Incorporation research
Option Shuffle
US incorporation for Canadian startups
Option Shuffle
“Follow the money card!â€
– The Inside Man, Three-Card Shuffle
Summary: Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.
If you don’t keep your eyes on the option pool while you’re negotiating valuation, your investors will have you playing (and losing) a game that we like to call:
Option Pool Shuffle
You have successfully negotiated a $2M investment on a $8M pre-money valuation by pitting the famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has created $8M of value.
Your teammates ask what their shares are worth. You explain that the company currently has 6M shares outstanding so the investors must be valuing the company’s stock at $1.33/share:
$8M pre-money ÷ 6M existing shares = $1.33/share.
Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00… this must be a mistake! Reading on, the term sheet states, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.â€
You call your lawyer: “What the fuck?!â€
As your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?â€
If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost you millions of dollars of effective valuation. Don’t lose this game.
The option pool lowers your effective valuation.
Your investors offered you a $8M pre-money valuation. What they really meant was,
“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call their sum your $8M ‘pre-money valuation’.â€
For all of you MIT and IIT students out there:
$6M effective valuation + $2M new options + $2M cash = $10M post
or
60% effective valuation + 20% new options + 20% cash = 100% total.
Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.33/share to $1.00/share:
$8M pre ÷ (6M existing shares + 2M new options) = $1/share.
Update: Check out our $9 cap table which calculates the effect of the option pool shuffle on your effective valuation.
The shuffle puts pre-money into your investor’s pocket.
Proper respect must go out to the brainiac who invented the option pool shuffle. Putting the option pool in the pre-money benefits the investors in three different ways!
First, the option pool only dilutes the common stockholders. If it came out of the post-money, the option pool would dilute the common and preferred shareholders proportionally.
Second, the option pool eats into the pre-money more than it would seem. It seems smaller than it is because it is expressed as a percentage of the post-money even though it is allocated from the pre-money. In our example, the new option pool is 20% of the post-money but 25% of the pre-money:
$2M new options ÷ $8M pre-money= 25%.
Third, if you sell the company before the Series B, all un-issued and un-vested options will be cancelled. This reverse dilution benefits all classes of stock proportionally even though the common stock holders paid for all of the initial dilution in the first place! In other words, when you exit, some of your pre-money valuation goes into the investor’s pocket.
More likely, you will raise a Series B before you sell the company. In that case, you and the Series A investors will have to play option pool shuffle against the Series B investors. However, all the unused options that you paid for in the Series A will go into the Series B option pool. This allows your existing investors to avoid playing the game and, once again, avoid dilution at your expense.
Solution: Use a hiring plan to size the option pool.
You can beat the game by creating the smallest option pool possible. First, ask your investors why they think the option pool should be 20% of the post-money. Reasonable responses include
- “That should cover us for the next 12-18 months.â€
- “That should cover us until the next financing.â€
- “It’s standard,†is not a reasonable answer. (We’ll cover your response in a future hack.)
Next, make a hiring plan for the next 12 months. Add up the options you need to give to the new hires. Almost certainly, the total will be much less than 20% of the post-money. Now present the plan to your investors:
“We only need a 10% option pool to cover us for the next 12 months. By your reasoning we only need to create a 10% option pool.â€
Reducing the option pool from 20% to 10% increases the company’s effective valuation from $6M to $7M:
$7M effective valuation + $1M new options + $2M cash = $10M post
or
70% effective valuation + 10% new options + 20% cash = 100% total
A few hours of work creating a hiring plan increases your share price by 17% to $1.17:
$7M effective valuation ÷ 6M existing shares = $1.17/share.
How do you create an option pool from a hiring plan? #
To allocate the option pool from the hiring plan, use these current ranges for option grants in Silicon Valley:
Title Range (%) CEO 5 – 10 COO 2 – 5 VP 1 – 2 Independent Board Member 1 Director 0.4 – 1.25 Lead Engineer 0.5 – 1 5+ years experience Engineer 0.33 – 0.66 Manager or Junior Engineer 0.2 – 0.33
These are rough ranges – not bell curves – for new hires once a company has raised its Series A. Option grants go down as the company gets closer to its Series B, starts making money, and otherwise reduces risk.
The top end of these ranges are for proven elite contributors. Most option grants are near the bottom of the ranges. Many factors affect option allocations including the quality of the existing team, the size of the opportunity, and the experience of the new hire.
If your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.
Bring up your hiring plan before you discuss valuation.
