Option Pool: What It is and How It Works

Being a startup founder, you face the critical task of attracting top-tier talent while wisely managing your financial resources. Offering competitive salaries is one strategy, but another powerful tool at your disposal is the option pool. This pool of reserved company equity is used to grant stock options to employees, creating a compelling incentive that aligns their interests with the success of your venture.

Option pools help attract and retain skilled individuals who are willing to invest their effort into your startup's success by offering them a stake in the company's future growth. This mechanism turns employees into stakeholders, ensuring they are equally invested in your startup's achievements and challenges.

This blog explores the crucial aspects of an option pool, including its meaning, ideal size, creation process, legal aspects, impact on founders and several others. Keep reading to know more. 

What is an option pool?

An option pool is a designated percentage of your company's shares set aside to be issued as stock options. These shares are reserved for employees, advisors, consultants, and other key stakeholders who provide services to your company. While commonly referred to as the 'employee stock option pool,' it is a versatile tool, and shares can be allocated to anyone playing a critical role in your business, not just full-time employees.

The company decides the size of the pool and is typically expressed as a percentage of the company's total outstanding shares. The value of each option is based on the fair market value of a private company's common stock, as determined by the most recent 409A valuation.

In practice, an option pool allows you to offer future equity as an incentive. This is particularly valuable when you need to attract top talent or retain vital contributors without the ability to offer competitive salaries. Offering equity in the form of stock options gives individuals a vested interest in your company's growth and success, which can be a powerful motivator.

For example, let's say you create a 15% option pool. This means 15% of your company's total shares are reserved for future stock option grants. If you plan to hire a software engineer and offer them 1% of the company in stock options, their ownership stake will come out of this pool, not your personal shares. As your company grows and you continue hiring, you can draw from the shares of stock in the option pool until it is exhausted, at which point you may need to expand it.

Why do startups need an option pool?

An equity pool serves as a strategic advantage for a startup company, offering several unique benefits:

• Securing investment: Potential investors often require an option pool as a condition for funding, ensuring that the startup can attract top talent and align their interests with the company's growth goals. This condition provides reassurance to new investors that the startup is well-positioned to build a strong, committed team.
• Cultural alignment: Stock options foster a culture of collaboration and shared goals, aligning employees with the company's mission and vision. When employees own a stake in the company, they are more likely to work towards its success with a sense of ownership and commitment.
• Flexibility in compensation: Option pools provide flexibility in compensation, allowing startups to reward employees for exceptional performance without immediate cash outlays. This flexibility can be crucial for cash-strapped startups needing to conserve resources while still offering competitive rewards.
• Future talent acquisition: An established option pool makes it easier to attract future hires, as it demonstrates a commitment to employee growth and rewards. Potential hires see the option pool as a sign of the company's long-term planning and willingness to share success.

Consider the example of Google, which famously used employee stock options to attract key early employees. Early hires received significant stock options that later translated into substantial wealth once Google went public. Without competitive salaries to offer in its early days, Google's company stock options were a huge draw for talented individuals willing to take a risk for long-term rewards..​

How is an option pool created?

Creating an option pool involves strategic planning from the initial stages of your company. Here's how the process typically unfolds:

• Initial setup of option pool: At the founding stage, companies usually set aside a certain percentage of equity, often around 10-15%, to form the option pool. This early allocation can provide you with flexibility in offering stock options to new employees and advisors as the company grows. It is a good idea for attracting the best talent and incentivizing early hires.
• Role of venture capital: When raising venture capital, reassessment or expansion of the option pool is common. Investors want to ensure there's enough equity available to attract new hires who are essential for scaling the business. You need to create a sufficiently sized option pool to secure external funding.
• Negotiation with investors on option pool size: The size of the option pool is often a subject of negotiation with investors, particularly during funding rounds. Striking a balance between preserving enough equity for current shareholders and setting aside sufficient equity to attract new team members is crucial. Your negotiations would involve detailed discussions on future hiring plans and growth projections, including the potential for the doubling of shares.
• Determining option pool percentage: The percentage of the option pool depends on your company's stage of growth and hiring needs. Early-stage startups might allocate a larger percentage (10-20%) due to more significant hiring requirements, while later-stage companies might allocate a smaller pool (5-10%) as they have already established a core team.
• Impact of option pool on dilution: Every time your company issues new shares from the option pool, existing shareholders are diluted. This includes founders and early investors. Careful planning in creating and expanding the pool is essential to avoid excessive dilution. Understanding the balance between attracting talent and maintaining ownership of the company is key to effective equity management.

