Employee Option Pool: Setting It Up Right

To build a successful startup, it is important to attract and retain top talent. Startups often face challenges in providing competitive salaries to their employees due to limited financial resources. Option pools can help with this problem.

Option pools allow startups to offer equity ownership in the company, which is essential to attracting and retaining top talent. Equity ownership aligns the interests of employees with those of the company’s founders and investors.

In addition to equity ownership, option pools allow startups to offer more flexible compensation packages. For example, instead of providing a higher salary, a startup can offer a lower salary with a larger equity grant. This approach helps startups conserve cash while still providing valuable incentives for employees.

This article will discuss the size of the option pool and how that impacts both equity offers and funding. Every situation is unique, so it’s essential to work with legal counsel to understand what’s best for you. If you’re looking for counsel, feel free to reach out to us here.

At Founding

A typical option pool size at incorporation ranges between 10% and 20%. Based on our experience setting up option pools over the last 15 years, 99% of startups fall within this range.

Also within this range, the size of the pool should be based on your hiring plan. You should have a rough sense of: (1) how many hires you’ll make, and (2) how much equity you plan to offer each hire between incorporation and your first round of equity financing.

The size of the pool may affect the size of your employee equity awards. Often, an equity offer is communicated to a prospective hire as a percentage (though we don’t recommend this). There are a number of ways to calculate percentages in a startup, such as authorized, outstanding or fully diluted. If you are issuing shares based on the fully diluted calculation, you may end up giving overly generous equity awards.

Consider two scenarios for our startup Gregarious Games Inc. At incorporation, 10 million shares were authorized, and the founders established an employee pool and issued the remaining shares to themselves. Their first hire is a VP of Engineering named Kiera. They have made her an offer that includes an equity award of 1% of the company’s fully diluted stock. The fully diluted calculation includes unissued shares in the pool (calculating based on outstanding shares would not include unissued shares in the pool).

  • Scenario 1 — 10% option pool: Kiera gets 100,000 shares. After the issuance, she will hold 10.99% (100,000 / 9,100,000 = 10.99%) of the outstanding shares in the company.
  • Scenario 2 — 20% option pool: Kiera gets 100,000 shares. After the issuance, she will hold 12.35% (100,000 / 8,100,000 = 12.35%) of the outstanding shares in the company.

Why does this matter? The outstanding shares matter for voting and for acquisitions. First, shareholder voting is based on the total number of outstanding shares, so the higher the percentage Kiera has, the more influence she has on governance of the company. The treatment of the unissued shares in the option pool at acquisition may vary, depending on the terms of the deal. One common strategy is to cancel the unissued shares. If that happens, Kiera will walk away with significantly more cash (and the founders will walk away with less) in Scenario 2 than in Scenario 1.

Framing the Equity Offer

Note that the delta between Scenario 1 and Scenario 2 completely revolves around the way the founders framed the equity offer. So how can a startup founder avoid these issues?

Do not use percentages in your offers. Instead of percentages, use the exact share counts.

However, if you feel you absolutely must use percentages, then be precise. Assuming the company had a 20% pool, here is an example of what the founders should have said:

“We are offering you a stock grant of 80,000 shares in the company at a fair market value of $0.00001 per share. This equity award is equal to 1% of the outstanding shares in our company as of October 1, 2024.”

Using exact share numbers instead of percentages can benefit both the company and the employee in several ways.

First, it provides clarity and transparency about the actual number of shares being offered to the employee. This can prevent misunderstandings or confusion later on about the value of the equity, especially when it comes to vesting or exercising options.

Second, using exact share numbers ensures that employees are not affected by changes in the company’s equity issuance over time.

Using exact share numbers provides greater clarity and fairness for both parties involved in an equity offer. To learn more about why you should use exact numbers instead of percentages, click here.

At Financing

A key term in equity financing is the size of the pool after the close. In the term sheet, it is generally represented as follows:

“The price per share of the Series A Preferred (the ‘Original Purchase Price’) shall be the price determined on the basis of a fully diluted pre-money valuation of $X (which pre-money valuation shall include an unallocated and uncommitted employee option pool representing Y% of the fully diluted post-money capitalization) and a fully diluted post-money valuation of $Z.”

What does this mean? It means that after the deal closes, Y% of the company’s stock will be allocated as unissued shares in the employee pool.

Note that the size of the option pool is included in the valuation term. This is because the size of the pool has a significant impact on the effective valuation of the company and the dilution of the founders. You can read more about this here

In general, the higher the % of the post-money pool, the more the founders are diluted and the lower the effective valuation.

For reference, according to a study of over 200,000 venture deals by the National Venture Capital Association and Aumni, the median option pool size as a percentage of fully diluted post-money capitalization by funding stage is as follows:

  • Seed — 10%
  • Series A — 9.6%
  • Series B — 7.4%
  • Series C — 2.3%
  • Series D — 5%
  • Series E — 2.5%

Of course, every deal has its own nuances. However, if the investor (or founders) propose a pool size that is significantly different from the figures above, they should have a compelling reason for doing so.

So, why does this matter to founders at incorporation? The bottom line is the fewer unissued shares you have in the employee pool, the more diluted the founders will be. Conversely, if you have a large amount of unissued shares in the employee pool, the dilution at an equity financing will be less severe.

The Role of a Board of Directors in Managing an Option Pool

A board of directors plays a critical role in managing an option pool and making decisions about its allocation. The board is responsible for approving the size of the option pool and determining how much equity should be allocated to each employee.

The board must consider several factors when making these decisions, including the company’s financial resources, hiring plan and industry standards. They must also ensure that the option pool aligns with the company’s overall compensation philosophy and motivates employees to contribute to the company’s success.

In addition to managing the option pool itself, the board is responsible for overseeing how it is administered. This includes ensuring that all grants are made in compliance with relevant regulations and that vesting schedules are properly implemented.

The board of directors plays a crucial role in managing an option pool and ensuring that it effectively motivates employees while maintaining control over the company’s ownership structure. By carefully considering all relevant factors and implementing sound governance practices, boards can create option pools that drive long-term growth and success for startups.

In conclusion, setting aside shares in an option pool can be an effective way for startups to attract and retain top talent. The size of the option pool should be based on the startup’s hiring plan and should fall within the typical range of 10% to 20% at founding. Using exact share numbers instead of percentages can provide greater clarity and fairness for both parties involved in an equity offer. At financing, the size of the option pool after the close is a key term in equity financing and has a significant impact on the effective valuation of the company and the dilution of the founders. Finally, the board of directors plays a crucial role in managing the option pool and ensuring that it effectively motivates employees while maintaining control over the company’s ownership structure. By carefully considering all relevant factors and implementing sound governance practices, boards can create option pools that drive long-term growth and success for startups.

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