What is the option pool shuffle and why is it controversial?
Short Answer
The option pool shuffle is a term sheet requirement to create or enlarge the employee option pool before the round, in the pre-money, so the pool's dilution falls on the existing shareholders rather than on the new investor.
Full Explanation
The practice works like this: the term sheet sets a headline pre-money valuation and also requires an unallocated option pool of a stated size after the round, often 10% to 15% of the post-money fully diluted share capital, to be created or topped up before the new money goes in. Because the pool's shares are counted in the fully diluted pre-money share count, the price per share is lower than the headline pre-money suggests, and the whole cost of the pool falls on the shareholders who held shares before the round. The new investor's percentage is unaffected. The pool's options are not issued to the investors; they are reserved for future employee grants.
An example shows the effect. A company raises £2 million at an £8 million pre-money with a 10% post-money pool created in the pre-money. The post-money is £10 million and the investor owns 20%, but the existing shareholders end with 70%, not 80%, because the pool takes the other 10%. Their shares are effectively priced at £7 million (£8 million less the £1 million pool at the round price). Had the pool been created after the round, everyone would be diluted in proportion: the existing shareholders would hold 72% and the investor 18%.
It is controversial because the headline valuation overstates what the existing shareholders receive, and because a pool larger than the company needs before its next round transfers value from founders and earlier investors to whoever is granted options later. Founders can respond by (1) sizing the pool from a hiring plan for the period to the next round, (2) counting options already granted and existing unallocated headroom against it, and (3) comparing offers on the effective pre-money and the price per share rather than the headline number. Our comparison of pre-money vs post-money valuation works through the full cap table.
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Further Reading
What is a down round and how does it affect founders?
A down round is a funding event where the company's valuation is lower than the previous round, signalling market concerns and potentially triggering anti-dilution consequences for founders.
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