How big should your option pool be?

Finalizing your option pool's size is essential for balancing equity distribution and attracting talent. Typically, option pools range between 10-20% of your company's total shares. 

This range provides a balance between incentivizing employees and ensuring that founders and early investors maintain a significant ownership stake in the company. 

• Your company's growth stage: Early-stage startups may need a larger option pool to attract professionals. As the company matures, you can gradually reduce the size of the option pool.
• Future hiring plans: If you anticipate significant hiring in the future, you will need a larger option pool to accommodate the new employees.
• Investor requirements: Some investors may have specific requirements for the size of the employee option pool. It is important to negotiate these terms carefully.

Creation of the option pool that is too large can dilute the ownership of founders and early investors. This can reduce the potential financial rewards and make it difficult for you to raise future funding. On the other hand, having a smaller option pool can make it challenging for your company to attract and retain the best employees in competitive markets.

Dilution and its impact on founders

Equity dilution occurs when new shares are issued from the option pool, reducing your ownership percentage. This can significantly impact your control over the company and your share of future profits. Let's explore some strategies to minimize dilution:

• Negotiate option pool size: Work with investors to determine an appropriate size for the option pool. Striking a balance between attracting talent and preserving equity is key.
• Raise only what you need: Avoid raising excessive capital that leads to unnecessary dilution. Focus on raising only the amount required to reach your next milestone.
• Bootstrap to key milestones: Grow your business organically as much as possible before seeking additional funding. This approach can help you maintain a larger ownership stake.
• Use convertible notes: Consider using convertible notes instead of traditional equity financing. These loans convert to equity later, minimizing immediate dilution.
• Anti-dilution provisions: Negotiate anti-dilution provisions in financing agreements to protect your ownership stake during future funding rounds.

Allocating options from the pool 

Once you have determined the size of your pool, it's time to decide how to allocate the employee stock options among your team. This process involves carefully considering factors like seniority, contribution to the company, and future roles.

Here is a general overview of how option grants might be structured for different employee levels:

• Founders: Founders (including yourself) typically receive a significant portion of the option pool, reflecting their role in creating and leading the company.
• Key executives: Executives who play critical roles in the company's success, such as the CEO, CTO, and CFO, also receive substantial option grants.
• Early employees: Employees who have been with the company for a significant period and have made valuable contributions may receive option grants as a reward for their loyalty.
• Later hires: Newer employees may receive smaller option grants, reflecting their shorter tenure with the company. However, the size of the grant can also depend on the employee's experience, skills, and potential contributions to the company.

For instance, early hires might receive 1-2% of the option pool, while senior executives could receive 3-5%. Advisors and consultants might get smaller grants, such as 0.25-0.5%, depending on their involvement and time commitment.

Vesting schedules and option pools

Vesting schedules determine when your employees can exercise their options and acquire the underlying shares of the company's stock. These schedules are designed to incentivize the employees to stay with your company for a certain period and contribute to its long-term success.

A common vesting structure is the four-year vesting period with a one-year cliff. This means that employees must stay with the company for at least one year to earn any options (the cliff). After the first year, a portion of the options (typically 25%) vests, with the remaining options vesting monthly or quarterly over the next three years. 

For example, if an employee is granted 4,000 options with a four-year vesting schedule and a one-year cliff, they would earn 1,000 options after the first year. The remaining 3,000 options would vest gradually over the following three years.

