What is an Employee Option Pool?
An employee option pool or employee stock option pool (ESOP) is a reserve of equity that is set aside for employees to receive as part of their compensation package. These options are usually given out based on how long someone has been with the company or the contribution they make to the business, such as level of seniority.
The option pool is created once a startup is ready to hire and the value of the pool is based on the individual share value.
Why do I need an Employee Option Pool?
Offering shares to future employees can be a great way of attracting skilled talent, especially when funds initially make it hard to pay competitive salaries.
How Option Pools Are Structured
Unlike ordinary stock, shares set aside in the option pool can have certain conditions applied to them, limiting the dilution of future shareholders. These conditions can be the length of service or a performance milestone, making the shares exit only rather than exercisable (meaning the employee can only sell their shares and not enjoy any voting rights).
In order to gain shareholder resolution and keep any negotiation regarding employee option pool dilution out of future conversations and funding rounds, it’s a good idea to subdivide existing shares, multiplying the number of shares available to employees and breaking it into smaller percentages that create incentive and reward without impacting founder and investors shares by too much.
How to Size the Employee Option Pool
The size of the option pool should be based on your expected hiring needs until the next funding round. If you expect to hire aggressively in this period, then a larger pool may make sense but if you're not expecting any major growth then a smaller pool would likely be adequate.
It's also important to keep in mind that your option pool shouldn't be so large that it would result in significant dilution for existing shareholders; ideally, you want to set the size of your option pool so that it balances these two competing interests of maximizing employee satisfaction while minimizing shareholder dilution as much as possible.
How Does the Employee Option Pool Dilute Ownership?
Whether your startup has 10,000 shares or 1 million, each time a share is allocated it will dilute the percentage of shares allocated to founders and investors. So, if the founder of a startup owns 100% of the shares and creates an employee option pool for 15%, the founder will be left with 85% of total shares, diluting their stake immediately. If there are existing stakeholders, the founder might have 60% and two shareholders 20% each, when the option pool is created with 15% of total shares, the founders stake is diluted to 51% and the shareholder's stakes each dilute to 17%, without any investment, the share value also dilutes.
Pre-Money Option Pool Example
In this example, we are going to imagine that the employee option pool has not yet been introduced. The business plan has been created, seed funding has been secured, the product produced and a customer base established. The next step is to secure Series A funding and secure €1,000,000 in funding for recruitment and marketing.
The pre-money valuation is the valuation founders and potential investors agree the company is worth before investment. In this case, the figure that has been agreed to is €4,000,000, and the investors would contribute €1,000,000 for a 20% stake. However, this is on the basis that 20% of shares are allocated to an employee option pool to help incentivize recruitment. Now the founder has a 60% stake instead of an 80% stake because the option pool has been deducted before investment.
It also means that investors have added on the 20% in pre-money valuation to accommodate the option pool, making the effective valuation only €3,200,000.
This is called an ‘option pool shuffle’ because although the employee option pool would be added post-funding, the dilution has been applied pre-funding. Investors are always going to opt for dilution pre-funding, if you have existing investors there may be push back but for this reason it’s important to think about hiring needs before approaching Series A funding and base the employee option pool size on a hiring forecast, rather than an arbitrary figure picked by investors.
Post-money Option Pool
In this scenario, the investors have agreed to allocate the option pool post-funding instead.
At the time of investment the founder hands over 20% of equity shares to the investor, and the founder is left with 80% of shares.
At the time of the option pool creation at 20% of equity, everyone gets diluted, the founder will hold 64%, the investors 16%, and the option pool 20%.
When planning your hiring needs and the size of your option pool, it’s important to remember that the disbursement of options will be dependent on the types of employees you hire; their skillset, seniority, and possibly the length of service. This means that a senior marketing manager may be allocated 1% of the option pool, whereas an administrator may only be assigned 0.25%, and the more experienced the hire, the more likely that they will negotiate this term. So, it’s a good idea to do your research and find out what your ‘dream team’ will cost in options and salary.
How much equity do you need for an option pool?
This is something you must determine through research and planning. How many people do you plan to hire, who will you need to hire, how do you plan to subdivide your shares, and what are start-ups needing a similar team offering?
What are the key terms set out in the stock option plan documents?
There are several items that should always be included in the stock option plan documents, these include; the equity incentive program, grant documents, exercise documents, shareholder agreement, share certificates, company by-laws, and separation letter.
How are the strike prices within the option pool determined?
Employee option strike prices are based on a startup's 409A valuation, which is an independent valuation made at the time of issue.
Are there alternatives to issuing employee options?
There are a number of different methods including profit pools, bonus pools and profit interest agreements.