Startup Employee Equity

Offering stock remuneration is now one of the most excellent recruitment methods among startups. Early-stage startups that are short on funds use equity as a form of payment in addition to cash compensation. Equity also attracts investors.  The startup equity pool, sometimes referred to as theoption pool, is the portion of equity designated for hiring and fundraising.

Having a stake in the company can be a significant financial advantage for the employee in the future if the value of this stock increases yearly alongside the startup’s valuation.

Also, startups may preserve capital and attract top talent with a longer-term outlook for their job at the company by providing shares to recruits. Employees who own equity will put in a lot of effort to guarantee that the startup scales since they have a stake in its success.

Equity pools are an indicator of how much the startup can hold onto. Every time a grant is made, the board decides on a fair market value as the exercise price (for options) or valuation (for restricted shares).

Once a startup is incorporated, the founders own all the company’s stock. Following that, founder shares are reduced with each new hire or fundraising round that calls for equity distribution. Let’s say a startup has three founders. It may be complicated to decide which founder shares and how much of it can be traded at every opportunity of dilution. This is why a startup equity pool must be created as soon as business operations begin.

Click here to read more about the employee stock option plan.

 

What Is An Employee Option Pool?

 

An equity pool, also known as an option pool, is a collection of shares set aside for stock options or restricted stock. This is meant to assist a company in recruiting, retaining, incentivizing, and aligning critical people for long-term value creation and success. Startup firms frequently utilize these shares to reward employees, directors, advisers, and consultants instead of cash.

As the startup grows and critical players are added, it will need to regularly analyze its equity pool, deciding how much  stake to give away and how much to keep for its team. Correctly sizing an equity pool is a balancing act which demands a prudent mindset.

Employee equity is provided in the form of stock options and restricted stock, and this is sometimes referred to collectively as the Employee Stock Option Pool (ESOP). Through options, employees are granted the right to acquire shares at a predetermined price on the day of the grant, commonly known as the strike price.

As the startup grows and its share value increases, employees acquire these shares at the strike price, which is lower than the market price. When employees exercise their options, they benefit from the difference between the market price and the strike price of the share.

Meanwhile, with restricted stock, employees are granted stock ownership all at once, but with restrictions based on time, performance, or incentive benchmarks. In this case, employees need not invest in ‘buying’ stocks.

Click here to read more about issuing employee stock option.

Employees who join early (top professionals, experienced key players) face substantial risk because the startup has only recently begun operations, and its future is unknown. This is why they are given a more significant percentage of the option pool than employees who join a few years later once the startup has become steady and profitable.

From an investor’s perspective, funds are granted right from the seed stage in return for a share of the startup equity pool. This is problematic since investors are usually wary about diluting their shares under any circumstances. Regardless of the risks, startups should not advance without first determining their option pool.

Click here to read more about attracting talent through equity compensation.

 

Why is the Option Pool Important?

 

Here are a few reasons why Option Pool could be a preferable choice for your organization:

1. Incentivize talent

Startups use employee stock options to persuade talent to join a startup. If they are already vested, employees can exercise their stock options to purchase a predetermined amount of shares at a predetermined strike price.

2. Reduce cash burn

Stock options enable startups to compensate staff while keeping their cash burn rate low. Giving employees stock options may be costly from an equity perspective—but the startup does not need to pay any additional cash.

  1. Equity compensation

Equity remuneration aligns the employee’s financial interests with those of the company. The employee value of stock increases as the company evolves into a successful potential. Employees benefit much in the long term by utilizing their options.

4. Strategic opportunity

Creating an option pool must be a strategic step if a startup intends to be purchased or go public in the next few years. A good option pool helps a startup create value and reputation. A clear vision for equity allocation is a hallmark of effective management.

5. Fund Raising 

Angels and venture investors will only collaborate with startups if they have a startup equity pool. They  finance for a short period and expect rapid rewards that are entirely dependent on the startup growing its share value.

However, as critical as the option pool is, the question is: how should a startup approach it? What is a reasonable size for an option pool?

Click here to read more about why startups issue employee stock options.

 

How Large Should An Option Pool Be?

 

Correctly sizing an option pool is a delicate balancing act that many founders misunderstand, which might be an expensive mistake. The size of the option pool influences the startup’s valuation, share price, and how much stock ownership the startup retains.

