Although an option pool for founders, investors, and employees, gives startups the necessary power to compete with established businesses in the labor market, many business owners are unsure of its benefits and drawbacks, and how they should be used to obtain maximum benefits.
An option pool allows you to retain the best personnel and motivates your workforce to be productive. Controlling your workforce and keep them motivated is crucial for creating a strong culture. Over time, this culture will aid in the growth of your startup.
This article will outline an option pool and some pros and cons of using one.
What is an option pool?
An option pool consists of stocks reserved for employees of a company. The company’s founders set aside an option pool to attract and retain distinguished personnel. Usually, these options are derived from the founder’s shares.
Option pools are often created based on a specific proportion of the company’s value. Early adopters often earn a larger share of the option pool than employees who join the company later.
Since angel investors and venture capitalists could also seek ownership, the initial size of the option pool may shrink with future investment rounds. Therefore, creating an option pool often brings down the founders’ stake in the company.
How is an option pool structured?
Instead of shares designated for investors, the shares that make up an option pool are often taken from the founder’s stock in the startup. This may be 15%–25% of the overall outstanding shares and may be ascertained when the startup receives its initial fundraising as part of the general terms set forth.
Also, after the initial option pool is created, a startup may create additional ones during its growth and subsequent funding rounds. The venture capitalists may specify or suggest that the pool’s size be set as a percentage of the startup’s pre-money or post-money valuation. Negotiations over the scope of the option pool can affect the startup’s overall price.
Investors could, for instance, prefer that an option pool given post-money valuation be valued at the pre-money valuation, which would bring down the company’s price.
4 benefits of using an option pool
In the startup industry, stock options have evolved into the industry norm. Investors in venture capital anticipate that startups will create an option pool and grant employee ownership.
Some of the benefits of an option pool are as follows:
1. Employees share ownership in the company
Option pools are essential for startups looking to provide employees with stock in a planned manner. It motivates employees to act like owners since they stand to gain financially from the startup’s expansion and long-term success. This increases employee dedication, making them more invested in the company and its growth.
2. Cost-effective, making employment compensation more attractive
Early-stage companies may compete for talent by offering stock compensation to employees without increasing their cash burn. For a long-term financial plan, they can be a wise investment. Employees with company stock options can invest without paying broker fees.
Although startups might need more resources to offer top-market salaries the way established businesses might, the potential upside of early equity in a startup firm can be a competitive advantage for attracting talent.
3. Recruiting and retaining talent
An option pool’s primary advantage is attracting and retaining talented employees. Startups require devoted, motivated personnel – especially in the initial phases.
Stock option vesting clauses usually demand that employees must continue to work for the startup for a predetermined amount of time. Employees will receive compensation if they put in much effort and the startup is sold for a high valuation.
An option pool also provides an alternative payment form for employees.
4. Prompts innovation
Moreover, as startups often lack funding, option pools could also help foster innovation.
Cons of an option pool
Although creating an option pool has many benefits, there are also some disadvantages to it.
1. Dilution of the founder’s stake
The biggest disadvantage of an option pool is that the startup’s founders are left with a lower ownership stake. When working with founders, investors often want to safeguard their investments. Hence they require option pools. As a result, the company’s founders may only own a modest ownership stake.
2. May not be suited for the long run
Although option pools provide numerous benefits, it can be difficult for employees to understand the tax consequences. Over time, dilution may be highly expensive for shareholders.
An option pool can help a startup retain its top employees while motivating them to put in extra effort and benefit the company. This can also instill confidence in prospective new investors, showing that the startup is concerned about retaining a committed and effective workforce.
However, creating an option pool will dilute the founder’s stake in the startup. Last but not least, knowledgeable shareholders would probably want the size of the options pool to be determined by the company’s valuation before their investment.
trica equity is a unified fintech platform for equity management and growth-stage transactions. We provide solutions to build and manage ESOPs, which enable companies to retain their star talent and keep teams motivated, save time by doing away with endless paperwork, and customize their ESOP plan.
If you are looking for an easy-to-use tool to create your ESOP policy and manage ESOPs for your team, contact us today.