Option Pool: Everything You Need to Know
An option pool is a way a startup company can acquire talented employees by offering them stock if the company does well enough to go public. 11 min read
What Is an Option Pool?
An option pool is a way a startup company can acquire talented employees by offering them stock if the company does well enough to go public. Employees receive percentages of the option pool when they're hired, with the amount changing based on how early the employee joins the company and what their position within the company is.
An option pool is a percentage of a company reserved for employees. New companies create option pools by setting aside common stock shares, and granting these shares to employees as a way to pull new talent into a startup.
Option pools are also called employee stock option pool (ESOP.)
Companies use option pools because:
- They want to offer an incentive other than money when they don't have much capital
- They want to give employees a reason to work hard enough for the company to go public (to make the pool worth something)
People who start working for the company early usually get more stock in the option pool than people who join the company later. When a company has more employees, deciding which employees receive options can be difficult.
- Is there another way to inspire those employees to work hard?
- Is the money you save when offering the options worthwhile in the long run?
How an Option Pool Works
A Series A company sets aside a pool of outstanding stock. That pool is often 15-25 percent, but the exact percentage varies. The option pool is a percentage of the value of the company, not a percentage of the available shares. If a round of funding adds shares, shares are added to the option pool to keep it at the negotiated percentage of the company.
Series A pools are usually large because:
- The company has the potential to build equity
- Shares of a young company aren't worth much
- To attract top talent, the company has to offer larger grants (0.25-3 percent)
Once companies grant most or all of the pool, they need to expand it. Expansion usually happens during Series B, and might be 5-10 percent more outstanding stock. By Series C and beyond, adding 1-2 percent is sufficient. The later an employee is hired, the smaller their grant is, because:
- The smaller amount has a larger value as each share grows in value
- More capital has been invested in the business
- The business is less risky
If the board votes to expand the pool between rounds of funding, that dilutes the existing shares. Startups also often split shares after Series B, usually into three or four. A company could go from having 10 million shares to 40 million shares. The shares created in the option pool during the Series B investments get added to the split shares.
After Series B, experts recommend companies make a compensation committee to deal with option pools.
- The head of HR and two members of the board make up the committee
- The committee creates salary ranges and stock option plans for new hires
- They compare what the company is offering to the industry standard
- They create an option pool budget for the shares the company will give to each year's new hires
Terms to Know
Buying a controlling share (more than 50 percent) of a company. You can acquire stock or assets. Some startups acquire other companies to diversify their own company.
Someone who manages and applies transactions for a company. The board of directors usually administers the stock plan for a startup.
Board of Directors
A group of people who manage the startup overall, not the daily operations. They decide big things like whether to sell the company or raise money. Shareholders elect the board of directors.
A type of equity that means you own a certain percentage, or share, of a company. Startup founders and employees usually get common stock. It's different from preferred stock, which usually goes to investors. Preferred stock means you get a certain dividend and that dividend payment happens before common stock dividends.
The individual shareholders elect who is on the board of directors. Directors in the board, by majority vote, decide to hire and fire executives (CEO, COO, CFO.) They also decide when to pay out dividends.
When shares of company stock lose value because the company adds or issues more shares.
A payment startups make to shareholders, usually of either cash or more stocks.
Owning part of a company.
Fully Diluted Capitalization
The number of shares in a company that have been issued.
The percentage of a company set aside for founders, investors, employees, etc., in common stock shares. Usually each round of funding has its own option pool.
How much a company is worth before receiving outside funding.
How much a company is worth after receiving outside funding.
The process your startup takes with the Securities and Exchange Commission (SEC) when you're going to sell shares publicly. You have to give the SEC a lot of information about your company when you register shares, including representations and warranties about how your company is doing.
An event for getting investments for your startup. When you discuss a round of investing, one lead investor makes the negotiations with the startup, but several entities invest. It all happens in one transaction, or round. The rounds are usually called Series A, B, C, etc.
