An option pool is a form of compensation where a company rewards those who contribute to its health and future with an equity share. This is paid from a “pool” of shares the company keeps aside specifically for this purpose. This typically happens when entrepreneurs validate their business model and go out to build a corporation with a team around it.
It is a fantastic way for businesses to encourage the long-term loyalty of talented and important employees, including founders.
In this article, I’m going to explore exactly what an option pool is, how it works, and how it can benefit your business.
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The Option Pool: Rewarding Success
As Mary Kay Ash, founder of Mary Kay Cosmetics, once said: “Everyone wants to be appreciated, so if you appreciate someone, don’t keep it a secret.” Undervalued employees tend to jump ship to another opportunity when it arises. Furthermore, happy and valued employees increase their productivity by a staggering 31%.
It’s clear then that making employees feel valued is a win-win for employers and their staff.
There are a lot of great ways to motivate employees and to generate that sense of self-worth, and an option pool is one of the most effective.
Typically the option is an important piece of the negotiation with investors during fundraising and perhaps expected as part of the business plan.
Offering adequate compensation to the talent pool they wish to hire is a huge challenge for startup owners. When they’re bootstrapping the company, offering stock options to retain their team may seem like a great idea. There are several other startup hurdles every entrepreneur faces. For more information on how to overcome them, check out this video I have created.
What is an Option Pool?
Also known as an ESOP (Employee Share Option Pool), an option pool is essentially a contract given to select employees, often during the early stages of a startup’s journey. It acts as a contract between the company and employee, stipulating that the employee can be rewarded with shares in the business.
The option pool contract includes:
- A maturation date when the shares can be released
- The number of shares that can be released
- The price of the shares being released
The agreed price is affected by “the strike price”, and that’s usually the same as the fair price value of each share at the time when the option pool contract is signed.
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Here’s where it gets a little complicated.
When an option pool is awarded, it isn’t for the original strike price. When the contract is signed, it’s under the explicit understanding that shares will climb in price as the company performs well.
The share value given to the holder of the option is therefore the difference in value between the strike price and the current market value of a single share.
What this means is that employees are awarded with shares totaling the value of how much the share price has increased since joining the company. In essence, employees are being rewarded proportionally for being part of the company’s good fortunes.
This in effect is the same reward investors get for their investment in terms of share price increases. If an investor buys shares at the same time as an employee signs an option pool agreement, the employee benefits from the upside value. This amount has been generated by the company as though they had bought shares at the same time as the investor.
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How is the Strike Price Calculated?
As option pool agreements are often created during the early stages of a startup business, the company may not already be trading publicly. This means that agreeing how much a share in the business is worth, is not an exact science.
That being said, there are ways to at least estimate a value, one which both sides will find reasonable, one of which is to value the strike price at the same valuation as during the last funding round.
Another way is to set the strike price at the fair market value for the company’s common stock. This means you’ll need to contact an appraiser to carry out a 409A valuation in order to come to an agreed price point.
To avoid being the bottleneck during startup fundraising, entrepreneurs should have this figured out.
Reducing the Principal-Agent Problem
One of the best aspects of using option pools is to reduce the principal-agent problem. To understand this, let’s define each term:
- Principals: These are the shareholders who collectively own a company.
- Agent: These are the people charged by the shareholders to run the company. This can be managers, chairpersons, or board members.
In an ideal world, agents will do what is best for the company and, consequently, what’s best for the shareholder. The better they steer the ship, the more value shareholders receive. However, the principal-agent problem refers to situations where agents look out for themselves. They steer the ship in a way that will benefit themselves and not those around them,
To minimize this issue, option pools can be used. Investors prefer to see these agreements in place so that the agents of a company are incentivized.
As option pools are directly connected to the share performance of a company, agents are therefore encouraged to ensure the decisions they make are for the betterment of the share price, not just their own situation.
In essence, agents are only rewarded when shareholders are rewarded, creating synergy throughout the company.
Another benefit of using option pools is that, while a single individual can receive a healthy share payout, this is insignificant to the overall company. The reason for this is that anything an individual receives is proportionate to how the share price is valued.
The amount the company adds to its own value across all its stock will always be cumulatively much higher than paying one individual the difference between their strike price and the current share value.
This is a mutually beneficial situation for founders, key employees, and the company, who have all agreed to an option deal to incentivize growth. Both profit tremendously from the agreement.
No Employee Cash Risk
Buying shares always carries risk. A company could fold or the price share could remain much lower than the initial purchase price. For those benefiting from an option pool, the reward is made because of the time and hard work they invested, not in return for money like a normal share purchase.
There is, therefore, no cash risk to the founder or employee because they haven’t had to pay anything to receive the shares.
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