During negotiations with investors, founders often focus on getting the highest possible valuation. However, this effort can be futile if they unintentionally agree to an excessively large option pool.
Founders should be mindful that investors may use the option pool size to lower the effective valuation of the company. This article explains how the option pool impacts valuation and provides tips for founders to address this issue.
The Purpose of an Option Pool in Startup Financing
An option pool is a common feature of startup financing that serves several purposes. It provides a mechanism to hire, incentivize and retain high-caliber talent by offering them equity in the company. This can be especially important for startups, which may not have the same resources as larger companies to offer competitive salaries or benefits packages.
The option pool is also important for investors. By ensuring that there is enough equity available to offer to future employees required to grow the company, the investors are protecting their investment.
How to Plan Your Option Pool
Determining the appropriate size for your option pool can be crucial during the startup financing process. There are several factors to consider when making this decision.
First, create an equity plan that takes into account your current and future hiring needs. Determine how many employees you plan to hire in the next few years and the roles they will fill. This can help you estimate how much equity you’ll need to offer each employee to incentivize them accordingly.
As you create your equity plan, keep in mind any existing agreements or contracts that may impact the percentage allocated to the option pool. For example, if you’ve already promised equity to certain employees or investors, this could limit how much equity is available for your option pool.
The equity plan is a powerful tool for a founder for two reasons. First, you have more knowledge of the company, so you can build a compelling case for the size of the pool you want. This makes it harder for investors to dispute the negotiation rooted in facts. Secondly, putting the plan down on paper shows venture capitalists (VCs) that you know what you’re doing and that you’re being thoughtful about growth.
It’s also important to consider what other startups in your field are offering in terms of equity. You want to offer enough to attract top talent, but not so much that you dilute existing shares.
Keep in mind the expectations of your investors as well. They may have specific requirements or expectations for the size of your option pool, so be sure to communicate with them throughout the process.
Finally, consider any potential changes or developments that may impact your hiring plans down the line. For example, if you anticipate rapid growth or changes in market conditions, you may need a larger option pool than initially planned.
Negotiating the Size of the Option Pool
When negotiating the percentage allocated to the option pool, the company’s growth stage is a key factor to consider. Early-stage startups may need a larger option pool to attract top talent and compete with larger companies while more established startups may require a smaller option pool.
According to a study of over 200,000 venture deals by the National Venture Capital Association and Alumni, the median option pool size as a percentage of fully diluted post-money capitalization by funding stage is as follows:
- 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 either party proposes a pool size that is significantly different from the figures above, they should have a compelling reason for doing so.
Strategies for Negotiating Option Pool Size with Investors
When negotiating the size of the option pool with investors, founders should approach the situation strategically. Here are some tips to keep in mind:
- Do Your Research: Before entering any negotiation, it’s important to understand what is standard for your industry and stage of funding. This will give you an idea of what to expect and where you can push back.
- Be Realistic: Investors want to see that you have skin in the game, so they will expect you to have a stake in the company. Be realistic about how much equity you need for yourself and your team while also leaving room for future hires.
- Consider Vesting Schedules: If investors are pushing for a larger option pool, consider proposing longer vesting schedules or other conditions that ensure employees stay with the company long-term.
- Negotiate Other Terms: If investors are unwilling to budge on the size of the option pool, consider negotiating other terms such as valuation or liquidation preferences instead.
Remember that negotiations should be a win-win scenario. While it’s important to advocate for yourself and your team, keep in mind that investors are taking a risk by investing in your company. Finding common ground is key to building a successful partnership.
The Impact of Dilution on Founder Equity
When negotiating an option pool, it’s important to consider the impact it can have on founder equity. As more shares are allocated to the option pool, the percentage of ownership held by the founders, early employees and early investors can decrease, leading to dilution.
Dilution can significantly impact the value of founder equity, especially in later rounds of funding where larger amounts of capital are being raised. For example, if a founder owns 20% of a company before a new round of financing but that round includes a large option pool that dilutes their ownership down to 15%, they may see a significant reduction in their potential payout if the company is eventually sold or goes public.
While some level of dilution is expected in startup financing, it’s crucial for founders to be aware of how much equity they’re giving up and how it could impact their long-term goals for the company. Careful consideration of the size and allocation of the option pool during negotiations with investors is essential in this regard.
How Option Pools Can Affect Future Fundraising Rounds
While an option pool can be a valuable tool for attracting and retaining top talent, it’s important to consider how it may impact future fundraising rounds. Specifically, a large option pool can signal to potential investors that the company may have trouble retaining employees or that the founders are not as committed to the success of the company.
If investors perceive a high risk of employee turnover or lack of commitment from the founders, they may hesitate to invest in the company or demand more favorable terms in exchange for their investment.
On the other hand, if the option pool is too small, it may signal to potential employees that there is limited room for growth or advancement within the company. This could make it difficult for startups to attract and retain top talent, which could ultimately impact their ability to grow and succeed over time.
To strike a balance between these competing concerns, startups should carefully consider how much equity they need to offer in order to incentivize and retain key employees while also being mindful of how this allocation will be perceived by potential investors. By finding this balance, startups can position themselves for future fundraising success while also building a strong team culture and foundation for growth.
Ultimately, good planning can help you thread this needle.
If you’re interested in diving deeper into the effects of option pools on valuation, check out our Founder’s Guide to Seed and Founder’s Guide to Series A.