Part of the Securities Act of 1933. It details the exceptions to federal registration of your stock option grants, if you have a written agreement with the people getting the grant.
A beginning company. Often one without outside investments, meaning the founders are bootstrapping the company while they work on it.
Why Is an Option Pool Important?
You need an option pool if you're raising venture capital for your company, because venture capitalists expect an option pool as a return on their investment. If you're starting a tech company, the talent you're trying to attract will also expect an option pool to be part of their incentive to join.
Stock options are a good way to build value in your company, especially if you intend to sell it. You can set up an option pool before anyone ever invests in your company. When an investor does invest in your company, they will have ideas about how much of an option pool you need to set aside.
Devaluing the Option Pool
The more options you offer, the less everyone else's options are worth. If you do not set aside options when someone invests in your company, then any piece of that company you promise to an employee as a stock option removes value from investors' investments. That's why investors almost always require an option pool.
When you give out options, it usually devalues the founder's options, not the investor's.
- Expects to own a certain percentage of the company
- Does not want to invest money in exchange for returns only to have the investment go down in value before the company goes public
- Expects that the founder will split their own share of the company to give to future employees or other investors
- Usually requires the founder to create an option pool for giving stock options to new talent
- The reason: If the founders are seeking investments when they don't have the talent they need for their company, the option shares for hiring new talent should come from the founders
- Needs to have options with enough value to attract more talent to the startup
- Cannot split their option shares into such small pieces that it stops being an incentive, or won't be able to attract good talent
- Might ask investors to take small devaluations to attract talent that will help the company go public and make money
The value of the options for both founders and investors is negotiable.
The pre-money valuation of a company is how much the company is worth before the first round of investing happens. When someone invests in your company, they dilute how much of the company you own.
- Your company's pre-money valuation is $3 million
- Someone invests $1 million
- That $1 million dilutes your share by 25 percent
Many venture capitalists expect a certain percentage of the pre-money valuation to include an option pool. If pre-money doesn't include an option pool, then when the founders create one later, they dilute the investment by handing over shares of the company, a small percentage of which the investor owns. The investor loses out on that small percentage of their potential return. When you make the option pool determines how much equity the investor gets in your company.
- Your company's pre-money valuation is $3 million
- The venture capitalist wants 10 percent of the pre-money valuation to be in an option pool
- That 10 percent comes out of the founder's share of the company, not the amount the venture capitalist will own after investing
- Now your share is diluted 35 percent; the investor's share isn't diluted
Remember, decreasing the size of your pool increases the value of your company.
- The pre-money valuation is $5 million
- A 20 percent option pool means your valuation is actually $4 million ($5 million minus 20 percent)
- A 10 percent option pool means your valuation is $4.5 million ($5 million minus 10 percent)
Option Pool Shuffle
The option pool shuffle is when the option pool gets valued in the pre-money of a company. Investors want the negotiations to happen like this, and many startup founders aren't prepared for it.
Though option pool negotiations come during pre-money valuation, investors want the value of the shares to be in post-money valuation.
- Option pools can impact an investor's price per share, or just a founder's
- To create an option pool, you add shares to the already existing shares of a private company
- You figure out price per share by dividing the pre-money valuation by the number of outstanding shares in the company
- Investors want the option pool to be separate from the shares they get by investing (preferred shares), so their shares do not get diluted thanks to the option pool
- If the option pool comes out of all shares, including the investor's, then that means the investor's shares are diluted, too
Series A and Series B
You create an option pool for each round of funding. If you don't give away your entire option pool by the second funding round, then those unused options go into the option pool negotiated in the second round of funding.
Fully Diluted Capitalization
If you have unused option pool shares, those shares still count against how much of the company you own. When you're getting financing for your company, the unused parts of the option pool count toward fully diluted capitalization. When you sell the company, unused option pool shares do not count as fully diluted capitalization. Your incentive is to make a small option pool so no shares are left unissued.
