How to know what is the right employee option pool?
“As for the employees, the payment in stock options revives, somewhat ironically, the old anarchist ideology of self management of the company, as they are co owners, co producers, and co managers of the firm.” — Manuel Castells.
As your startup business grows and you consider employing staff, it’s critical to decide what should be the right amount of equity options you have to set aside for your team. Effectively sizing an equity pool is complex balancing work with which many entrepreneurs make mistakes.
Well-advised companies will only reserve what they plan to use in the option pool. Otherwise, they risk over granting stock, given how equity grants are typically pledged. Although the equity option pool may not be utilized fully, businesses should not book more than they intend to use. The pool’s size is set by various factors involving the founders and their investors.
As the employee option pool will impact the whole thing, from how much of your business you keep, to its valuation, control, and ability to attract financing, it is in your best interest to perform the math and determine the size of your pool well. In this article, we will take an in-depth look at what you need to know about the employee option pool, and how to know what the right employee option pool is.
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Here is the content that we will cover in this post. Let’s get started.
- 1. What Does an Employee Option Pool Entail
- 2. Why Does A Firm Need An Employee Option Pool
- 3. How a Firm Structures an Employee Option Pool
- 4. Why Is It Important To Choose the Right Employee Option Pool?
- 5. The Employee Option Pool Dilutes the Ownership
- 6. An Employee Option Pool Impacts the Effective Valuation & Share Price
- 7. How Do Option Pools for Pre-Money & Post-Money Valuation Work?
- 8. Strategies for Selecting the Right Size of Employee Option Pool
- 9. Use Benchmarks Cautiously
- 10. Consider Your Hiring Needs In The Future Realistically
- 11. Avoid Reserving More Than You Intend To Issue
- 12. Primary Considerations While Negotiating the Right Employee Option Pool
- 13. The Ideal Employee Option Pool Size
- 14. Conclusion
What Does an Employee Option Pool Entail
An option pool, also known as an employee stock option pool (ESOP) or an equity pool, is a block of company shares that the firm creates, including its on-hand number of shares and reserves for potential recruits.
Some shares will be set aside for an employee option pool at some time early on, often ahead of hiring staff or closing your first round of funding. An equity incentive arrangement is a legal structure that includes the employee option pool. The option pool is usually 20% of the company’s shares, but it could be 10%, 15%, or various proportions, especially for startup enterprises. After creating the pool, the company’s board of directors distributes shares, or options, from the pool to new employees as they join.
Why Does A Firm Need An Employee Option Pool
Simply put, employee option pools can assist you in attracting staff and investors. Firms use an option pool for a variety of purposes, including:
- To attract talent for growing businesses with limited sales and cash flow
- To keep employees and lower attrition rates
- To offer additional incentives besides salary
- To encourage staff to work harder and perform at their best since they will have a share in the company’s success
- To give employees a monetary incentive to boost the company’s stock value
Thus, offering equity to your employees helps you attract and retain talent, mainly when you cannot afford to pay market-rate salaries. Employees are more likely to perform similarly to business owners and act in a way that can aid the firm in developing and growing successfully. Including making decisions and treating customers in a way that increases company value.
Also, you will make a solid first impression by doing the math to find out what is the right employee option pool you’ll need before meeting with investors.
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How a Firm Structures an Employee Option Pool
The employee option pool is often 15–20 percent of the total outstanding shares, and it is created when the firm gets its initial round of funding.
The size of a pool is decided by several factors involving the founders and investors. Having a small pool of investors might be beneficial because it demonstrates the company’s commitment to maintaining ownership during negotiations. You can increase the size of the option pool later.
The firm can also create multiple employee option pools during its growth and investment rounds after the primary one has been established.
Rather than being allotted to investors, the shares that structure the employee option pool are usually selected from the company’s founding stock.
As a result, the founders’ shares are often diluted when an option pool is formed.
For example, if you hold 1,000 shares (100 percent of the firm) and form a 150-share option pool, you now have 1150 fully diluted shares of company stock. You now own 87 percent of the company (1,000/1,150) following the generation of the 1150 stock option pool.
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Why Is It Important To Choose the Right Employee Option Pool?
Choosing the right amount of stock to share with employees and setting it aside should not be done randomly. The following are a few reasons why it is crucial to choose the right employee option pool.
The Employee Option Pool Dilutes the Ownership
Technically, they dilute the ownership of all current stockholders. But investors generally believe that businesses should generate an employee option pool before their investment. Therefore, a firm’s initial employee option pool typically dilutes its shares. This dilution of stocks happens far more quickly than you might think (remember the example from earlier?) You now control 87 percent of the company (10,000/11,500) rather than 100 percent after the firm generated that 1,500 stock option pool.
An Employee Option Pool Impacts the Effective Valuation & Share Price
When investors offer the firm a pre-money valuation, they almost always include an option pool. And the larger your pre-money option pool, the lower your per share valuation will be.
This doesn’t mean you shouldn’t make any options at all; you should create the right option pool of stocks to catch the attention of the employees you require. Finding the correct size for the share price and successful evaluation is crucial.
How Do Option Pools for Pre-Money & Post-Money Valuation Work?