Discuss your hiring plan with your prospective investors before you discuss valuation and the option pool. They may offer the truism that “you can’t hire good people as fast as you think.†You should respond, “Okay, let’s slow down the hiring plan… (and shrink the option pool).â€
You have to play option pool shuffle.
The only way to win at option pool shuffle is to not play at all. Put the option pool in the post-money instead of the pre-money. This benefits you and your investors because it aligns your interests with respect to the hiring plan and the size of the option pool.
Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t work.
Your investor’s norm is that the option pool goes in the pre-money. When your opponent has different norms than you do, you either have to attack his norms or ask for an exception based on the facts of your case. Both straits are difficult to navigate.
Instead, skillful negotiators use their opponent’s standards and norms to advance their own arguments. Fancy negotiators call this normative leverage. You apply normative leverage in the option pool shuffle by using a hiring plan to justify a small option pool.
You can’t avoid playing option pool shuffle. But you can track the pre-money as it gets shuffled into the option pool and back into the investor’s pocket, you can prepare a hiring plan before the game starts, and you can keep your eye on the money card.
US incorporation for Canadian startups
by Carl Mercier
In March 2009, I gave a talk entitled How I founded, bootstrapped, grew and sold my web startups at Mesh U in Toronto, Canada. Ever since, people have been fascinated by how I incorporated Karabunga (Defensio‘s parent company) in Delaware despite living in Canada, and yet maintained the simplicity and benefits of running a Canadian company. I don’t think a month has since gone by without me having to explain in more detail how I did it. Today, I thought I’d finally share with the world what I learned.
There are numerous reasons to incorporate your startup in the USA, particularly in Delaware. I won’t bore you with the details, since I assume you did your homework. Right? Read this great thread on Quora explaining the benefits of Delaware incorporation for startups. Read the whole thing. It’s a goldmine.
The reasons for me to incorporate in the US were very simple:
- I thought I might raise capital from US investors
- Exit was most likely going to be an acquisition by a US company (that’s what eventually happened)
- Wanted the option to move to the US (possibly with an L-1 visa)
- I expected to sell our product mostly to US-based customers
- Wanted to escape Quebec’s stupid French-language laws
After weighing different options with my excellent US/Canada tax accountant Robert Chayer, it was clear that I had to incorporate in Delaware. If you are starting a tech startup, you are most likely doing it wrong if you incorporate in a US state other than Delaware. 60% of Fortune 500 companies, 50% of publicly traded companies and 50% of all American corporations are based in Delaware.
Facebook? Google? LinkedIn? Yahoo? Amazon? YouTube? Sendgrid? Quora? Yup. Delaware. (search here)  This didn’t happen by accident. But it’s not the point of this post; I’ll let you figure out on your own why Delaware is usually the right choice.
I finally incorporated Karabunga as a Delaware C Corporation on March 6, 2007 through Delaware Intercorp. I also used them as my Registered Agent until I sold Karabunga to Websense in 2009. I do not hesitate to recommend them. They were very professional and knowledgable every time I had to deal with them. I also used their mail forwarding service which was as advertised.
I did not use Delaware Intercorp’s generic Certificate of Incorporation since it didn’t fit the requirements of a tech startup. I had a good idea of what I wanted/needed in terms of number of shares, par value and so on, but I thought hiring a lawyer to draft the legal document was the smart thing to do. YOU SHOULD ALWAYS consult with an expert before incorporating a company. If you screw up, you may have to pay a ridiculous $165,000 franchise tax to the State of Delaware. Doing it right only cost me an extra $150. Ryan Roberts recently published an awesome incorporation checklist. You should need to follow his advice and discuss it with your attorney.
With Karabunga incorporated, I was ready to do business in the US. I was however running the business from a small town near Montreal, Canada. Having Canadian employees working from Canada for a US entity is a pain in the ass and a tongue-twister. Moreover, American companies cannot benefit from the generous startup tax credits offered in Canada.
This is where it gets fun! I ended up incorporating a second company in Canada to deal with these issues. In my case, I incorporated in the province of Quebec for simplicity. Let’s call this new company “QC-incâ€.
Both Karabunga and QC-inc would be owned directly by me. According to Robert, this is critical. A Canadian individual owning a US company that owns a Canadian company forms what he called a “sandwich†(CA – US – CA), and although sandwiches are yummy, they have important tax implications that you should in most cases avoid. In retrospect, I wonder what would have happened if I owned QC-inc, and QC-inc owned Karabunga (CA – CA – US). This could have had interesting tax-minimizing benefits after the acquisition. It’s definitely something to bring up with your tax accountant. There was probably a reason why we didn’t do it this way, I forget.