- You give a new hire a certain percentage of the company, which they want in fully diluted shares
- The bigger the option pool is, the more shares represent that percentage
- If you have unused shares in the option pool when you sell the company, those shares stop adding any value to the company
- The shares that new hire had now represent a bigger percentage of the company
- Investors technically bought their shares with their investment in the company
- That investment got them a certain percentage of the company (say 5 percent), and like with the employee example, a bigger option pool means more shares
- If option pool shares are unused, the company's shares rise in value
- They essentially paid for 5 percent and got, for example, 8 percent instead; that's partially your pre-money they're getting
- Investors want that money to come from the founders' share of the company, not the portion the investors own
- The bigger that percentage, the less money you end up with when you have to add to the pool
- Investors have an incentive to ask for a high number, while founders have an incentive to make the number low
- You can increase the pool size if you run out of shares. If you do this post-investment, everyone's shares absorb the dilution, not just yours
Option Pool Shuffle Best Practices
Founders and lawyers don't want to delve into option pool shuffle questions, because they're focused on other things. Founders should, though, because a too-big option pool means you give away more of your company to other people than you might have to.
Accept That Option Pools Go Into Pre-Money
It would be best for you, the founder, if the option pool didn't come out of pre-money. Unfortunately, no investor will accept those terms. To them, it's normal for the option pool to go into pre-money and you won't get anywhere arguing against that. Instead, use normative leverage to focus on negotiating option pool terms that work best for you.
Create a Hiring Plan
Before you even think about an option pool, make a hiring plan for the next year. With the expected growth of your company, you'll need to hire a certain number of employees. Focus on who you'll need to hire, when, and why.
Use the Hiring Plan to Make an Option Pool
Plan out how many stock options you'll issue to your new hires. Not all of them will get the same percentage. Leave a little room for negotiation, then add it up. You probably won't hit the 20 percent option pool your investors will want.
Silicon Valley usually grants CEOs 5-10 percent, while independent board members get 1percent, and junior engineers get 0.2-0.33 percent.
The earlier someone joins the company, the more they get. If you're talking about a hiring plan between A and B rounds of funding, the closer you get to Series B, the lower the option grants will be.
Talk About the Hiring Plan First
When you're negotiating, discuss your hiring plan with your investors. That's your baseline for explaining why you think your option pool should be smaller. It also forces them to explain why they think the option pool needs to be bigger.
Lower Valuations and Smaller Pools
Sometimes you accept a lower valuation and a smaller pool. The math in this instance is most important, because even with a lower valuation, a smaller pool will not take as big a chunk out of your post-money valuation.
Here is a simple example:
- Your company has 10 million shares of common stock, 1 million shares of outstanding options, and 1 million shares in the option pool.
- If your company is valued at $15 million with a 20 percent option pool, that means the rest of the common stock is worth 67.05 percent
- If your company is valued at $12 million with a 15 percent option pool, the rest of the common stock is worth 70.28 percent
As you can see, your option pool can have a bigger impact on how much your common shares are worth in post-money than the pre-money valuation of your company.
Frequently Asked Questions
- How Much Should Everyone Get?
Employees hired at the beginning usually get a higher percentage of the company. Employees with more significant roles, similarly, get a higher percentage of the company.
- Who Should You Include in the Option Pool?
You include your original employees. You can also include contractors, service firms, consultants, and other people who do early work with your startup.
- Do You Need an Option Pool?
If you want to get outside funding for your company, you will need an option pool.
- How Big Should the Option Pool Be?
Investors often request 20 percent of the startup's post-money valuation.
A survey by J. Thelander Consulting revealed that, in 2015, the median percentage for option pools didn't vary much despite differences in funding. Companies that received less than $5 million in funding had a median pool of 16 percent, while companies that received more than that were between 10-16 percent median. Most option pools, according to the survey, are between 10-18 percent.
Seek Legal Help
To get more information about creating an option pool for your startup, or for help negotiating with investors, find a qualified startup lawyer in your area. UpCounsel screens legal talent near you to find the attorney who can help you best.