By now, you should have a good idea of why it’s so crucial to select the right employee option pool effectively and how to go about doing so. The strategies you use to select the right size of an employee option pool are of utmost importance. but first, you should consider the differences between post-money and pre-money option pools.
In other words, whether you build your option pool before or after seeking capital will impact how it dilutes everyone’s ownership.
Pre-money option pools are created before an investment, as the name implies. Investors frequently prefer this sort of option pool because it is more investor-friendly. It only dilutes your shares if the firm creates an employee option pool before raising funds (hence before issuing shares to investors).
Post money option pools are generated when your investor would consent to allow the business to build or expand its option pool after making a financial commitment. This employee option pool is more founder-friendly because you and your investors’ shares are diluted once you create the pool.
Strategies for Selecting the Right Size of Employee Option Pool
In a perfect world, your employee option pool would be big enough to employ adequate persons to bring you to the next round of funding. If it becomes too big, you’ll dilute the rights too much more than needed. On the other hand, investors may not be interested if it’s too small. Furthermore, you may not attract sufficient talent to satisfy the operating strategy you presented to investors.
As you might expect, selecting the right employee option pool is both an art and a science. Here are a few guidelines for evaluating the right size of the employee option pool.
Use Benchmarks Cautiously
Benchmarks help ensure that the firm’s size of the employee option pool isn’t too large, but they can be risky to rely on. There’s a reason why the typical amount set aside by founders varies so much (like from 5 percent to 30 percent); each business is unique. Some businesses demand more (or fewer) employees than others. Or need to give up a lot more, or less to attract the talent they need.
It’s crucial to be strategic rather than reacting to what others are doing and what your investor wants, which leads us to our next point.
Consider Your Hiring Needs In The Future Realistically
One of the most effective ways of choosing the right employee pool is to calculate how many options you’ll need to attract critical hires in the upcoming 18 to 24 months. It should be based on the positions you would need to fill in this duration.
However, when developing your hiring plan, take into account:
- Because early employees take a greater risk by joining an unproven company, you may need to give them more shares.
- If you plan to hire C suite executives or top-notch advisors before your next fundraising round, you should increase the size of your option pool because you’ll need to offer them a healthy percentage to entice them to join.
- The average employee equity pool may grow as the company competes for the best talent.
Additionally, having a particular plan might help eliminate the excitement of over granting equity because you only have a certain number of shares to work with.
Avoid Reserving More Than You Intend To Issue
Remember that the larger your initial option pool, the more dilution you will experience (as an alternative to giving out the dilution to further owners).
Investors prefer larger option pools since they suggest your employee option pool will last for a long time, potentially reducing dilution. As a result, they may exploit market comparisons to persuade you into creating a larger choice pool than necessary. This is where your hiring strategy comes in; carefully plan out your significant hires over the next year or two and the amount of stock they require. You can show investors how you arrived at your figure and possibly bargain for a smaller, more sensible pool.
Offering stock options as employee compensation is a great move. But, you should also know how to position the team in a pitch deck when starting a fundraising initiative. If you’re not quite sure how to do that, check out this video I have created.
Primary Considerations While Negotiating the Right Employee Option Pool
A few things to remember for founders:
- The option pool will be derived from the pre-money valuation. Exceptions do exist, but they are less common.
- A hiring plan that lasts until the subsequent financing round can help you negotiate a narrower pool of options.
You may have to accept a lesser valuation with a narrower choice pool. Depending on the circumstances, a lower pre-money valuation with a smaller option pool may be preferable to a higher pre-money valuation with a more extensive option pool.
For lead investors:
- The more diluted they are, the less incentivized the founders are. So, it may not be in the company’s best interests to push for the most extensive option pool size available.
- You’ll have an advantage in subsequent rounds if you have a larger pre-money option pool that could result in unissued options (because others will be taking excess dilution instead of you). This can create problems in later rounds.
The Ideal Employee Option Pool Size
Employee option pools should be the “Goldilocks” size. Not too huge to be too dilutive, but not too little to prevent the firm from acquiring the finest talent.
There is no such thing as “one size fits all.” There is a lot of diversity depending on the needs of each company and the current market conditions.
Remember that firms often don’t have to raise their employee option pools rapidly (for the percentage of post-money valuation) after initial rounds. From an employee’s standpoint, the startup is less hazardous by then. As a result, the firm can give newer employees fewer alternatives, reducing the need to expand the option pool significantly, even as it scales.
Option pools are a crucial aspect of the startup ecosystem. They can also be a sensitive discussion subject because they involve dilution. As your startup company expands and you consider hiring employees, it’s vital to figure out how much equity you should set aside for your employees. It holds importance mainly because it dilutes the ownership and impacts share price and company valuation. Also, it helps in attracting and retaining talent.
Well-informed companies will only reserve what they intend to employ in the option pool in the coming year. Otherwise, they risk granting too much stock. But to establish an agreement, both founders and investors must thoroughly comprehend the ramifications of option pools. To decide the right employee option pool, you should use benchmarking cautiously, consider your hiring needs in the future realistically, and avoid reserving more than you intend to issue.
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