Option Pool: All You Need to Know Before Creating and Using It
Option pools have become an ideal compensatory tool for startups looking to lower costs while retaining employees with attractive reward systems.
However, designing such an option pool entails a delicate balance between every party’s needs and must be built to facilitate easy management throughout its lifetime.
We help you understand how this can be done through our comprehensive guide.
What Are Option Pools, and Why Are They Important?
Let’s start by understanding option pools, more specifically, their definition, structure, and purpose.
An option pool is essentially a company structure that allows the formal allocation and reservation of shares of stock for employees in a company.
This is critical for startups; it increases company value and makes the company much more attractive to both investors and talent alike. It is particularly important since venture capitalists and angel investors wager on the long-term success of option pools in attracting talent, thereby ensuring returns on their investments.
Furthermore, the shares earmarked for employees are separate from those meant for investors. The former is what makes up the option pool and could be up to 25% of the founder’s stock.
What Should Be Considered When Creating an Option Pool?
As mentioned earlier, creating an option pool is no easy task. It entails carefully considering many factors, such as the ones outlined below:
1. Share type and class
Founders have a couple of options here and can choose between issuing new or existing shares. Issuing new shares can be beneficial in the long term if they are issued over non-voting and non-dividend shares. Nevertheless, this may not pose much of an issue if the pool will be exit-only rather than exercisable.
Understanding whether a company has enough liquid shares to meet the commitments of an option pool sustainably is critical. Startups could start with as little as a dozen shares or even a few hundred, but this may mean that shares are not liquid enough.
Ensuring sufficient liquidity for the option pool could entail subdividing existing shares to increase the overall number. While the value per share will decrease, the share in and of itself remains meaningful. Hence, even the distribution of small percentages of equity to employees still proves to be a meaningful act, all while maintaining a liquid option pool.
3. Hiring plans
Understanding and anticipating future needs are crucial in designing an option pool that will cater to employee and investor requirements. An excellent place to start is to determine how many employees would need to be onboarded over the next two years (or however long it will take before the next round of funding). Thereafter, ascertain how many stock options would be enough to attract new talent into accepting an offer.
It must be noted that founders must create an incremental plan to accommodate yearly growth and consider the potential hiring of C-suite employees. Both of these factors could necessitate an increase in pool size, which we deal with in detail in the next point.
4. Pool size
Option pool sizes depend on what percentage of the company’s equity can be allocated towards it and how many of the founder’s shares can be diluted.
Settling on the correct size is no small task, as pool size can determine how much ownership founders retain, company valuation, and share prices.
Normally, pool sizes can range from 5%-15% of the company’s total equity but must consider investor and employee needs.
For example, too large a pool dilutes equity to where ownership is at risk. Conversely, too small an option pool could be met with investor disdain and disinterest from employees who deem the compensation unattractive.
Related: Four Things to Consider When Deciding on the Size of an ESOP Pool
5. Stages of funding
Since option pools represent a share of the company’s value and not of available shares, subsequent funding rounds can add shares to the company.
These are usually added to the option pool to even out the pricing. However, pools at every stage of funding look like this:
- Series A: large pools, since there is potential to build equity even though share prices may be low.
- Series B: 5%-10% of shares are added to the pool since there is more room for expansion.
- Series C and beyond: only 1%-2% of shares have been added since the business was established, and share prices have increased substantially. Also, employees hired at this stage receive fewer options than contemporaries hired earlier.
6. Valuations: pre-money vs. post-money
Option pools are included in the pre-money valuation delivered by investors, and they prefer it this way. This type of option pool is more investor-friendly since it’s created before investments, and dilutes only the founder’s shares. A large pre-money option pool means a lower valuation on a per-share basis.
Contrastingly, post-money option pools are created after investments and dilute both founder and investor shares. This is undoubtedly more founder-friendly since the dilution is shared.
Creating an option pool that suits your business can be overwhelming if you’re not well-versed. However, trica equity can help you simplify the process. We offer transparent pool management with our software by digitizing and customizing your cap table as your company grows. Book a demo today.