How large an option pool should you allocate? Here is some data to support your decision.
Startups face a fundamental problem that sometimes precedes product development, determining product-market fit, and even fundraising: how the heck do you properly incentivize people?
Answer? Equity. Absent the ability to pay employees more than the minimum amount they need to live, you’ll need to offer equity compensation to both hire and retain anyone that resembles “top talent.” Not only will equity compensation influence new and existing employees to think like owners (since they actually are owners), you’ll be able to extend your cash runway for the types of activities that will yield revenue and, eventually, profit. Things like fine-tuning your application, designing the user experience, and sales and marketing activities.
How Equity Compensation Works
Companies provide equity compensation to employees primarily through common stock options or restricted stock units. For private firms, especially early-stage startups, common stock options are overwhelmingly the most prevalent form of equity granted to employees. Based on our data (culled from thousands of valuations of early and late-stage firms, including their cap tables), we found that only 2% of these companies used restricted stock units as compensation.
Stock options give the holder (employee) the option to purchase a specific amount of stock at a specific price (the exercise price). The lower the exercise price, the more valuable the stock option is to the holder.
Restricted stock is the right to own stock with certain limitations. Generally, restricted stock offers a commitment to give a specific number of the company’s common shares in the future for which payment is not required. For the sake of clarity, granting restricted stock is a direct transfer of value from the company’s shareholders to the employee. For the sake of brevity (and because only 2% of our data universe of companies have used RS for compensation), you can find an extended discussion of RS and how it differs from options here.
Only 2% of our data universe of companies have used restricted stock for compensation.
The Equity Pool
It’s not an elite Vegas destination for the nouveau riche (at least not yet, and hopefully not ever), but it is where the portion of equity options reserved to incentivize employees and future hires sits. The equity pool is also known as the option pool, and determining the size of this pool is important. Typically, option pools are created as part of a new round of financing and assigned a vintage year (e.g. “EIP 2014”; EIP referring to Equity Incentive Pool, and 2014 is self-explanatory).
But what is the proper size? 5% of the cap table? 10%? 20%? Well, no one really knows the answer to that question (except that it’s definitely not 0%; if you think it is, you shouldn’t be reading this), but we have a rough guideline that you can refer to when deciding:
Our data shows that over 50% of startups reserve between 10 and 20% of their capitalization table for the option pool. You can also see how the option pool increases at each successive stage of financing, due to VC demands, and what type of compensation premiums non-founding CEOs command relative to founding CEOs.
The range of percentages exemplifies how determining option pool size is more art than science. Ideally, you want to create an option pool that is sufficient for your anticipated hiring purposes until your next financing round. But finding the right balance involves skilled negotiation. If your pool is too small, VCs will push back. If it’s too large, your VCs will receive beneficial anti-dilution effects when the next round closes at the expense of your ownership.
11% of the companies in our data universe have surrendered over 25% of their FDS
A distribution of 5% of the fully diluted share (FDS) count to above 30% FDS highlights the variety of situations that startups find themselves in when trying to figure out how to properly incentivize current and future employees, retain proper equity stakes for founders, and reward VCs for their risk. Yes, some entrepreneurs and companies are simply naïve and buckle to venture capital demands (11% of the companies in our data universe have surrendered over 25% of their FDS), but 18% have negotiated option pools of 10% or less of FDS. A good rule of thumb would be to start with the 15% average that we have observed from our data.
18% have negotiated option pools of 10% or less of FDS
It is also important to remember what the chart on the right implies; if you have to hire C-suite level executives to get your company over the proverbial hump, you will definitely sacrifice your equity stake in the process. Expect to surrender a higher percentage of FDS the earlier you hire an external CEO, too (around 8% more for Seed-stage companies, dropping to about 6% after a Series C raise). These days, good help is expensive.
Add 6–8% to your option pool if you plan to hire a CEO.
But growth is good, and an increasing option pool is something you’ll need in the future when it comes time to add employees again.
As with any critical decision, you’ll need to consider the more nuanced factors of your company’s situation before deciding on a percentage for the option pool, and will probably have to conduct more research because, as referenced above, there can be severe dilutive effects upon a liquidity event (help from LTSE being here, and externally here). Read up; this stuff is important!
We hope that this discussion and our data serve as a useful starting point in your decision-making process.
Credit: Writing, data and visuals from the team at Shareworks by Morgan Stanley.