In an ideal world, a startup’s option pool would be large enough to recruit enough people to get it to the next round of funding. If the option pool is too big,  the startup will have more ownership dilution than needed. If it’s too small, potential investors might not support it.

Additionally, it’s possible that the startup won’t find enough talent to carry out the operating strategy it presented to investors (which can affect future fundraising negatively).

Therefore, the ideal strategy is to forecast hiring needs for at least the first 12 months of operations. The startup must consider staggered employee equity plans that take into account the employee’s position within the business. An executive at the C-level would request a bigger percentage than an executive at a lower level. Setting aside 6–8% of the budget for this group of employees is a safe strategy.

The equity to be set aside for the option pool before the next fundraising round may be roughly estimated using this line of reasoning. It is good to be economical at the start, and in the future, the option pool’s size can consistently be increased.

Click here to read more about creating an option pool.

 

Option Pool Sizes at Different Stages of a Startup

 

The number of shares reserved in the option pool represents the total amount that may be granted as equity incentives to employees, directors, consultants, and other service providers.

Of course, each founder independently determines the option pool’s size, with investors usually offering suggestions.

1. Very Early Stages (Bootstrap, Pre-Seed, and Seed)

Often founders go for fundraising after reaching a milestone. Therefore, planning for hiring and building a sizable pool to distribute among the employees becomes imperative. Creating a product and testing its viability on the market are the primary objectives of seed-stage enterprises. Here, product development accounts for the majority of hiring. Given the financial constraints, a startup cannot pay these recruits competitive salaries. ESOPs are utilized to recruit and keep talent to make up for reduced cash-based remuneration. Employees who join early assume greater risk and want compensation in line with that expectation. When deciding whether to offer an option to a recruit, the startup should consider the value the hire brings to the business, the pay decrease they will get, and the risk they are taking by joining the team.

The market considers a suitable ESOP pool size as one between 10% and 15%, although the startup can keep a lower or larger option pool based on its recruiting requirements.  Since new investors may wish to increase the option pool as they participate, diluting the founder’s equity, a bigger pool is not advisable. Employee preferences also influence the size of the pool. Those with an entrepreneurial mindset might want to accept more stock options and could be willing to accept a pay cut. The startup may want to give each new hire more options from the pool (than others who join the startup later) to reward them for joining the startup at this time. Employees should be willing to accept a portion of their pay as stock options if they are prepared to share a long-term goal with the founder.

At this stage, the startup may want to hire mid-seniority people who can advance to leadership positions later.

2. Stages Series A and B

When a startup reaches this stage, the product has already  been built and tested with beta customers. Series A and B goals include gaining more customers, and their crucial recruiting requirements are for laying the groundwork for scaling.  The startup may want to hire sales experts and growth marketers at this stage. As the startup starts generating some revenue at this stage and may have raised a few rounds of funding, it can afford to give better salaries.

Additionally, the startup is more established, and new employees take comparatively less risk than those in the early stages. As a result, the startup may offer lesser stock options to the talent joining at this point. The market norm for an option pool is 7–10% equity at this stage, and all the current investors dilute their stake when a new pool is created.

If the option pool previously created has not been used up or there are still some options available for distribution, founders can negotiate a minimal top-up to the option pool with the new investors. The new investors may request that the startup forms a new option pool, even if it has unallocated options from the previous option pool. Thus, the startup risks over-diluting ownership for both founders and the other existing shareholders.

Founders can counter this by demonstrating that the pool size they have suggested is enough for the hiring requirements and provide anti-dilution protections to the new investors as assurance. This means that if the planned option pool is insufficient, the only sources for the remaining pool would be the current shareholders. At this point, stock options are typically provided only to important hires or as a performance incentive. This may be the time to shift from founder-driven sales to sales led by growth professionals.

3. Growth Startups

Growth startups are those that have reached the series C, D, E, etc. stages. They  have healthy cash flows and a good product-market fit. They are often more stable now, well-known, and at lesser risk. As a result, recruiting talent is comparatively more straightforward because individuals would want to work with these firms.

The stock options should be provided depending on performance and used to motivate the employees as the startup can afford to pay attractive compensation. Recently, startups have started purchasing back options at various stages to give liquidity to option holders, resulting in wealth creation for the employees who do not have to wait for years for the company to exit, or go public, or be acquired.

