Option pools are notorious in the startup world. In many ways, they are considered a necessary evil. Very necessary because you need an option pool to attract talent, especially when your startup is strapped for cash. Evil, because the option pool dilutes founders equity and allows investors to benefit disproportionately from your pre-money value. This move is sometimes referred to as the option pool shuffle.
This article is your crash course on everything you need to know about the option pool. For a more technical discussion of option pool size negotiations, see this earlier LawTrades article.
What is the option pool?
An option pool, in layman’s terms, is a percentage of shares in your company that is set aside – i.e. they don’t belong to you (founders and current employees) or to investors. These shares are set aside for future hiring needs. It is sometimes referred to as the employee option pool.
Option pools have become standard practice for startups. They allow startups to remunerate employees whilst saving on cash (every startup’s initial challenge). Option pools also incentivise employees to stay with, and perform for, the startup. In the VC community, startups with option pools are considered safe bets: they will be able to attract, and retain, talent.
For this reason, option pools are required by the VC community. In other words, if you plan on fundraising, you will need one. That being said, deciding on the option pool’s size as far reaching implications, and should be carefully considered.
Why is the option pool size so important?
When investors are looking to acquire stock in your company, they typically negotiate for a certain percentage of your total company stock. When you take on an investment, you are agreeing to transfer that percentage of your company’s shares to the investor, in exchange for capital.
The term sheet for such an investment will almost always include a provision that requires an option pool, however. Investors will typically calculate the option pool out of the pre-money shares, because they are simply buying the post-money percentage ownership.
What this means, in practice, is that the option pool dilutes your stock as founder, and your employees’ stock, without diluting the investor’s stock. Why? Well, you are setting aside a percentage of shares from the total of shares that you own, and only after that dilution will the investor take up her his/her agreed percentage.
Another crucial element of this mechanism is that, if your company should exit before all the shares in the option pool are granted, the de-dilutive effect of those unissued shares affect investors and founders proportionately. This means founders stock loses out twice, in effect.
Remember that all of this is negotiable, of course. It is possible, and advisable, to agree with investors that the option pool should not only come from pre-money shares. Keeping your eye on all the implications of the size of the option pool, as well as whose stock it dilutes, will help you negotiate a deal that is fair to both parties.
So how do I decide on the size of my option pool?
Essentially, you need an option pool that is sufficient to serve your staffing and recruiting needs, whilst not diluting your ownership unnecessarily. The best way to do this is to set up an employee stock option budget, based on post-closing percentages, that clearly shows the hires you need to make to reach the strategic goals of the business.
This information will help you plan the option pool’s size in accordance with your unique strategic needs. If you can align your option pool with your overall growth plan, you can be sure that it will be as small as possible, whilst still allowing you to hire and grow at the rate you need.
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