What is an option pool? | LTSE Equity

Why options pools are important to founders?

Option pools are crucial in a startup’s equity strategy, especially in the early stages when you might not have adequate financial resources to offer competitive salaries. Founders leverage option pools as a means of incentivizing and rewarding employees. Startup leaders must understand proper option pool allocation to attract and retain top talent in a competitive market.

By allocating a part of your company’s equity to an option pool, you can offer talents a stake in your startup. This grants them a share in the organization’s success and helps align their interests with your startup’s long-term growth and profitability.

Option pools also serve as a negotiation tool during funding rounds. Understanding option pools aids you in securing better terms with investors. At the same time, it helps you maintain control over your startup’s equity structure. While options pools are primarily intended to incentivize employees, you may also use them to grant stock options to advisors, contractors, or other stakeholders.

You can navigate complex equity distribution and ownership dilution by grasping the intricacies of option pools. This fosters a motivated and dedicated team that drives your startup forward.

How to create an option pool?

Establish an effective option pool for your startup using the following steps:

1. Assess your staffing needs

Before creating an option pool, evaluate your startup’s current and future staffing requirements. Consider the roles you’ll need to fill and the expertise required to drive your startup’s growth.

2. Determine the pool size

Calculate the option pool size based on your staffing needs and industry benchmarks. Typically, an option pool should account for 10% of your startup’s total equity, with a normal range between 5% and 20%.

3. Understand ownership dilution

Be aware of how creating an option pool can dilute the ownership of existing shareholders, including startup leaders. Strive to balance offering attractive incentives while minimizing dilution.

4. Establish an equity incentive plan

Draft a comprehensive equity incentive plan, detailing the terms and conditions for issuing stock options or shares. This plan should outline vesting schedules, exercise prices, and other relevant provisions.

5. Seek board approval

Present the proposed option pool and equity incentive plan to your startup’s board of directors for approval. Address any concerns or suggestions they might have to refine the plan.

6. Obtain shareholder consent

After board approval, seek consent from your shareholders. This may involve presenting the equity incentive plan at a shareholders’ meeting and holding a vote.

7. Implement the option pool

After obtaining the necessary approvals, implement the option pool. Then, start offering equity incentives. Employees, advisors, and contractors can receive incentives according to the established plan.

How to calculate option pool dilution?

Option pool dilution occurs when new shares are issued as part of the equity incentive plan. To calculate the dilution, divide the number of shares in the option pool by the total number of outstanding shares. For example, if your startup has 1 million outstanding shares and you create an option pool with 100,000 shares, the dilution would be 10% (100,000/1,000,000).

Pre-money option pool vs. post-money option pool

A pre-money option pool occurs before a financing round and is part of the pre-money valuation of your startup.

In contrast, a post-money option pool happens after the financing round, factored into the post-money valuation.

The primary difference between the two is their timing and effect on your startup’s valuation.

What is a management option pool?

A management option pool is a subset of an option pool issued by your company to senior management. It serves as incentive compensation upon terms determined by the company’s board of directors.

Does adding an option pool change company valuation?

Yes, adding an option pool can impact your startup’s valuation. When an option pool is created, it dilutes the ownership of existing shareholders, including startup leaders.

The size of the pool and the number of shares issued will affect the overall valuation of your startup. Consequently, it is essential to strike a balance between adequately sizing your pool and minimizing dilution.

What is the option pool shuffle?

The option pool shuffle pertains to discussions between startup leaders and investors. This term involves a scenario in which an investor desires an expansion of the option pool but expects current shareholders to cover the cost. This is done by incorporating the increase into your startup’s pre-money valuation.

Can an option pool change in size?

Yes, your initial option pool size may reduce during later funding rounds due to investors’ equity requirements. Creating an option pool often dilutes startup leaders’ shares in your startup. This occurs because investors, like angel and venture capitalists, insist on it.

Effectively allocating early equity at each new funding round is crucial. However, your startup’s lead investors will often request an increase in the option pool. This increase is commonly called a top-up. Top-ups ensure the option pool has enough share issuances until the next round of financing.

What happens to unused option pools?

Unallocated option pools are typically rolled over into a new option pool during the next round of funding. In some cases, you may cancel unused option pools, and the corresponding shares are returned to the treasury. This reduces the total number of outstanding shares, increasing the ownership percentage of existing shareholders.

Option pools: Key takeaways

In conclusion, planning your option pool is one of the most important first steps you can take when building your startup. It helps attract and retain top talent in a competitive landscape. Option pool creation and management are crucial for startup leaders to understand. You should find a balance between providing appealing incentives and reducing ownership dilution.

Staying vigilant during investor negotiations is essential, and you should be ready to adjust your option pool size. This flexibility is necessary as your startup grows and evolves. By doing so, you can maintain control over your equity structure. At the same time, you foster a motivated and dedicated team.

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Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.