How to decide the size of your employee option pool

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As you grow your startup and begin thinking about hiring employees, it’s important to figure out how much equity you want to set aside for your team. However, this can be trickier than it sounds—sizing an equity pool correctly is a delicate balancing act that many founders inadvertently get wrong.

Option pools can affect everything from how much of your company you retain to your company’s effective valuation and share price, so it’s in your best interest to do the math and estimate how big you need your pool to be. In this guide, we’ll explain what you need to know when sizing your initial option pool, how to limit dilution, and more.

What is an option pool?

Also called an employee stock option pool (aka an employee stock ownership plan, or ESOP) or equity pool, an option pool is a block of company shares you create, add to your existing number of shares, and set aside for future employees. For example, if you own 10,000 shares (100% of the company) and create an option pool of 1,500 shares, there are now 11,500 shares of company stock on a fully diluted basis.

Why do I need an option pool?

To put it simply, option pools can help you attract both employees and investors.

You probably already know the employee part—that offering equity is one of the best ways to attract and retain talent, especially if you can’t afford to pay market rate salaries just yet. By offering employees an opportunity to own part of the company, you encourage them to act like owners and do everything they can to help the company grow so they can eventually share in its success.

However, what you may not know is prospective investors often expect an option pool to ensure you can attract the best talent and continue scaling. After all, once they have a financial stake in your company, they want your business to succeed almost as much as you do. So it’s really not a question of if you should create an option pool, but when you’ll create it. And by doing the math to figure out how big of a pool you need before talking to investors, you can make a good impression by showing up prepared.

Why sizing an option pool correctly is so important

Choosing how many shares to create and set aside isn’t something you should do willy-nilly. Here are a few reasons why you want to get it right:

Option pools dilute your ownership.

Well, technically they dilute all existing shareholders’ ownership. But investors often insist that you create a pool before they invest, so your first option pool usually only dilutes your shares. And dilution can happen faster than you’d expect—remember that example up top? Once you create that 1,500-share option pool, you now own 87% of the company (10,000/11,500), not 100%.

Option pools affect your share price and effective valuation.

When investors give you a pre-money valuation, they usually include an option pool in that valuation. And the bigger your pre-money option pool is, the lower your effective valuation will be on a per-share basis.

Bigger option pool Smaller option pool
$3 million company worth

+
$1 million investment
+
$1 million option pool
=
$5 million post-money valuation

$3 million company worth

+
$1 million investment
+
$500,000 option pool
=
$4.5 million post-money valuation

Effective valuation: 60%
($3 million / $5 million)
Effective valuation: 67%
($3 million / $4.5 million)

 

For example, if an investor offers you a $4M pre-money valuation, they may really think your company is worth $3M but want you to create a $1M option pool, which, when added to your company worth, would get you to that $4M valuation. Add their investment of $1M on top of everything, and your post-money valuation would be $5M, leaving you with a 60% effective valuation. In comparison, if you created $500,000 worth of options for your pool, giving you a $3.5M pre-money valuation and $4.5M post-money valuation, your effective valuation would be 67%.

Of course, this doesn’t mean you should barely create any options—you do want to set aside enough shares to attract the hires you need. The key is finding the right size so your effective valuation and share price feel fair to everyone. 

How pre-money and post-money option pools work

By now, you hopefully understand why it’s so important to size option pools correctly and are wondering how to actually go about doing so. But before we cover that, let’s take a quick detour into the difference between pre-money and post-money option pools. It’s relevant, we promise.

In short, whether you create your option pool before or after you raise money could impact how it dilutes everyone’s ownership.

As the name implies, you create pre-money option pools before an investment. Investors often insist on this type of option pool because (surprise, surprise) they’re more investor-friendly. When you create an option pool before raising money (and therefore before you issue shares to investors), it only dilutes your shares.

On the other hand, an investor may agree to allow the company to create or increase its option pool after taking on an investment. This type of option pool is more founder-friendly, as both you and your investors’ shares get diluted once you create the pool.

Strategies for sizing your option pool (and limiting dilution)

In an ideal world, you want your option pool to be just large enough to hire enough people to get you to your next round of funding. Too big, and you’ll dilute your ownership more than you have to. Too small, and investors might not be on board. Plus, you might not be able to attract enough talent to meet the operating plan you presented to investors (which can look bad when you begin fundraising again).

As you can imagine, sizing an option pool is as much art as it is science. Here are a few tips for determining how much you need:

Don’t rely on benchmarks.

While benchmarks can be helpful in ensuring your option pool size isn’t too off-base, they can be dangerous to rely on. There’s a reason why there’s such a large range in the typical percentage founders set aside—anything from less than 5% to 30% or more—every company is different. Some companies are more cash intensive than others, and some require more (or less) headcount. 

Instead of basing your option pool size on what everyone else is doing (or what your investor wants), it’s important to be strategic, which brings us to our next point:

Be realistic about your future hiring needs.

One of the best ways to estimate how big your option pool should be is to figure out which positions you want to fill in the next 18 to 24 months (or whenever you want to raise your next round) and how many options you’d need to attract these key hires.

When building out this hiring plan, keep in mind:

  • You may need to offer early employees more equity since they’re taking a bigger risk joining a relatively unproven company.
  • If you anticipate hiring C-suite level executives before your next fundraising, you may want to increase the size of your option pool, as you’ll likely need to offer them a healthy percentage to incentivize them to join.
  • According to our data, the size of the average equity pool is gradually increasing each year as companies struggle to compete for the best talent.

As a bonus, having a specific plan can help remove the temptation to over-grant equity, as you only have a specific amount of shares to work with.

Try not to reserve more than you plan to issue.

Remember: the bigger your initial pool, the more dilution you personally take on (instead of sharing the dilution with other owners).

Investors prefer larger option pools because that usually means your option pool will last longer, potentially reducing their dilution. Because of this, they may pressure you into creating a larger pool than you need, citing industry benchmarks. This is where your hiring plan comes in—by thoughtfully mapping out your key hires over the next year or two and how much equity they need, you can show investors how you came to your number and may be able to negotiate a smaller, more realistic pool.

Diving into the pool at the deep end

Sizing an option pool may be as much art as it is science, but that doesn’t mean you can’t make informed decisions. By putting together a realistic hiring plan, you can get a good idea of how many options you need to set aside, giving you a basis to push back if investors ask you to create a bigger pool than necessary.

Once you figure out how big your pool should be and are ready to start creating one, check out Carta’s sample stock option plan. This document can serve as a starting point for you and your legal representation to begin creating your company’s option plan, which is often one of the toughest parts of the process.

At Carta, we help startups with fundraising, compensation, valuations, equity management and much more. Talk to us to find out how we can help you grow.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2021 eShares, Inc. d/b/a Carta, Inc. (“Carta”). All rights reserved. Reproduction prohibited.

 

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