Option Pool

First things first – this is the size of the option pool as a percentage of the post-money valuation and where ALL of it comes from the founder’s equity. This is the least founder-friendly way to present this, but it is also the point at which most early stage investors will start the negotiations.

So what is the option pool? Simply explained, the option pool is the percentage of your company that you are setting aside for future employees, advisors, consultants, and the like.

The expectation from traditional venture firms is that this will equal 15%-25% of the company after they make their investment. The option pool is one of the most complex and, from the entrepreneur’s perspective, confusing terms in an equity financing scenario.

The most frequently asked questions we run across regarding the option pool can be grouped into two categories:

  1. Who is the option pool for? How much should everyone get? Do I really need one of these?
  2. How big should the option pool be? Why does the option pool dilute the founding team disproportionately as compared to the investors?

Who Is the Option Pool for?

The option pool is used primarily for two, highly intertwined, purposes. The first is to have a way to pay people with a currency other than cash when a venture is bootstrapping. The second, and related use, is to incent people (employees, consultants, service firms, etc…) to help make a venture succeed, and in turn make their options worth something. The earliest hires in a company are usually the largest recipients of the option pool — The basic thought process being that the earlier someone joins, the more risk they are taking and the less posh their life will be for the near future.

Beyond the first employees, there are quite a few different schools of thought on who should get stock options and who should not, the best policy is to understand the implications of issuing different parties options and make sure that you’re promoting the desired incentive alignment. For example, would it be worth giving your attorney options in return for a lower hourly rate? Answer: It depends. If it’s a lawyer who is material to the future success of your venture on an ongoing basis then maybe. If it’s a lawyer being used for a specific, time-sensitive transaction then probably not. There are lots of ways to provide incentives for getting things done and stock options are but one…use them wisely.

How Many Options Should Everyone Get?

This is often a point of major contention in early stage (and even later stage) companies. Some equity ownership statistics can be found here from ventures in the life science and technology industries. Typically, the earliest employees to join a venture receive stock options corresponding to their position and expected role — all of which vest over time, usually 4-5 years. For some ballpark ideas, option grants for early hires range from 5-8% for a CEO who is hired to run a venture to a fraction of a percent for a later or more junior hire. Early engineering hires, a group we frequently get asked about, vary a lot from fractional percents to low whole number percents. Like most things, it really depends on their value to the ventures success.

Do I Really Need One of These?

If you’re planning on raising venture capital, then yes; the VC community will require it. If you’re in the technology world, the smartest potential hires will expect this to be part of their compensation package. If, on the other hand, you have all the cash you need and you can attract the right talent to help you build your venture — or in the very rare case that you don’t need any additional help — then maybe not.

One other thought worth considering is what is your desired outcome for your employees if you sell your company in the future? If you’d like to motivate them towards building as much value as possible and helping you achieve this outcome, then stock options can be a good tool.

How Big Should the Option Pool Be?

Most venture firms will request that you make this 20% of the post-money valuation for very early financing. However, this, like everything else is subject to negotiation and it’s worth addressing explicitly (see next question for why this is the case). A good idea is to really discuss what it is going to take to get you to the next valuation event and issue enough options to get you to that point (with some buffer). If you’re only raising enough money for one year of operations and think that you’ll only issue 10% of the company in terms of options in that time, then why issue more than that? You can always issue more options later at a higher valuation.

Why Does the Option Pool Dilute the Founding Team Disproportionately as Compared to the Investors?

Maybe this should lead this section because it’s a very commonly misunderstood piece of a financing.

In this tool — as of the writing of this, we have modeled the worst deal for the founders to illustrate what stance your investors will likely begin the negotiations with. In the tool, ALL of the dilution from the option pool allocation comes from the founders stock — meaning none of it comes from the investors. BUT – This, like most everything else is a negotiable term in a financing and it should be treated as such because its impact can be significant.

In an attempt to try and provide some insight on this issue, here is the case from each side — investor and founder.

INVESTOR: Here are two reasons that will hopefully help put this conversation in perspective from the investor side of things.

  1. As the investor, it can definitely be argued that a complete team is a pre-requisite for having a compelling and investable venture. Assuming that the option pool is largely to fill-out an incomplete team, the allocation for these future employees should come out of the founder’s hides. After all, if the team was complete at the time of financing you wouldn’t need an option pool.
  2. Again, as the investor, it does seem a little weird to invest cold-hard-cash in a company and then immediately own less of the company than the amount that was invested. When an investor agrees to take some of the dilution hit from the option pool, it can look and feel a lot like they are taking a haircut on their investment before anything even happens.

FOUNDER: From the founders perspective there is really only one reason that it makes sense for the investors to share in the dilution that accrues due to the option pool — but it’s a good one. It is that you can’t reasonably expect to build a company without investing in your team — and not just the founding team. It takes engineers, developers, scientist, sales people, etc to build a company and these are not necessarily founding team members. But they are necessary ingredients for building a company and the investors should respect and take part in that. Another way to think about it is that immediately post-financing, the investors and the existing team are partners and they will move forward together on many fronts — one of which is building the rest of the team…so wouldn’t it make sense for them to share in allocating the option pool?

The impact of this can be quite significant if a company is successful — This is why it is worth your time to really understand this as a negotiable deal term and not just a check box in a term sheet.

Also, understanding what happens unallocated options is important so don’t be afraid to discuss this with your investors.

Additional Option Pool Resources