There’s no doubt that option pools bring a host of benefits for startups. However, miscalculating the size of your option pool can quickly spiral into a flurry of issues. Startups must get their option pool size precisely right as not doing so can impact their ability to attract both investors and employees alike.
Sizing it too large can lead to unintended equity dilution among existing stakeholders while sizing it too small can create challenges related to attracting employees and investors.
So, to help startup leaders like you navigate through the nuances of option pools, we’ll cover:
- The consequences of incorrectly calculated option pools
- Best practices when calculating your option pool’s size
- Two common ways to calculate option pools
3 consequences of poorly executed option pools
Employee option pool sizing requires accuracy and diligence as wrong calculations can lead to:
Unexpected equity dilution
Nobody likes surprises, especially when they risk impacting your startup’s ownership structure. This problem is often seen in option pools that have been incorrectly sized as too large.
As option pools tap into founders' shares, they can cause significant dilution among existing shareholders, including founders, leading to various issues such as discontent among founders, a decreased valuation of the startup, and even loss of control over the startup's direction.
Inability to hire and attract
Startups with small-sized option pools can’t attract and retain talent as effectively. Equity compensation packages may be viewed as uncompetitive, leading to a lack of motivation among existing employees and resulting in higher turnover rates.
Furthermore, you might be compelled to offer higher salaries in place of equity and increase cash burn to keep up with your competitors.
Risk of legal disputes
Regardless of whether your option pool is too big or small, one thing is certain: disputes will arise.
Stakeholders with overly diluted shares may complain that they’re giving up too much leading to arguments; employees can feel like they are being inadequately compensated; and disagreements related to valuations may arise with investors. All of which will ultimately derail your startup from achieving its mission.
4 best practices when sizing your option pool
While it’s not always possible to calculate your employee option pool size with surgical precision, following these best practices can help minimize potential issues:
#1 Understand pre-money vs post-money option pools
Realizing the differences between pre and post-money option pools is key to minimizing unintentional equity dilution. Pre-money option pools established before receiving investments are preferred by investors as dilution impacts existing stakeholders rather than potential investors.
On the other hand, post-money option pools account for external investments after a funding round, and dilution impacts new investors, making them less investor-friendly.
#2 Plan well for the future
To size your option pool correctly, long-term planning and foresight are highly essential. Founders must recognize that option pool sizes are not fixed. The option pool created during the startup's pre-seed stage will differ significantly in size compared to the future series A option pool.
#3 Obtain accurate 409A valuations
Annual 409A valuations provide value that goes well beyond satisfying strict regulatory requirements. It helps establish the strike price (also referred to as exercise price) by determining the fair market value of your startup’s common stock. This, in turn, can be used to determine your option pool size and ensure that it is appropriately sized.
#4 Monitor your competition
You should keep an eye on their competitors and observe how large their option pools are and how much equity they're offering their employees. You can then size your option pools accordingly.
Survey data and publicly available information are just a couple of ways to get the required information. However, keep in mind that you should factor in your unique circumstances rather than blindly following your competitors.
Common approaches when calculating option pools
There isn’t any fixed or imposed method when it comes to determining your option pool size. You can use conventional and established benchmarks, or even online calculators like LTSE Equity’s TLDR Stock Options.
Here are some approaches commonly used by startups to calculate their option pools:
- Benchmarking: Using conventional industry standards to size your option pool is a method that has helped many startups find their ideal size. A general rule of thumb is to allocate roughly 10% to 20% of your startup’s total value to your employee option pool, though this can be fine-tuned based on your circumstances.
- Founder-first: Another method starts with determining specifically how much ownership should be retained by founders before calculating your option pool size. By doing this, you can fully ensure that founders don’t risk losing control because of unaccounted-for dilution.
Option pools with LTSE Equity
Option pools are vital components that support a startup’s success in every stage, from retaining talent to expanding the size of the business. This is why you cannot afford to get it wrong. No matter how ambitious they start out to be, startups will be left dead in the water without an effective option pool.
To help your startup create and maintain your option pool, equity management tools should be seriously considered. For instance, LTSE Equity provides startup leaders with a powerful equity management platform so they can comprehensively manage and monitor their option pools, plans, and grants all from a single, intuitive dashboard.
That said, the most prevalent issue that affects all option pool planning is equity dilution. Why not learn more about what it is and how you can avoid it?