For startups, setting up an option pool is an essential step in gaining and keeping an edge in hiring the best talent. An option pool is a reserved tranche of shares of stock that are set aside for the employees of a private company. In addition to cash, it’s a way of rewarding employees for contributing to the startup’s success and is an expected part of any startup employee’s compensation.
The reason to set aside shares in a pool is to accurately plan the division of stock between stakeholders, including the startup’s investors and founders. Option pools typically come out of the founder’s equity or common stock, which means that the founders’—not the investors’—shares get diluted with each new hire.
For this reason, it’s important for founders to understand the most beneficial way to set up an option pool to maintain as much personal equity as possible. Yet, when we surveyed almost 500 founders in our early 2022 report, we found that more than half don’t know how to prioritize maintaining their founder equity and liquidity. Let’s change that.
How does dilution work?
Options pools are designed to help you avoid dilution and ensure there is enough equity set aside for employees to be a competitive recruiter. Dilution occurs when the ownership percentage of a shareholder in a company decreases when new shares are issued. This can happen when the company raises new funding through equity financing, or when stock options are granted to employees.
To offer a sense of how dramatically a single investment can affect common stock, let’s imagine that you have a business with 100 shareholders, each owning a single share, or 1%, of your company. If your company issues 100 new shares and one of the existing investors snaps them all up, your company now has 200 shares, with one investor owning 101 of them—more than half the company. Each of the other 99 original investors now owns just 0.5% of the company, instead of the 1% they used to own, since their ownership has been diluted by the doubling of the shares.
Investors are typically eager to invest after stock has already been diluted—that is, after the founder has issued or reserved aside stock options to employees that are joining the startup. This allows investors to retain more of the value of their investment.
Pre-money vs. post-money option pools
This brings us to the distinction between a pre-money and a post-money option pool. The word “money” in these names refers to investments, and the idea is that whether you establish an option pool before or after you get an investment can affect how the equity pool dilutes ownership.
A pre-money option pool is set up prior to receiving any investment, excluding any external funding or the latest round. It only dilutes the founders and factors the size of the company into the valuation. On the other hand, a post-money option pool is established after the company receives external funding, and it doesn’t factor size into the company’s valuation. Post-money option pools dilute the founders and every shareholder. Founders may opt for a pre-money pool if they do not want to be further diluted after an agreement with an investor has already been made.
Right-sizing your option pool
While it’s important to consider when to set up your equity pool, it’s also vital to set up a right-sized option pool and take into account the role of convertible securities in your calculation. Doing this calculation will help you avoid diluting your stock more than necessary.
Let’s look at an example of how the size of an option pool affects common stock. If the size of your pool is unreasonable, it is very easy for your common stock to take a nose dive from 100% to 50%. Say you start with 100% of 6 million shares of common stock, with a pre-money valuation of $4 million. You set up a 20% option pool at a cost of $1 million, get $500,000 in convertibles, and take on a new investment of $1 million. After you’ve made these moves, the investor now owns 20% of the company, the convertibles make up 10% of the company, the option pool accounts for 20%, and the common stock is down to 50% of the shares.
A smaller option pool—say 10%—in this same scenario leaves the common stock at 60%, a far better outcome.
4 best practices for setting up an equity pool
- Understand the impact of pool on your ownership. Founders should have a grounded sense of how the size and timing of the pool will affect their ownership of the company. A pre-money pool will have a different impact on your shares than a post-money pool, and a pool that is too large will leave you overly diluted unnecessarily. Understand the dynamics of dilution and how the timing of investments affects your stock before you decide how to set up your pool.
- Keep the pool just big enough for your staffing plans. If you make your option pool too large, you will be diluting your shares more than you need to. Your pool should be big enough to keep up with your staffing plans for your next round of funding without providing an inexhaustible runway. The pool must be large enough to attract investors, too, since investors will want assurances that your pool is structured to ensure competitive hiring. But there is no hard-and-fast rule about what this means, so work to find a happy medium that minimizes your dilution but also provides a robust pool for your company’s growth and your investors’ advantage.
- Negotiate with your investor. Investors prefer pre-money pools, but that doesn’t mean they aren’t willing to discuss different options, including creative arrangements like agreeing to allow for option pools to be set after investment, causing both the investor and the founder to share the dilution caused by future hires that are outside the plan. Work with your potential investors to set up your equity pool in a way that reduces the cost to you while still providing attractive advantages to them.
- Get annual 409A valuations: A 409A valuation is an assessment of the fair market value of a private company’s common stock, which should be done by an independent appraiser. The best practice is to get a 409A valuation before issuing your first common stock options and then once every 12 months thereafter, as well as after raising each venture round and upon approaching a turning point such as an IPO, merger, or acquisition. It’s a good idea to get annual 409A valuations so you always have an up-to-date understanding of the value of your company and the price of your stock. This will help you effectively negotiate with investors.
While the mechanics of option pools can be confusing, it’s essential for a founder to learn how to design one that matches the company’s needs and trajectory. Consult with financial professionals who can help you right-size your equity pool and implement it at the right time to give the most benefit to you and your company while still attracting investment.
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