The Option Pool Shuffle — The Dilution Hidden Inside the Valuation

Every VC term sheet requires the company to have an employee option pool of a certain size. The critical question — which determines how much founders are diluted — is whether the option pool is included in the pre-money or post-money valuation. In virtually every VC deal, the pool is included in the pre-money count, which means founders bear the dilution.

The Mechanic Explained

Consider a simple example. A VC offers to invest $5M at a $20M pre-money valuation and requires a 15% option pool. There are two ways to construct this:

Scenario A: Option Pool in Post-Money (Founder-Friendly)

Scenario B: Option Pool in Pre-Money (Standard VC Ask)

The Fred Wilson (Union Square Ventures) and Brad Feld (Foundry Group) posts on this topic from 2007–2008 remain the definitive explanations, widely referenced in the startup community. The short version: VCs are not doing anything deceptive — this is disclosed in the term sheet and is market standard. But founders who don't model it will consistently overestimate their effective valuation.

Impact on the IPO Share Count

At the IPO, the full option pool — including unissued (authorized but ungranted) shares — is typically included in the fully-diluted share count. This matters for:

• IPO valuation: The price per share implied by the IPO valuation is calculated on the fully-diluted count including unissued options. A larger unissued pool means a lower implied price per share.
• S-1 disclosure: The capitalization table discloses both outstanding options and the unissued reserve. Institutional investors evaluate the "overhang" — the ratio of unissued options to shares outstanding.
• Post-IPO equity plan proposal: At the first annual meeting, the company will likely ask shareholders to approve an additional share reserve for the equity plan. ISS evaluates this request using its SVT (Shareholder Value Transfer) model, which takes the pre-existing option overhang into account.

How Founders Can Push Back

The option pool shuffle is a negotiation point, not a fixed term. Founders who understand the mechanic have several options to limit the dilution it creates:

• Argue for a smaller pool: VCs request large pools (often 15–20%) because they are managing a portfolio and apply a template. The actual hiring plan for the next 18–24 months may only require 8–12%. Build a specific hiring model and negotiate the pool size down to what is actually needed.
• Push for a post-money pool: Under a post-money option pool structure (used with post-money SAFEs and increasingly in priced rounds), the pool is sized as a percentage of the post-money capitalization — after the new investment. This shifts the dilution for the pool to all shareholders pro-rata, rather than concentrating it on founders and employees pre-raise.
• Negotiate timing: The pool expansion can sometimes be delayed — arguing that a portion of the pool expansion happens at the next financing rather than at this one, based on actual grants made versus projected grants.
• Understand the VC's model: The VC's ownership percentage target is based on post-money capitalization including the expanded pool. If you negotiate the pool from 18% to 12%, the VC achieves the same ownership target at a lower valuation — the pool reduction often comes with a corresponding valuation reduction, not a net gain for founders. Model it both ways.

Interaction With Post-Money SAFEs

Post-money SAFEs — the YC standard since 2018 — are designed so that the SAFE investor's ownership percentage is calculated on a post-money basis that includes the option pool. This means the option pool is dilutive to founders under a post-money SAFE in exactly the same way it is dilutive in a priced round — the shuffle mechanic does not create additional dilution beyond what was already in the post-money SAFE calculation.

Pre-IPO Option Pool Sizing for Employee Retention

In the 12–18 months before an IPO, the company typically needs to establish a new public company equity incentive plan and set aside a share reserve. The two decisions — how large the pre-IPO pool should be and how large the public company plan should be — are interrelated:

• Run-rate grants: Model the annual equity grant budget as a percentage of fully-diluted shares — typically 2–4% of shares outstanding per year for technology companies at IPO scale. The pre-IPO pool needs to be large enough to fund grants until the public company plan is adopted and registered.
• Retention grants ahead of IPO: Many companies make broad-based retention grants to employees in the 6–12 months before the IPO to reduce turnover through the lock-up period. These grants require pool availability — plan accordingly.
• Public company plan reserve: The public company Equity Incentive Plan adopted at IPO typically reserves 10–15% of fully-diluted post-IPO shares for future grants, plus an evergreen provision (automatic annual replenishment of 3–5% of shares outstanding) to avoid annual shareholder approval for routine grants.
• Shareholder approval timing: The pre-IPO plan and the post-IPO plan are both approved by the board and shareholders (pre-IPO by written consent; post-IPO through the proxy process). ISS and Glass Lewis evaluate both the size of the reserve and whether the plan terms are shareholder-friendly.

Evergreen Provisions — What They Are and When They Matter

An evergreen provision automatically increases the equity plan share reserve each year by a fixed percentage of total shares outstanding — without requiring a separate shareholder vote. For example: "The number of shares reserved under the 2024 Plan shall automatically increase on January 1 of each calendar year by the lesser of (a) 5% of the total shares outstanding on December 31 of the prior year or (b) such smaller number as the Board determines."

• Evergreen provisions are standard in public company equity plans — they reduce the administrative burden of returning to shareholders for plan replenishment every 2–3 years
• ISS evaluates evergreen provisions as part of its "burn rate" and "overhang" analysis — a 5% annual evergreen on a large share base can result in ISS recommending against the plan if total potential dilution exceeds ISS's sector-specific threshold
• The compensation committee's discretion to reduce the evergreen increase provides a safety valve — the board can keep actual grants below the automatic increase if needed to stay within ISS guidelines
• Glass Lewis is generally more accepting of evergreen provisions than ISS, but also monitors total overhang (outstanding unexercised options + unvested RSUs + pool available for future grants as a percentage of fully-diluted shares)

Primary Sources