What is an Employee Option Pool?

An employee option pool—or employee stock option pool (ESOP)—is equity specifically allocated for employees. Given the boom-or-bust nature of startups, employee option pools are helpful for attracting the necessary talent to help grow the company.

Founders create an employee option pool when the company is ready to hire. Since the option pool represents a portion of ownership in the company, its creation impacts the ownership stake of founders and existing investors. This dilution makes option pools an important negotiation point.

In this guide, we’ll cover the fundamentals of employee option pools.

What is an Employee Option Pool?

The employee option pool consists of shares reserved for granting to employees. The value of the option pool is based on the per share value of the common stock (as determined by the most recent 409A valuation). The number of shares in a startup’s employee option pool can be found in the cap table, once determined by the company.

The shares in the option pool are typically allocated to employees according to seniority and date of employment. All the details of each employees’ stock options—including strike price and vesting period—will be listed in the stock option plan documents (more on this later).

Why do Startups Need an Employee Stock Option Pool?

Startups use employee stock options for two reasons. First, they’re used to incentivize talent to join a startup. Employees can exercise their stock options—provided they are already vested—which would allow them to buy a predetermined amount of company stock at a predetermined strike price.

For example, in 2005, graffiti artist David Choe famously took his $60,000 fee for painting Facebook’s building in stock options. When Facebook IPO’ed in 2012, his stock options were worth about $200 million. Stock options have also become an industry norm—employees now expect it as part of joining a startup.

The second reason is that stock options allow startups to reward employees without increasing their cash burn rate. Giving employees stock options may be costly from an equity perspective—but the startup doesn’t need to pay out any additional cash. Stock options allow startups to grow and attract talent while keeping a lid on their cash outflows.

While employee option pools are now a standard component of the startup world, the size is often negotiated between founders and the lead investor during a financing. The reason is because the larger the option pool, the larger the resulting dilution.

Understanding Option Pool Dilution

The creation of the option pool will naturally result in dilution. This is because the option pool will comprise a certain percentage of the total equity ownership—meaning the other equity holders must have their total stake reduced to accommodate this new equity.

There are two ways to calculate the dilution from the option pool—from the pre-money valuation or post-money valuation.

Carving out the option pool from the pre-money valuation means all the option pool dilution impacts the founders and existing investors. New investors would thus avoid any dilution from the creation of the option pool. It’s most common to carve out the pool from the pre-money valuation. On the other hand, if the employee option pool is carved out from the post-money valuation, that means the new investors would also be diluted.

Pre-Money Option Pool Example

Assume a startup with 8M shares outstanding and no option pool heading into its Series A, where it plans to raise $2M. The investors offer a pre-money valuation of $8M—implying a post-money valuation of $10M.

The founders may naturally assume that the investors are valuing their company stock at $1.00 a share, resulting from the pre-money valuation of $8M divided by the 8M of outstanding shares.

But there’s a catch—the investors expect this pre-money valuation to include an option pool equal to 20% of the post-money valuation. That comes up to a $2M option pool (20% of the $10M post-money valuation).

This means that the effective valuation of the startup is actually $6M. The investors believe the startup’s pre-money valuation should actually be $6M but raised it to $8M because they wanted to create an employee option pool as well. The formula breaks down as follows:

The implication is that the per-share valuation of the company is also $0.75 per share ($6M divided by 8M outstanding shares) since new shares will have to be created for the option pool.

The founders’ stake in the startup is also diluted to 60%. The investors, meanwhile, can maintain their undiluted 20% stake.

Post-Money Option Pool Example

But what if the investors had agreed to carve out the option pool post-money instead?

Let’s assume the investors still valued the startup at a pre-money valuation of $8M, giving it a $10M post-money valuation. The founders will hold an 80% stake and the investors 20% prior to the creation of the employee option pool.

This time, the 20% option pool is carved out from the post-money valuation, meaning everybody gets diluted by 20%. Post-option pool creation, the founders will hold 64%, the investors 16%, and the option pool 20%. The option pool dilution is equally distributed.

