What is an Option Pool? How are employee option pools structured?

An option pool is a reserve of unissued stock options that a company allocates to new hires and existing employees. Read on to find out more about option pool.

TABLE OF CONTENTS

  1. What is an Option Pool?
  2. Why do companies use Option Pools?
  3. How are Option Pools structured?
  4. Pre-Money and Post-Money Option Pool

What is an Option Pool?

An option pool is an allocation of a company’s equity options, specifically reserved for employees. They are also called employee stock option pool (employee stock ownership plan, or ESOP) or equity pool. 

In venture-backed startups, stock options are commonly used as a strategy to attract and retain top employees. In addition to the salary, employees would receive a small percentage of the option pool when hired. 

Although the amount varies from company to company, it generally depends on how early the person joins the company and their position within the company. Senior roles, for instance, typically command a larger option pool than other positions. Moreover, early employees of the company normally receive more stock options than those who join later. 

As a result, if the company becomes successful enough to go public, the employees will be compensated with shares — which can be highly valued later on.

Why do companies use Option Pools?

Employee stock option pools are the potential common stock shares that are reserved for employees of the company. These stock option pools are created when startups or existing companies issue new shares that are set aside for employees. 

Prior to hiring employees, a predetermined number of shares will typically be reserved for employee option pools. If an employee is granted stock options, the amount granted is from the option pool of the company. 

Option Pool is usually a part of an employee’s total compensation package. The amount of the pool is determined by various factors such as the size of the company, expected growth of the company and expected future value of the stock.

A company will use an option pool to give employees options to buy shares of the company at a discount. 

These shares will be allocated to the employee at a later date and can be used as a form of payment. The actual number of shares will be determined later and will depend on the percentage of ownership that the employee has. 

An option pool is used by companies for a number of reasons, including:

  1. To attract talent for companies that are growing but have limited cash flows and revenues.
  2. To retain talent and reduce attrition rates.
  3. To provide other incentives in addition to salary.
  4. To motivate employees to work harder and perform better as they would also receive a piece of the company’s success.
  5. To ensure that employees have an incentive to increase the value of their stock. 

It's important to note that the option pool will be determined at the time that the company is valued and the employee will be granted that amount of shares automatically.

These shares are often granted at a discount from the remaining shares that are not yet issued. The company can also buy back these shares from employees, which is usually done at a premium from the price at when the employee initially was issued the shares.

The goal of an option pool is to make sure that the company has an adequate amount of shares to issue to employees and to give employees a way to gain ownership of the company.

How are Option Pools structured?

The option pool is part of a legal structure called an equity incentive plan. The typical size of the option pool can range from 15–25% of the overall outstanding shares and is allocated when the startup receives its first round of funding. 

A pool's size is determined by various factors between founders and investors. Having a small pool of investors can be advantageous as it shows the company is committed to preserving ownership during negotiations. The size of the pool could be increased later.

Additionally, a company may set up additional option pools over the course of its development and subsequent funding rounds after the initial one is set. 

Generally, the shares which make up an option pool are drawn from the founder stock of the company rather than the shares allocated to investors. As a result, the creation of an option pool typically dilutes the founders' shares.

For example, if you own 1000 shares (100% of the company) and create an option pool of 150 shares, you now have 1150 shares of company stock on a fully diluted basis. After creating the 1150-share option pool, you will now own 87% of the company (1000/1150).

Finally, upon establishing the pool, the company's board of directors grants shares from the pool to the employees.

Pre-Money and Post-Money Option Pool

Typically, the size of the pool is determined by the venture or angel investors, who may suggest a percentage of the pre-money or post-money valuation of the company. 

Mostly, investors usually tend to include an option pool in a pre-money valuation. This affects the startup’s overall price and effective valuation. The larger your pre-money option pool is, the lower your effective per-share valuation will be.

Pre-money valuation is the company value before getting investment from investors. In most cases, the pre-money valuation is lower than the post-money valuation. If we calculate pre-money and post-money valuation, we will get to know the complete value of the company.

The pre-money valuation is calculated by taking the company's valuation (i.e. pre-money valuation) minus the investor's investment.

Post money valuation is the value of a company after raising funds. Post-money valuation is calculated as: Post-money valuation = pre-money valuation + investment amount. For example: If a startup is valued at $5 million and raises $5 million, then the post-money valuation will be $10 million ($5 million + $5 million = $10 million).

Example of an Option Pool at a startup

John is a software developer and he has built his tech startup. In order to scale his company, he is seeking investment from angel investors and venture capital firms. After reviewing his application, an investor is willing to offer him a $2 million pre-money valuation. 

According to the investor, John’s company has a pre-money valuation of $1.5 million, and he would also have to create a $500,000 option pool for his employees, which would get him to the $2 million valuation.

After the investor invests $500,000 in John’s company, the post-money valuation would be $2.5 million, leaving him with a 60% effective valuation. 

The founders should, therefore, make sure to size the option pool properly, as a large option pool means you give away more of your company than you need to.