Option Pool Question (Bananas Given)
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I think part of the equation is missing, namely: How much equity does management currently own, and what portion of that are they going to roll into the deal? If 10 of those hundred shares are currently owned by mgmt and they roll them all into the deal, there's your pool - w/ no dilution to the new owners. If they are selling all their shares at $12 and then being reloaded with equity for the next X years, then the sponsor's ownership at exit needs to contemplate that they will then own 90% of the stock, not the 100% they bought. What's likely to happen is somewhere in between, where management sells some stock to reward them for value already created, and rolls some into the deal to align their interests with those of the buyer, resulting in net dilution to the sponsor at somewhere between 0 and 10%.
This is a really good and comprehensive answer. That said I read it in a more straightforward way. It's safe to assume (or if it's an interview scenario state that you're assuming) that mgmt is selling all their shares (or rolling common) such that at the second the deal closes, and before option issuances, there are 100 common shares at $1200 total equity value. This means you create 11.11 option units for mgmt at a strike of $12 each. At exit, common gets first $1200 of equity (12 per unit) and any equity above and beyond that amount is 90% common, 10% mgmt options
Edit to add, it's not super uncommon for a sponsor to issue 10 option units here and claim it's a 10% pool (it's not...)
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Basically the waterfall is as follows:
First 1,200 (or less if you sold below cost) - all Sponsor Everything else - 90 Sponsor / 10 Execs
So for 2,400 equity value exit: 1,200 to Sponsor
1,200 leftover after Sponsor recoups 1x proceeds (options become in the money) 1,080 to Sponsor 120 to Execs (options)
Total 2,280 to Sponsor 120 to Execs
Quick note: you could use the treasury method if you wanted to here - it would get you the same answer - but as waterfalls become complex and various option tranches can be in vs. out of the money (think tiers struck at 3x, 4x, and 5x) it's more intuitive to think of how the $ would actually flow in order when you sell the Company.
You'll note that sponsor gets 95% of proceeds here even though they only have 90% fully diluted ownership. This is because of the effective 1x preference sponsor has (you get your money back before options become in the money and start being paid out). You'll occasionally see the term "fully diluted at sale" or "fully diluted at current valuation", which will be the calculation of how proceeds would actually flow. (For example, if you held the PortCo we've been describing, and did a quarterly valuation where its equity value was 2,400, sponsor would say they have 100% common, 90% FD, and 95% "FD at sale assuming current valuation")
Awesome, thank you!
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