The definition of option pools is simple: they are a portion of a startup’s shares specifically reserved for employee compensation purposes. Equity compensation is a popular tool startups often deploy to attract, motivate, and retain employees without needing to tap into their capital. This helps ensure that the burn rate is not affected.
One example of an option pool is the employee stock option plan (ESOP). It grants employees the right—but not the obligation—to purchase a fixed quantity of shares at a predetermined price, though the specific terms of ESOP pools vary by startup.
Benefits of option pools for managing employee equity
Option pools, when correctly executed, offer an extensive range of benefits for startups in terms of equity management:
Giving away equity on an ad hoc basis, such as making verbal assurances to employees, is a slippery slope when done without an option pool. Disputes may arise, and you may lose track of how much you are giving away without any safeguards, leading to serious consequences (e.g., excessive dilution).
Conversely, option pools provide a structured and transparent process for everyone involved, ensuring that equity grants are given according to an established framework in a fair but sound manner.
Help conserve cash
Cash will always be a scarce resource, especially during your startup’s early stages. Since startups tend to spend a lot on compensation, it is important to carefully monitor your finances as other areas also require funding, like product development, marketing, and legal.
Using an option pool helps reduce immediate cash expenses, keeping cash outflow lower than it would be if equity is used instead.
Improve employee morale
Possessing a transparent option pool is an effective way to incentivize and retain existing and potential employees.
It signals your commitment to rewarding hard work, innovation, and productivity, which, in turn, helps align the goals of your employees with your startup’s. This ultimately leads to a healthier and more cohesive work environment.
3 option pool best practices
Constructing an effective option pool requires you to be aware of several key best practices. The most important ones are:
1. Realize that option pools are not static
Thinking that option pools are static and fixed once they have been created is a misconception and cannot be further from the truth. Just like cap tables, you need to periodically update your option pools to reflect the changing circumstances of your startup as it grows.
Good equity management requires you to be familiar with the present situation of your startup and anticipate your startup’s future needs. For instance, if you plan to increase your startup’s headcount, you should evaluate whether you’re utilizing your existing option pool sufficiently, before deciding on increasing your option pool’s size.
2. Use well-maintained cap tables to track equity
When it comes to option pools, cap tables are invaluable. As your startup and your option pools grow, equity structures can become increasingly complex. Cap tables cut through the noise, providing clear breakdowns of your ownership structure at any time.
However, you need to properly update and maintain your cap tables to effectively plan and navigate your equity structures. Not doing so often leads to poor and inaccurate decision-making that may cause disputes, legal issues, and above all else, unintendedequity dilution.
3. Closely monitor equity dilution
The biggest enemy of option pools is equity dilution. When you allocate shares for your option pool, dilution comes into play by affecting your startup’s ownership percentages.
Founders must carefully manage dilution with their equity compensation plans to avoid needless consequences such as losing control over the startup and causing discontent among existing shareholders. Careful record-keeping and planning (e.g., using cap tables), can help you monitor dilution, but don’t hesitate to consult external counsel if necessary.
Option pools with LTSE Equity
Creating an option pool for your startup is only one side of the coin. The other comes in properly managing, executing, reviewing, and adapting it as your startup moves from seed to series.
Option pool management doesn’t have to be a laborious process. With equity management platforms like LTSE Equity, startups just like yours will be able to easily create, manage, and monitor your option pools with ease.
That said, why not continue your journey by learning how to size your option pool?
The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Information about the company is provided by the company, or comes from the companies’ public filings and is not independently verified by LTSE. Neither LTSE nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding LTSE-listed companies are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. Advice from a securities professional is strongly advised.
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