Vesting schedules protect both your employees and your company. For employees, they ensure that they are rewarded for their long-term contributions to the company. If an employee leaves the company early, they may forfeit their unvested options. For your startup, vesting schedules help retain key employees and prevent them from leaving with a large number of unvested options.

Legal and tax considerations for option pools

Creating and managing an option pool involves several legal and tax considerations. You must ensure that your option pool complies with US securities laws, including regulations set by the SEC, to avoid legal complications and ensure that your stock options are legally sound.

When your employees exercise their first common stock options, they must pay taxes on the difference between the stock's market value and the exercise price (also known as the strike price). This profit is considered ordinary income and is reported to the IRS as compensation. Your employees might also be eligible for certain tax benefits, such as ISO tax treatment, which can provide favorable capital gains tax rates if specific holding requirements are met.

Maintain thorough paperwork in the form of option agreements, shareholder agreements, board resolutions, etc., to avoid disputes over equity ownership. Clear documentation is essential to ensure that all parties involved in the option pool understand their rights and obligations. This helps lower the risks of legal disputes later.

Adjusting the option pool as your company grows

As your startup evolves and secures new funding rounds, adjusting your option pool becomes essential. Growing companies often face increased hiring demands, necessitating a larger option pool to attract top talent. Investors may also request an expanded pool to ensure equity is available for new hires, making it crucial for maintaining investor relations. 

Regularly assessing and resizing the pool helps balance incentivizing employees and protecting founder equity. Negotiating with investors allows you to strike a balance between meeting business needs and minimizing dilution. By proactively managing your option pool, you can align it with your company's growth trajectory, ensuring that you continue to attract and retain the best talent.

Conclusion

A well-structured option pool is crucial for startups to attract top talent and achieve sustainable growth. However, managing various aspects of an option pool, such as allocation, vesting schedules, and minimizing dilution, can be complex and time-consuming.

Qapita offers a comprehensive solution for these challenges. As the #1 rated equity management software by G2, our platform empowers startups worldwide to efficiently and transparently handle their equity. From setting up option pools to managing employee grants, we streamline the entire process for your startup.

By leveraging our expert guidance and innovative tools, you can confidently manage your equity and option pools, supporting your company's long-term success. Contact our team today to learn how we can help with your option pool requirements. 

‍

FAQs

Is the option pool the same as ESOP?

No, an option pool and an Employee Stock Ownership Plan (ESOP) are not the same. An option pool is a part of a company's equity set aside for employees, advisors, and executives, typically in the form of stock options. An ESOP, on the other hand, is a qualified retirement plan that allows employees to become partial owners by buying company shares, often at a discounted price. 

Does the employee option pool get diluted?

Yes, the employee option pool can get diluted. As the company issues new shares, either through additional funding rounds or expanding the option pool, the percentage ownership of existing shareholders, including employees with stock options, decreases. This dilution is a natural part of equity financing and must be carefully managed to balance the interests of all stakeholders.

When to create an option pool?

Creating an option pool is typically advisable during the early stages of a startup's growth. Establishing an option pool can be a powerful tool for attracting and retaining top talent by offering them the potential for significant financial rewards. However, it's essential to carefully consider your company's specific circumstances, such as its stage of development, funding needs, and hiring plans, before making a decision. Consulting with experts at Qapita can help you determine the optimal time to establish an option pool.

What happens to the unused option pool?

If a startup's option pool is not fully utilized, the unused options may expire or be repurchased by the company. The specific treatment of unused options can vary depending on the company's policies and applicable laws. It's important to consult with legal and financial experts to understand the options available to your company and the potential consequences of not fully utilizing the option pool.

What are the different types of option pools?

Option pools can be classified into two main categories:

• Pre-Money Option Pool: This type of pool is established before a company receives new funding. The size of the pre-money option pool is determined based on the company's valuation at that time.‍
• Post-Money Option Pool: This pool is created after a company receives new funding. The size of the post-money option pool is determined based on the company's valuation after the funding round.