What is an option pool?

20 December 2022
The Carta Team

An option pool is a block of shares set aside by a company so that equity can be issued to people in the future. Although they are often called “employee stock option pools,” the set-aside can be used to issue shares to anyone who provides services for the company, such as advisors, consultants, and independent contractors as well as employees.

Why do I need an option pool?

Option pools are crucial for companies seeking to provide equity to their employees in an orderly way. And issuing equity ownership is important—it helps startups attract and retain talent and aligns employee incentives with overall company goals. Equity encourages employees to act like owners, because they will directly benefit if the company grows and has long-term success.

Compensating employees with equity also enables early-stage companies to compete for talent without bloating their cash burn rate. Startups may not be able to afford to pay top-market salaries like established companies can, but the potential upside of early equity in a growing company can be a competitive advantage for winning talent. 

Equity compensation has become the industry standard in the startup world. Venture capital investors expect startups to grant employee equity, and to build an option pool to do so. 

How option pools work

The option pool is part of the cap table (capitalization table), which is the document detailing and tracking all ownership in a private company, including that of founders and investors. 

An option pool allows startups to budget out how much equity they will reserve for hires between each funding round. Without an option pool, employee equity would have to be granted and dilution would occur on a one-off basis to each and every employee, investor, and existing stockholder. This would add a ton of work to each new hire and would be complicated and burdensome. 

Option pools allow companies to budget for dilution and for investors to understand the percentage of a company they are buying when they invest, and to price their offer. 

While it’s called an “option” pool, the actual equity granted from the pool could be stock options or other types of equity grants like RSAs and RSUs.

→ Calculate the size of your option pool

How do I form my option pool? 

Your option pool is formed by your stock option plan, which includes information about how many shares will be reserved as part of the pool. Under Rule 701, you need a formal plan in order to issue securities to service providers. These plans typically last for 10 years; while you will likely expand your option pool more regularly than once a decade, once you have this plan in place, you can simply make an amendment to the plan to increase the number of shares in the option pool. The initial plan and any expansion must be approved by your board of directors and then by shareholders. 

You’ll want to work with your law firm to create your stock option plan, but these sample documents can help give an idea of what one looks like. 

Once the option pool is created, the board is responsible for granting options from it. In order to do so, your company will need an up-to-date 409A valuation

Common mistakes to avoid  

Sometimes founders mistakenly think that they have given equity to an employee simply by detailing the new hire’s share of equity compensation in an offer letter. While it’s a good idea to have equity as part of an employment offer, stock options still need to be formally granted by the board to lock in the option’s strike price at the then-current fair market value. Promising equity to employees without the mechanisms in place to actually grant it could create legal and financial problems. This is why it’s ideal to set up your option pool and get your 409A valuation done sooner rather than later, so you can start making hires and granting equity. 

What is an ESOP? 

The abbreviation ESOP is sometimes used to refer to “employee stock option pool” (the subject of this article), especially among VC investors and startups. But it also can refer to “ employee stock ownership plan,” which is a type of retirement account a company funds with stock for employees and which has certain tax benefits. The latter is used across industries, including construction and manufacturing, and may be used by public or private companies. 

Since the abbreviations are the same and both relate in some way to employee stock ownership, confusion can result. It’s best to say “option pool” or “equity incentive pool” rather than “ESOP” when referring to employee stock option pools.

How big should my option pool be? 

Option pools should be large enough to attract the talent you’ll need to be successful and to align employee incentives, but not too large as to cause more dilution than necessary. 

You need enough equity in your pool to make grants to new hires, and to give refresh grants (grants to existing employees for tenure, performance, or promotion) through to your next funding round. According to Carta data, the average time between rounds for early-stage companies is between 18 months and 2.5 years—and this timeline can shift along with changing market conditions. Most companies will expand their equity pool as needed for headcount goals at each funding round. 

Read more about how to size your equity pool and how it affects your valuation.

Calculate your option pool with Carta 

Carta’s option pool calculator is a free resource for pre-seed and seed founders to model potential stock option pools and financing rounds. Compare your anticipated option pool to your round size and expected hires and see how your option pool and your round compares to the market, using Carta data.