A Founders’ Guide to Sizing the Employee Option Pool the Right Way

Stock options are a great tool for startups and other fast-growing businesses to reward their workers and encourage excellent performance. They align employee interests with company interests, enabling employees to gain from an increase in the share price of the company they work for.

As the startup grows and considers hiring employees, it is essential to decide how much equity it must set aside for its employees. Effectively sizing an equity pool requires accurate judgment, which is where many startups falter.

It is prudent for founders to reserve only what they intend to use in the option pool. Otherwise, startups run the risk of over-granting shares. Several factors involving the founders and their investors influence the option pool size.

A founder should carefully calculate the size of the employee option pool because it will impact how much of the company they control, its value, and the capacity to secure funding.

The shares of stock set aside for private company employees make up an option pool. A startup can attract talented professionals by offering them stock options for their contributions to making the business successful. Employees who join the startup early typically get a larger share of the option pool than those who join later.

In most cases, the option pool represents 10%-20% of the company’s shares. After creating the option pool, the startup’s board of directors distributes the options among the new hires.

It is well-known that employees who have a stake in a startup are more motivated and dedicated to the company than their peers who only receive financial compensation. In addition, a startup may create an option pool for several reasons. Some of them are listed below:

1. Stock options align the employee’s financial interests with the startup’s. The value of shares increases as the startup grows into a profitable business. In the long term, employees can profit immensely by exercising their options.
2. Creating an option pool must be a strategic move if the startup plans to be acquired or go public in a few years. A profitable option pool enhances a startup’s value and credibility.
3. Angel investors and venture capitalists are more likely to partner with startups with an option pool. Angel investors collaborate with firms that they believe have a promising future. They weigh the risks and wait till the starting period has passed before focusing on making a profit. They are, in essence, a long-term investment.

Option pools are often funded by the founders’ equity or common stock, which implies that with every new employee, the founders’ shares get diluted.

The founders develop an employee option pool when the business is ready to hire. Read on to find out why choosing the employee option pool is important.

An employee option pool dilutes the ownership of every current investor. Hence investors prefer the startup creating a pool of employee options before they invest. Consequently, a startup’s initial employee option pool usually dilutes its shares.

To understand how significantly a single investment can impact the common stock, consider a company with 100 shareholders who each own one share, or 1%, of the business. If the startup issues 100 additional shares and one of the current investors buys them all, there are 200 shares in your company, with 101 owned by a single investor, which is, essentially, more than half of your company. The company’s doubling dilutes the other 99 initial investors’ ownership. Each of them now only owns 0.5% of the company instead of the 1% they once did. The doubling of the shares has diluted their ownership.

Investors are often willing to make investments after the stock has already been diluted or after the founder has granted or set aside stock options for new employees. As a result, investors can keep more of their investment’s value. It is important to note that some investors will insist that the option pools be created from the founder’s shares. They may also want assurance from the founders that at no point in the future will the addition of shares in the option pools lead to the dilution of their stake.

Investors always include an option pool when they provide startups with pre-money valuations. Remember, the larger the pre-money option pool, the lower the per-share valuation.

A startup should choose the correct option pool of stocks to attract interested employees. Determining the right size is necessary for the right share price and a successful evaluation.

The strategies a startup uses to create an employee option pool are crucial. However, the startup must first know the difference between pre-money and post-money option pools. There are two ways to calculate the dilution from the option pool:

A pre-money valuation refers to the value of a company before it goes public or receives other investments, such as external funding or financing.

Pre-money option pools are established before an investment. This type of option pool is more investor-friendly. The shares will only be diluted if the startup creates an employee option pool before raising capital.

Post-money valuation is a company’s estimated worth after outside financing and/or capital injections are added to its balance sheet.

Post-money option pools are created when the investors give the go-ahead for the startup to create or expand its option pool after making a financial commitment. This option pool is more founder-friendly since the founders’ and their investors’ shares are diluted when the pool is created.

Creating an option pool from the pre-money valuation implies that all the option pool dilution impacts the founders and investment firms. Any dilution caused by the formation of the option pool would not affect new investors. Hence, it is common to create a pool out of pre-money valuation. However, if the employee option pool is created from the post-money valuation, it would dilute new investors.

Employee option pools are typically deducted from the startup’s pre-money valuation, as is standard practice in the sector.

Founders should exercise caution when giving a higher percentage to the option pool than is necessary, as that would dilute them even more. For several reasons, an excessively wide option pool may be unfair to founders.

Options from the pool that are not issued may “carry over” into the following round. This implies that if the option pool size had to be limited in the next funding round, the investors from the prior round wouldn’t need to be diluted as much.

Unissued and unvested options will be canceled if the company is sold before the subsequent round. This is called ‘reverse dilution.’ Reverse dilution is when a company repurchases a shareholder’s stock and the remaining shareholders’ ownership percentage increases.

This benefits all investors, although the founders’ common stockholders were initially responsible for the dilution. Since a larger option pool can benefit investors at the founders’ expense, the lead investor may try to ask for an employee option pool that is larger than necessary. This is called the “option pool shuffle”—a colorful term for the negotiations surrounding the size of the option pool.

In this scenario, the investor also wants existing shareholders to cover the cost by ensuring that the company’s pre-money valuation reflects the increase.

The investor wants to switch from a post-money valuation to a pre-money valuation to determine who pays for the option pool (in which case, the investor will bear a portion of the increase, where only the existing shareholders will pay for the increase).