As the company’s valuation is high, the option pool size decreases from 5% to 7% or less. Since options are primarily intended to encourage growth, they should only be granted to people who contribute and bring value.

It is recommended that founders exclusively give stock options to their most essential employees. If an employee has innovative and disciplined ideas, prioritize them for the stock option grant. You can employ specialists and managers who can streamline operations, establish procedures, and save expenses. Stock options may be awarded to these personnel depending on their performance and the  cost they save for the company.

Click here to read more about an option pool.

 

Approaches to Sizing the Option Pool

 

There are two main ways to size your option pool:

1. Top-Down

This approach looks at the data for what other companies typically do. The equity pool should typically account for 10% of the company’s shares. Still, this data may be further analyzed by company stage, industry, and other factors to see how the business compares to its contemporaries. This strategy allows you to build your option pool on standard industry practices.

2. Bottoms Up

This approach focuses on creating a recruiting strategy based on the demands of the business and projected growth up until the anticipated subsequent funding round. This method entails creating a compensation plan and calculating the amount of equity required for each hire. Then add up the total, plus expected refresh grants, to know how large an equity pool you will need.

Tips for Sizing the Option Pool    

1. Do Not Rely Solely on Benchmarks

While using benchmarks from other companies might assist in ensuring that your option pool size is reasonable, doing so can be risky too. Every firm is unique, so the usual proportion founders set away has a wide range. For instance, some companies are more cash-intensive than others, and some require more (or less) headcount.

2. Be Realistic About Future Hiring Needs

One of the best methods to estimate the size of your option pool is identifying the roles that need to be filled in the next 18 to 24 months (or whenever you want to raise your next round of funding).

When designing this hiring strategy, bear in mind the following:

  • The startup must offer early employees more equity since they are taking a bigger risk joining a relatively unproven business.
  • At every fundraising round, option pools are typically increased. If the startup anticipates hiring C-suite-level executives before the next fundraising round, it may need to offer them a good percentage to incentivize them to join.
  • As the value of the startup increases, the option pool will also increase.

3. Try Not to Reserve More Than You Plan to Issue

Investors prefer bigger option pools since that generally means the option pool will last longer, potentially reducing their dilution. Citing industry benchmarks, they could exert pressure to build a bigger pool than needed.

This is where the recruiting strategy comes in. By carefully mapping out critical employees over the next year or two, and then the startup needs, it can demonstrate to investors how it arrived at that number and maybe negotiate a smaller, more reasonable pool.

Click here to read more about how to size the option pool.

 

How Does Option Pool Work?

 

From a business standpoint, we know that founders must reserve between 10% and 20% of all shares for the startup equity pool. Before the startup starts issuing shares, this needs to be done. Investors often demand that the option pools are calculated using the pre-money valuation – before they commit new funds.

Once on board, no investor will consent to have their options diluted. Investors can evaluate their post-money option pool right away using a pre-money valuation.

Once the investor decides to give funds in exchange for equity, the question is how much of the option pool they are ready to pay for.

Startups must ensure they have a substantial option pool because investors will pressure them to increase if it is too small. However, if it is too substantial, investors will pressure founders to give up their proportion of shares without putting their own at risk in the subsequent fundraising round when dilution is necessary.

For instance, assume Company NDA has issued 5,000,000 shares to its founders before soliciting outside investors and has a pre-money valuation of $2.833 million. This suggests that the founders are currently the only owners. An investor now contributes $500,000 to the firm as part of a seed investment round in exchange for a 15% ownership.

The investor also demands a 10% option pool based only on the post-money valuation. It follows that the startup must establish an option pool before getting the funding, diluting the founder shares such that, following the grant of the funds, the investor receives his share of 15% without having to make any contributions to the new 10% option pool.

 

The Bottom Line

 

Once you have selected your startup’s option pool, the next crucial aspect is the cap table. Determining how much equity to distribute is just the first step in the process. A thorough procedure for issuing, monitoring, and managing shares must be carried out. For this, a capitalization table is employed. It’s advisable to avoid handling the cap table manually as the business expands and engages with more diverse stakeholders (including both investors and employees).

A trusted partner of over 800 startups,trica equity‘s sophisticated software is designed for your ESOPs and cap management needs. With this easy-to-use platform, companies can efficiently create stock option plans for startup employees and automate cap table management.

Request a demo to learn more about our services.