Sizing an option pool correctly is a delicate balancing act that many founders get wrong—a potentially costly mistake.
The size of your employee option pool affects how much ownership of your company you retain, as well as the company’s equity valuation and share price. In this guide, we’ll explain what option pools are, what you need to know to calculate your initial option pool, and how to limit dilution.
What is an option pool?
An option pool (also called an employee stock option pool, employee stock ownership plan, ESOP, or equity pool) is a block of company shares set aside for future employees.
An option pool is created by the Board of Directors and stockholders who authorize a certain amount of shares to be reserved for equity compensation of service providers to the company. 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 (more on that below).
This video explains how to size your option pool and how it affects dilution.
Why do I need an option pool?
Offering equity to employees is one of the best ways to attract and retain talent, especially if you can’t afford to pay market-rate salaries 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.
Prospective investors will consider whether your option pool is large enough to attract the best talent and continue scaling the business. After all, once they have a financial stake in your company, they want your business to succeed as much as you do. By doing the math to calculate 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
Creating an option pool is a good strategy for growth, but it also dilutes stock, changes your share price, and can even alter your company’s valuation. You’ll want to consider each of these factors as you calculate the right size.
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).
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. To continue with our example, if you own 10,000 shares and create an option pool of 1,500 shares, you’d now own 87% of the company (10,000/11,500), not 100%.
Option pools affect your share price, valuation, and ownership
When investors give you a pre-money valuation, they usually include an option pool if one doesn’t already exist. And the bigger your pre-money option pool is, the lower your post-money ownership percentage will be. If an option pool already exists, your investor may ask to increase the size if they think it is not enough shares to cover hiring until the next funding round
Here’s a side -by-side comparison of how an option pool size can affect a company’s valuation:
|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
|Your ownership percentage: 60%
($3 million / $5 million)
|Your ownership percentage: 67%
($3 million / $4.5 million)
In the example scenario above, if an investor offers you a $1M investment on a $4M pre-money valuation, they may really think your company is worth $3M but want you to create a $1M option pool. When that option pool is added to your company worth, it 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% remaining ownership stake in the company (or $3M).
By 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 ownership percentage would be 67%.
Of course, this doesn’t mean you should create very few options—you do want to set aside enough shares to attract the hires you need. The key is finding the right size so your ownership percentage and share price feel fair to everyone.
Option pool calculation (how to size and limit dilution)
Sizing an option pool is as much art as it is science. Here are a few tips for determining how much you need:
Decide between a pre-money or post-money option pool
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 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.
Don’t rely on benchmarks
While benchmarks from other companies 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 and every company is different. Carta data from Q2 2022 shows that the middle half of companies saw equity dilution between 9% and 23% at the seed stage. Some companies are more cash-intensive than others, and some require more (or less) headcount.
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 of financing) and how many stock 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.
- Option pools are typically increased at each fundraising round. Especially if you anticipate hiring C-suite level executives before your next fundraise, you’ll likely need to offer them a healthy percentage to incentivize them to join.
- The size of your equity pool will typically increase as your company’s valuation rises.
As a bonus, having a specific compensation plan can help remove the temptation to over-grant equity, as you’ll only have a specific amount of shares to work with.
Try not to reserve more than you plan to issue
Investors prefer larger option pools because that usually means your option pool will last longer, potentially reducing their dilution. 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
There’s no precise formula for how to size your option pool. 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.
When you’re ready to create an option pool, 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. Request a demo to find out how we can help you grow and prepare for your first option pool.
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