Here’s what the corporate structure looked like:
Karabunga owned all the IP, the Defensio name, the trademarks, the code and the servers (in our case, EC2). Karabunga owned and controlled all the value.
QC-inc was a simple consulting firm that had only one client: Karabunga. Our employees, office, dev computers, ping-pong table and our infamous Dev1 development server all belonged to QC-inc. The idea is to keep both companies as independent as possible. If QC-inc went out of business for whatever reason, it would not have impacted Karabunga in any way (aside from losing all the employees). QC-inc also obeyed Quebec’s French-language laws such as Bill 101. Hopefully you don’t have that problem where you live.
Karabunga is the company we sold to Websense and the employees became Websense employees. I later dismantled QC-inc since it lost its only client and no longer had a purpose.
Having two independent companies also meant treating them as such. It was important for QC-inc to invoice Karabunga at a fair market rate for consulting services. For example, it would have been illegal to take a loss in QC-inc to keep Karabunga’s expenses low. From what I understand, as long as QC-inc breaks even or makes a small profit, you should be fine. But then again, talk to your tax accountant!
Because QC-inc is just like any other Canadian entity, it was eligible for SR&ED. We dealt with Raymond Luk and his fantastic team at Flow Ventures. I advice you to work with a consultant for your tax credits and grants. They’ll take a small cut, but it’s worth it. As a startup founder, you shouldn’t be wasting your time filling out paperwork. I don’t hesitate to recommend Raymond and Flow every occasion I get.
I mentioned earlier that our employees worked for QC-inc rather than Karabunga. “What about stock options?†I can hear you all say! Well, turns out, that was never an issue. QC-inc and Karabunga had an agreement to grant Karabunga stock options to QC-inc employees. End of story.
The US/Canada setup worked very well and was easy to manage. Believe it or not, most headaches came from dealing with the provincial government, not from the State of Delaware. Incorporating and maintaining an incorporation in Delaware is also very affordable.
The first problem I ran into was opening a bank account in the US for Karabunga. Since the shareholders (i.e.: me) were Canadian, banks wouldn’t let me open and account. This is because of some new anti-terrorism laws since 9/11. I applied at 2 or 3 banks and was turned down every time. I finally found RBC Centura (now called RBC Bank), which at the time was owned by RBC in Canada. The closest branch was in Virginia Beach, so I went there an opened an account without any problems. I later learned that I could have opened an account with RBC Centura through a Canadian branch, but I could not have expensed my beach vacation. RBC Bank was recently sold and is no longer owned by a Canadian bank, but according to their website, they will maintain US banking for Canadians.
Another problem arose when I had to file Karabunga’s tax return. I called a few people specialized in US taxes in Canada but they all quoted me thousands of dollars, even though we were not yet profitable. I ended up hiring a small family-run accounting firm in Burlington, VT who did everything over email for just a few hundred dollars. This goes for lawyers as well. US-specialized lawyers in Canada can be ridiculously expensive. US-based lawyers are just expensive.
If you think a good reason to incorporate in Delaware is to save money and avoid taxation, think again. As far as I know, corporate taxes are the same, or maybe even a little higher in the US. Moreover, selling a US corporation instead of a Canadian one could cost you an extra ~$180,000 CAD in taxes. Let me explain.
Every Canadian has a $750,000 lifetime capital gain exemption. It can only be used once. If you sell a Canadian company for $750,000. You pay $0 taxes. If you sell a Canadian company for $1M, you’ll pay taxes on $250k. Only half your capital gain is taxable, and this amount would be taxed at approximately 48%. In this case, you’d pay $60k in taxes ($250k / 2 * 0.48).
If the same million-dollar company was incorporated in the US, the capital gain exemption does not apply. The formula would be $1M / 2 * 0.48. You would have to pay $240k in taxes. These numbers are all approximate, obviously.
The following table illustrates the impact of the capital gain exemption. As you can see, the impact (in percent) decreases as the value of your company goes up. Nevertheless, it’s something to keep in mind.
This dual-incorporation structure is not for everyone. I think it’s a great way to get the best of both worlds, however. It was relatively easy to manage; much easier than I originally envisioned.  Now that you have all this information, it should be relatively easy to replicate. If I started another Internet startup, I would definitely consider replicating the Karabunga setup.
I hope this was helpful. I’m open to questions or comments.
UPDATE: This article is being discussed on Hacker News. Join the conversation.
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