the business. In order to truly understand whether your stake is appreciating in value, keep an eye on the price per share as opposed to the absolute value of the valuation. Yes, its conceivable that your price per share has in fact declined when your pre-money has grown appreciably.

One last piece of advice, its absolutely crucial that you do your homework before engaging in any negotiations. Understand what are the conventions. An investor will never allow you to try to sneak in the option pool in the post-money calculations, but you can consult a lawyer and read up on how you can negate some of the negotiation tactics used by experienced investors in a financing round. There are a lot of tremendous resources out there where VCs themselves write about how entrepreneurs can avoid the many pitfalls that will ruin your ability to raise a next round of financing thanks to getting in bed with an opportunistic investor. On this particular topic of option pools, heres a great piece by Rob Go of NextView Ventures. Happy reading.