In the past, we’ve discussed term sheets and which terms to really focus on in negotiations. One such term to keep an eye on during term negotiations is the option pool (also referred to as an employee stock option pool). To go a little bit deeper, we’ll be walking through what an option pool is, how they work, and how they can affect valuation.
What is an Option Pool?
An option pool is the percentage of common shares in a company that have been set aside for future grants for employees, and they are often used to attract and retain talent. If the company does well and is eventually able to go public or gets acquired, the employees will be compensated with stock. Because employees have a stake in the growth and success of the company, they tend to be more inclined to put in the work to help reach these aims. The amount each employee receives is largely determined by employee role and tenure, which roughly correlates with risk. For example, an early executive hire would receive a larger percentage of the pool than a more junior employee who was hired later.
How Do They Work?
When a company is created, it also determines the number of shares or equity interests it’s authorized to create and generally also sets aside a certain amount, or a percentage, of equity for the employee stock option plan. When a company accepts an investment, it is agreeing to accept the money in an exchange for a percentage of its shares. Usually, a VC term sheet includes a provision that assumes the creation of an option pool.
The size of a company’s option pool depends on their plans for hiring until the next round of funding, (or at least it should), and will typically be renegotiated by the board and investors with each subsequent round of capital. An important distinction to make here is that the option pool is a percentage of the value of the company, not a percentage of available shares. If a future round of funding adds shares, more shares may be added to the option pool upon approval.
Why Do They Matter?
A common point of contention between founders and VC’s during negotiations is the “option pool shuffle.” This is when the option pool gets valued in the company’s pre-money valuation (the value of the company before the investment), rather than the post-money valuation (the value of the company after the investment).
Investors tend to prefer that the option pool is calculated from pre-money shares for a couple of reasons:
- It’s easier for them to calculate their post-money percentage ownership
- They want to avoid immediately diluting themselves upon investment
Investors may not like calculating the option pool from pre-money shares because it draws from their shares. Not only does it dilute their shares, but it can also decrease the valuation. That said, most investors are unlikely to accept terms that don’t take the option pool out of the pre-money valuation. At that point, it’s a matter of negotiating a size that is agreeable for both parties, and the best way to do that is to come prepared with a hiring plan and negotiate from there. It’s also worth remembering that for founders, dilution is just a fact of life.
What Happens to Unused Shares?
If a company has unissued option pool shares, those shares still don’t count towards founders’ percentage of ownership; rather, they are considered fully diluted capitalization. If a company is sold, those unissued option pool shares effectively go away.
Correctly sizing an option pool can feel a lot like Goldilock’s porridge dilemma – not too big that a company ends up with an excess of reserved shares, but enough to meet the demands of hiring. Because of this, it’s important that startups take the time map out what roles are needed, measure magnitude each role will have on the company’s future success, and where they would like to be hire-wise before the next round of funding. By doing this, startups have a better chance of hitting that sweet spot.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.