Option Pool Sizing and the “Option Pool Shuffle”

While the post-money option pool is much more founder friendly (as it spreads the dilution across the new investors as well), it rarely happens. The industry norm is for employee option pools to be carved out from the startup’s pre-money valuation.

This means that founders must be wary about allocating a larger-than-necessary percentage to the option pool (as that would dilute them even more). An option pool that is too large can be unfair to founders for a couple reasons:

• Unissued options from the pool can “carry over” into the next round. This means if the option pool size needs to be increased at the next funding round, the investors from the previous round would not need to be diluted as much. In other words, the founders’ excess dilution carries over.
• If the company is sold before the next round, unissued and unvested options will be canceled, a form of “reverse dilution.” This benefits all investors—even though the original dilution came from the common stockholders (the founders) in the first place.

Because a larger option pool can benefit investors at the expense of the founders, the lead investor may try to ask for an employee option pool that is larger than necessary. This is called the “option pool shuffle”—a colorful term for the negotiations surrounding the size of the option pool.

Key Considerations When Negotiating the Size of the Employee Option Pool

A few things for founders to keep in mind:

• The option pool is most likely going to come out of the pre-money valuation. Exceptions can apply, but they are rare.
• A hiring plan that can last until the subsequent financing round can be a useful tool to negotiate a smaller option pool. This way you can justify a certain option pool size by mapping it onto the plan.
• You may have to accept a lower valuation with a smaller option pool. However, remember that the effective valuation is what’s important here. Depending on the specifics, a lower pre-money valuation with a smaller option pool may be better than a higher pre-money valuation with a larger option pool.

For lead investors:

• The more diluted the founders are, the less incentivized they might be. Pushing for the largest option pool size possible might not be in the company’s best interest.
• Having a larger pre-money option pool that could result in unissued options gives you an advantage for subsequent rounds (because others will be taking excess dilution instead of you). This can raise issues in subsequent rounds.

The Ideal Size of an Employee Option Pool

The ideal size of an employee option pool should be in the “Goldilocks” zone—not too big that it’s overly dilutive, but not so small that it prevents the company from hiring the best talent.

However, there is no “one size fits all.” There’s tremendous variation depending on the individual startup’s needs and current market conditions.

Remember also that startups typically don’t need to grow their option pools as quickly (in terms of percentage of post-money valuation) once they’re past Series B or C rounds. By then, the startup is considered less risky from an employee’s perspective. Therefore, the startup can allocate fewer options to newer employees, meaning it need not grow the option pool so significantly—even though it’s scaling.

FAQs

What are the key terms set out in the stock option plan documents?

The key terms that should be listed are:

• Strike price. The price the employee will pay to exercise their option and receive company stock.
• Vesting schedule. The schedule which stipulates when the employee can exercise their options. Most startups have a vesting schedule of four years with a one year “cliff.” The cliff is when the first portion of the options vest, giving the employee the right to purchase them (i.e., after they’ve been at the company one year). After the cliff, the remainder of the options gradually vest over the remaining years until the employee is “fully vested.”
• Issue date. The date the options are granted.
• Exercise date. The date by which an employee can exercise their options.
• Expiration date. The date after which the employee can no longer exercise their options.

How are the strike prices within the option pool determined?

The strike prices of the stock options are based on the startup’s 409A valuation—an independent third-party valuation—at the time of issue.

Are there alternatives to issuing options?

A popular alternative is restricted stock units (RSUs). Unlike stock options, RSUs entitle employees to directly receive shares of the company or its cash value equivalent. RSUs thus do not have strike prices, although they typically do have vesting schedules. Companies usually only begin offering RSUs at more mature stages, when the strike price for the options becomes too high for the employees to comfortably pay.

Another option is profits interest, which is ownership stake in a partnership or limited liability company. Unlike stock options, a profits interest grant doesn’t have to be bought—the employee accrues ownership as they vest.

Employee Option Pools in Summary

Option pools are an essential part of the startup ecosystem. And because they involve dilution, they can be a contentious point of negotiation.

Both founders and investors must fully understand option pool implications so they can reach common ground.