Negotiating the option pool is, essentially, a part of price negotiations. The size of the option pool directly affects not only your company’s valuation, but also the price per share and founders equity.
Often, negotiations with investors will focus on your startup’s valuation and the amount to be invested, without paying explicit attention to their option pool size demands. Don’t fall into the trap of thinking about money and valuation without thinking about the option pool – the option pool directly affects both of those things.
This article provides a brief overview of what the option pool is and how it works, why negotiating for a smaller option pool is beneficial, and how to successfully approach such negotiations.
What are Option Pools?
Option pools are shares of stock kept aside for future employee stock option grants in a private company – it is created from, and directly impacts, the share value and ownership percentage of common stockholders – and therefore founders equity. The shares in the option pool are kept separate and unallocated, to be distributed in option grants to future employees (or, in some cases, to provide additional employee stock option grants to current employees for high performance.)
Having shares in an option pool available to employees is a strategic part of the startup business model. Having options incentivises employees to really add value to the company – they have skin in the game, so to speak. Because most of these grants usually stay subject to a vesting provision, it also tends to incentivise employees to stay with the startup for longer. Additionally, allocating employee stock options allows a startup to attract talent that it would not otherwise be able to afford.
The size of the option pool is determined by the board of directors, and usually expands with financing transactions – as part of a funding agreement with an investor. Typically, the pool is expanded with each funding round. Up until now it might seem apparent that option pools are necessary, strategically valuable, and not all that contentious.
However, the size of the option pool should often be considered carefully and negotiated fiercely. Here is why: the option pool is a percentage of the value of the company, rather than a percentage of the shares. In most cases, the pool represents the percentage of the post-closing, fully-diluted capitalization of the company that is available for future option grants. The size of the option pool is therefore critical.
Why is the Size of the Option Pool so Critical?
The full percentage amount of the “post-closing” stock allocated to the option pool is deemed part of the pre-closing capitalization when calculating the price per share. Essentially, this means that the shares in the option pool dilutes founders equity, and not new shares.
In other words, the option pool has the effect of only diluting the ownership of common stockholders, and not preferred stockholders. Importantly, because the option pool is expressed as a percentage of the post-money despite being allocated from pre-money, it eats into the pre-money deceptively more than the percentage it is expressed as.
There is another reason why large option pools are attractive to investors but not common stockholders: If the startup is sold before the next series of funding, the un-issued and unvested options will be cancelled. Here, the reverse dilution affects all stockholders proportionally, even though the original dilution (when the option pool was created) only affected common stockholders. A big win for the investor: when your startup exits, some of your pre-money valuation now belongs to the investor.
What are Typical Sizes for Option Pools
Series A funding usually creates the largest pool of outstanding stock – about 15%-25%. It is this large because the company is still small and young, with a relatively low valuation. It is also this large because the company needs to attract talent and therefore has to offer large grants.
When a company grants most or all of its pool, it gets expanded – usually with series B funding. Series B would typically be up to 5%-10%, and series C will similarly be smaller at a percentage of about 1%-2%. This is because shares have gone up in value and the company has as well, so the option pool at a smaller percentage represents larger value. As a result of this, employee stock option grants can be smaller: the value of the shares have grown, and these later employees are joining a less risky venture.
Founders have Incentives to Keep the Option Pool Small
The cost of higher valuation is often a lower value per share for the fully diluted shares. If you have a large option pool, you will have a larger valuation; but less value per share price and less founders equity. Keeping the option pool small will allow the company’s actual valuation, and your stake in it, to be higher.
How to Negotiate
Set up an employee stock option budget, based on post-closing percentages, that clearly shows the hires you need to make. If you can show a relationship between the projected growth that you’ve shown to investors, your option budget, and hiring plan, there is no reason for an investor to demand a larger pool. The result of this kind of scrutiny is often that the pool will be smaller than the average percentage required by investors. Be sure the option pool aligns with your plan – you want it as small as possible, but you don’t want to have to dilute in between financing rounds.
Another part of this strategy is to have a clear idea of the market price of your company (without an option pool). Negotiation is much less contentious once everybody is on the same page about the value of what they are negotiating for. Investors won’t likely insists on paying more that the startup is worth for a larger option pool.
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