An employee option pool would be big enough to employ adequate persons to bring you to the next round of funding. You’ll dilute the investors’ rights more than necessary if it becomes too big. On the other hand, if it’s too small, investors may not be interested and the startup may not be able to recruit enough talent to fulfill the operating strategy.

The appropriate size of the employee option pool can be determined using the following guidelines:

Although benchmarks can be risky to rely on, they help ensure that the startup’s option pool isn’t too big. Every startup is unique, which explains why the typical amount founders set aside for option pools varies considerably (from 5 to 30 percent). Some companies require more employees than others.

It’s critical to be strategic rather than react to what others are doing and what the investors desire.

A 409A valuation assesses the fair market value of a private company’s common stock, which an independent appraiser should conduct. The recommended practice is obtaining a 409A valuation before releasing your first common stock options, then once annually after that. Founders must also do it after raising each venture capital funding round and as the startup approaches turning points like initial public offerings (IPOs), mergers, or acquisitions.

It’s a good idea to obtain annual 409A appraisals so that the startup is always aware of the price and value of the company’s stock. This will enable the startup to negotiate with investors more successfully.

The pool should be large enough to accommodate your hiring needs for the future without offering an endless runway.

Interested investors will demand proof that an option pool exists to assure competitive hiring. There is no hard-and-fast rule regarding what this entails, so try to strike a balance that limits the dilution while still offering a large pool for the business’s expansion and the investors’ benefit.

One of the most efficient ways to choose the correct option pool size is estimating the number of options a startup needs to attract key employees in the next 18 to 24 months. This would depend on the positions the startup has to fill during that time.

However, a startup must keep the following in mind when it creates its hiring strategy:

1. Give early employees a larger share since they undertake more risks by working for an unproven company.
2. Before the next fundraising round, if you intend to bring on C-suite executives or top-notch advisors, it should expand its option pool because it will need to give advisors a significant incentive to join.
3. The average option pool may expand as the startup competes for the best talent.

Additionally, because a startup has only a certain amount of shares at its disposal, having a specific plan may help prevent the risk associated with over-granting equity.

Investors favour pre-money pools, but that doesn’t mean they won’t be willing to discuss other options. For example, they might let option pools be set up after the investment, letting new hires and the founder share the dilution caused by future hires.

Work with potential investors to build the pool so the startup can save money while giving new employees attractive benefits.

Remember, the larger the initial option pool, the more dilution a startup will experience.

Investors want bigger option pools because it will be active for a long time, potentially decreasing dilution. They might thus use market comparisons to persuade the startup into making a larger option pool than is required. Here’s where the hiring strategy is crucial.

Carefully consider the key employees and the amount of stock they’ll need over the next year or two. A startup can bargain for a smaller, more realistic pool by explaining to investors how it arrived at its estimate.

The founders should understand the size and time of the pool in terms of how they will impact their ownership of the business. A pre-money pool will affect your shares differently than a post-money pool, and an excessively big pool unnecessarily over-dilute you. Before deciding how to set up the pool, be aware of the mechanics of dilution and how the timing of investments affects your stock.

A few considerations for founders to keep in mind are:

1. The option pool will most likely come out of the pre-money valuation. Exceptions can apply, but they are rare.
2. A startup might be able to negotiate a limited option pool with a hiring strategy that lasts until the next financing cycle.

With fewer options, a startup may have to accept a lower valuation. Depending on the situation, a smaller option pool with a lower pre-money valuation can be preferable to a larger option pool with a higher pre-money valuation.

Some things for lead investors to remember:

1. The more diluted they are, the less incentivized the founders are. So, pushing for the largest feasible choice pool size might not be in the company’s best interests.
2. Suppose a startup has a larger pre-money option pool that could provide unissued options. In that case, as an investor, you are at an advantage in following rounds, as others will be taking excess dilution instead of you.

If we take a simple view of the startup equity pool, we can conclude that maybe, more is better. The likelihood of hiring the best minds in the sector increases with the size of the option pool. However, on the flip side, the larger the option pool, the greater the dilution effect on the founders’ shares.

Therefore, the ideal strategy for dealing with this is to forecast hiring demands for at least the first 12 months of operations, starting when a startup issues employee stock. The startup must consider staggered employee equity plans that consider the employee’s position within the company. An executive at the C-level would request a bigger percentage than an executive at a lower level. Setting aside 6–8% of your budget specifically for this group of employees is safe.

The ideal size for employee option pools should be such that it is not too small to hinder the startup from hiring the best talent but not too big to be unduly diluted. There is no “one size fits all” solution. Depending on each business’s requirements and the market’s condition, there is a great deal of variability.

Remember that startups often don’t need to raise their employee option pools significantly after the early rounds. By that time, the startup is less risky for the employees. As a result, the startup can offer fewer options to new hires, negating the need to increase the option pool even as it grows.

Option pools are an essential component of the startup ecosystem. Hence, a startup must determine how much equity it must save when it grows and hires new employees. This is because it affects ownership, share prices, and corporate valuation. Also, it helps in attracting and retaining talent.

Although the mechanics of option pools might be complicated, a founder must grasp how to create one that meets present demands and future business plans. Consult with financial experts who can guide you in choosing the appropriate pool size and timing for implementation so that you and your business can benefit the most from it while still attracting investment.

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.