When you do an early funding round, you might decide to create a share option pool, ready to set up an Option Scheme for your employees.
But how do you decide what size option pool to create? Make it too small and you’ll need to get shareholder approval to increase it later (awkward, time-consuming), make it too large and you’ll over-dilute your own shareholding. And when it’s time to sell your company, if there are still unallocated shares left in the pool, how do you make sure you get them back?
Founders often ask us about this so we came up with a solution. Read on to find out why it’s important to specify what happens to unallocated shares and how to do this on SeedLegals.
What are unallocated shares?
Unallocated shares are shares you set aside in an ‘option pool’. Your company can then use the pool to create a share options scheme as an incentive for employees. It’s up to you how big you make the pool – that is, what percentage of your total shares it comprises.
Shares in the option pool are ‘unallocated’. As your company grows, you allocate shares from the pool to your team. If and when you sell your company, you might have already allocated all the shares in the option pool. But if there are any remaining, those are the unallocated shares that we want to go back to you.
Before we look at why you need to set down this right in your contracts, let’s look at when to create an option pool.
Ideally, create your option pool before a round
When you create an option pool, you ‘dilute’ all the other shares. Let’s say you and a co-founder just started a company and you each hold 50% of the shares. If you create an option pool of 10%, then you’d each hold 45%.
This dilution becomes more significant when you have investors. It’s normal for companies to do more than one funding round and investors know their shareholding will be diluted in the next round. That’s fine – but they won’t want you to dilute them sooner. For example, if just a few months after welcoming onboard new investors, you decide you’d like to set up an option scheme so you need to create a pool – which dilutes all your shareholders. Your new investors might approve it – but they’re not likely to be happy about it.
If you think you might want to offer shares as an incentive for your team, it’s important to set up the option pool before you bring in investors. And if you don’t have a pool, that’s why potential investors might suggest you create one before they invest.
Protect your right to get back unallocated shares
Often there are clauses in Shareholder Agreements and Articles which say you can’t allocate shares to yourself. But that doesn’t seem fair when it comes to unallocated shares remaining in your options pool because the pool was created from your own shareholding. So now, when you create agreements on SeedLegals, you can add a clause which says that on the sale of your company, unallocated shares go back to you and any co-founders:
- Log into SeedLegals, go to Funding and open your Funding Round
- Go to Advanced Terms
- In the section Share Option Scheme, the last question will ask you:
On the sale of the business, unallocated options go back to the founders?
Here, if you select Yes, the clause it automatically added to your funding round documents.
When you add this clause, you take away two big risks. First, the risk of creating an option pool that’s too big and losing the unallocated shares. And second, the risk of selling your company for less than the full valuation. Let’s look at how this works:
Cut the risk of creating a larger option pool
If you magically choose the right size option pool, then all of the shares will be allocated by the time you come to sell. Marvellous – no unallocated shares, no problem. But it’s tricky to guess the perfect size for your option pool: you can’t yet know how many shares you’ll allocate through your options scheme, or when you’ll sell the company.
When a company is sold, the usual process is that the option pool evaporates: the unallocated shares vanish, so the percentage of shares held by all your shareholders goes up, in proportion to their individual holding. Which is nice. But wouldn’t you prefer that you and any co-founders get back any unallocated shares in the options pool, so that you give yourselves a higher percentage of the shareholding, rather than boosting that of your investors?
When you specify in your agreements that unallocated shares go back to you, you take the risk out of creating a larger option pool.
Cut the risk out of selling the company with unallocated shares
Another reason to make sure you get back unallocated shares on the sale of your company is because unallocated shares might not be included in a valuation.
When the time comes to talk to a potential buyer, you’ll need to carefully check the deal they’re proposing. Let’s say a buyer has valued your company at £100million. You have an option pool of 10%, all still unallocated.
When you ask what exactly the £100million includes, the buyer might say unallocated shares don’t count, because the option pool will evaporate on the sale of the company. So in fact, they’d only offer £90million. If that’s the case, you’ll be extra happy you added the clause about getting back unallocated shares because the shares become ‘allocated’ to you, and your company would be worth the full valuation amount.
Add this clause to your documents as early as possible
You might not be thinking about selling anytime soon, or even in the foreseeable future, but it’s sensible to add the clause about unallocated shares to your legal documents as early as possible – when you create your option pool. It’s common for companies to do more than one funding round so if your documents already contain the clause about unallocated options, you’ll be in a stronger position to preserve your right to keep it in future rounds. And if you’ve already allocated all the options from the pool, then you no longer need the clause. Either way, it’s a smart move for founders.
To make sure your investors are happy, you’ll need to create your option pool early. And to make sure you’re happy – because any unallocated shares end up back as part of your own shareholding – you’ll need to add the clause to your documents.
Start a chat or email us firstname.lastname@example.org. To find out more about setting up an option scheme for your company, book a chat with our experts.