This is How Business Owners Can Decide the Size of Employee Option Pool

Once you set the ball rolling to build your dream company, you must plan for the future. Hiring the top and right talent lays a solid foundation for the long-term success of most early-stage startups. However, retaining  talent is critical, and offering equity incentives is one way to do that. Investors and business owners have no qualms about sharing equity with people who have the company’s best interest and work hard to grow the company.

The shares allocated in the option pool are the total amount that is used to grant equity incentives to consultants, employees, and other stakeholders. However, before getting to that stage, business owners need to determine the option pool size. Of course, it is a personal decision a founder has to make with regular input from investors.

This article sheds light on what business leaders need to understand while deciding the size of the option pool. Without further ado, let’s begin.

What is an option pool?

An option pool is also referred to as an equity pool or an employee stock option pool (ESOP). It is a slice of company shares that the company allocates for its employees and recruits.

Typically, owners set aside a specific number of shares for an option pool during the initial stage of the company, especially while hiring new employees or after raising the first round of funds. The employee option pool is included in the equity incentive arrangement, a legal structure overlooking matters related to option pools.

Once an option pool is created, the board of directors distributes stock options to new employees when they join the company.

Startup owners need to create an employee option pool only after thorough planning. Here are a few reasons it becomes critical to choose the right employee option pool.

1. Employee option pool takes away ownership

When founders  create an employee option pool, they dilute all current stockholders’ ownership. Most investors prefer that an option pool be created before investing in a company. Thus, a company’s initial employee option dilutes the founder’s equity holding.

2. Employee option pool influences the firm’s valuation and stock price

Investors usually include an option pool in their pre-money valuation offer to the company. The larger your pre-money option pool, the lower is your per-share valuation.

Option pools for pre-money and post-money valuation

After understanding the importance of choosing the right option pool, the strategies you used to pick the ideal size of an employee option pool become crucial. But before we get there, let’s examine the difference between pre-money and post-money option pools.

1. Pre-money option pools

As the name suggests, pre-money option pools are created before an investment. Investors usually prefer this kind of option pool since it is investor-friendly. Your shares will only be diluted if the company establishes an employee option pool before raising capital (hence before issuing shares to investors).

2. Post-money option pools

Post-money option pools are created when investors allow the company to establish or expand its option pool after making a financial commitment. Since your (owner) and the investor’s shares are diluted only after the employee option pool is created, post-money option pools are entrepreneur-friendly.

The size of your employee option pool matters. Decide wisely.

The size of the employee option pool is calculated by considering a bunch of complex factors by the investors and founders. Employees must understand that a small pool benefits them by showing that the company is preserving ownership while negotiating with investors. The size of the pool can be increased over time.

Let’s look at the general guidelines to determine the size of the option pool.

1. Smart use of benchmarks

Benchmarks keep the size of a company’s option pool in check. In simple words, it ensures that the size is not very large. That being said, business owners should tread cautiously and understand the risks involved.

Every company is unique and has its way of looking at things. That is why you typically see founders across different companies setting aside between 5% to 30% stock.

As the needs of every business vary, it is crucial to be smart and refrain from blindly following what other companies are doing.

2. Identify your hiring needs

Companies must understand that a tried and tested way to determine the size of an employee option pool is to calculate the percentage of options required for hiring the right people in the foreseeable future. The pool size should depend on the positions you aim to fill in that period.

In addition, when you have a thorough hiring strategy, you are less likely to grant more equity since you have a few shares to work with.

3. Avoid reserving more than you plan to issue

As mentioned above, the larger the initial opinion pool, the more dilution. From the investor’s standpoint, a larger option pool is more attractive as it shows that it will last for a longer duration, decreasing dilution. Therefore, investors could push you to create a larger pool that your business requires. Therefore, your hiring strategy needs to be on point. You can use your recruitment plan to explain to your investors how you have calculated the size of your pool and bargain with them.

Final thoughts

Employee option pools are important, and every business will need them to enjoy a good run. Apart from enabling the growth of a startup, it provides a clear picture of the company’s equity structure.

Trends suggest that top and successful startups will only reserve a laid-down strategy. They determine the pool size based on their hiring strategy and investors’ input. 

If you want to decide the size of the employee option pool, get in touch with trica.