How Does a Startup Option Pool Work?

Your startup’s stock option pool is one of the most powerful tools you have to recruit top-level talent and help your project take off. Plus, it’s a major concern for investors—they want to know how you’re using your stock option pool before they buy in.

Here’s your guide to stock option pools for startups—the way they work, why you should care, and how to use them to the greatest effect.

In this article you'll find information on:

• What is a stock option pool in a startup
• Why issue stock options to employees
• Stock option pools vs founders’ stock purchases
• How dilution influences your stock option pool
• How do you set a strike price for stock options?
• Stock options vs Restricted Stock Units (RSUs)

Your stock option pool is a collection of stocks reserved for employees of your company. Consisting of 10% – 20% ownership of your company, this pool is typically drawn from founders’ shares.

Your stock option pool is a percentage of the value of your company—not a percentage of available shares. So, if you add shares to your company through subsequent rounds of funding, if you want to maintain the relative value of your pool, you’ll need to add shares to it as well.

Otherwise, as the overall number of shares in your company increases, the value of your stock option pool will go down—regardless of the size of the option pool. That’s why early-stage employees—who join before, say, before Round A—may end up with more shares than employees who join later on.

Capbase makes it easy to track these changes with automatic cap table adjustments.

There are a number of good reasons to make employee stock options part of your hiring plan:

• Employee stock option grants are an essential part of startup culture. Startups are a high risk, high reward operation. Part of what attracts talent to a startup is the opportunity to get in early on a private company that will be wildly successful.

• They incentivize employees to do their best work. Stock option holders benefit the most when your company has a “big exit”; when your employees hold stock, they’ll keep that goal in mind.
• It lets you recruit top talent when you’re cash strapped. In the early days, when you can’t offer employees competitive salaries, stock options are a way to attract. Some of the best talent out there may be willing to work for you at a low salary in exchange for an equity incentive—for them, it's a chance at a big cash out later on.
• It helps attract venture capital. Venture capitalists strongly prefer companies that make use of equity compensation. They want to see you invest the best talent available, while keeping expenses at a minimum. Issuing employee stock options is one of the best ways to do this.
• You’ll retain employees. Stock options have vesting schedules. Your employees have to stick around if they want to buy stock with these options; they’ll have good reason to stay on when the going gets rough.

Think of founders’ stock as the parent of your stock options pool. When your company incorporates, founders purchase common stock at a low rate. (Capbase lets you purchase founders’ stock automatically after you form your company.)

Then, that stock is distributed in three “layers”:

• Founders. A large number of shares in the company are distributed as options to the founders.
• Early employees. Additional portions of the equity pool are divided among the first employees at the company.
• Later employees. Future employees receive stock options, but fewer than the earliest employees. That’s because, as the company grows and becomes more established, the risk of working for stock options decreases—compared to existing shareholders, new employees are more likely to get returns on their investment.

So, when we talk about the stock options held by founders, and the stock options held by employees, we’re talking about shares that come from the same initial founders’ stock purchases.

Your company’s stock option pool will change during fundraising, as you go through subsequent rounds.

Series A stock option pool

Stock option pools at Series A are typically large because your company still has the potential to build equity. Shares of your company don’t have much value yet, and you’ll need to offer larger grants in order to attract talent.

Series B stock option pool

Once you’ve granted most of your options from Series A, you’ll need to grow your pool before you grant any more. A Series B funding round will add about five to 10 percent more stock to the pool.

Series C stock option pool

By Series C, your stock option pool should grow by about one to two percent.

Remember, as your business grows, you’ll be granting fewer stock options to new employees. As the company increases in value, so does each share—so stock options are worth more, per percentage point, than they once were. And the company’s prospects are less risky.

As new stock is added to the pool, the value of existing stock necessarily changes. This is called dilution, and it’s important to understand before you start planning funding rounds.

As you issue more shares in your company during funding rounds, the value of existing shares in your company goes down.

For instance, suppose the founders and employees of your company own 90 shares altogether, and that 90 shares is 100% of the company’s value. After your next round of funding, your company issues 10 more shares to investors.

Your company now consists of a total 100 shares; your founders and employees no longer own 100% of your company with 90 shares, but 90%.

If it decreases the value of your stock options, why issue more shares at all? Why allow dilution to happen?

With each funding round, your business is reevaluated; as the value of your company increases, so does the value of shares. Ideally, as your share in the company dilutes, the value of your shares increases.

Dilution is represented in your cap table. If you manage your cap table by hand, that involves a lot of math. But Capbase lets you issue shares and automatically updates your table to reflect dilution.

Issuing stock options isn’t your only option. You may choose to offer employee restricted stock units (RSUs).

RSUs function as a promise to the holder that you’ll issue them stock once a certain milestone is met. You may issue the stock itself, or the equivalent cash value. Who gets to make the choice between cash or stock—you or your employee—is set out on the terms agreed upon when they’re hired.

Companies typically don’t begin offering RSUs until the later stages of funding.

A stock option plan document lays out the rules around an employee stock option plan (ESOP.) It’s through the ESOP that employees are able to exercise their stock options—purchasing them according to a vesting schedule.

When an employee signs a stock option plan document, they agree to the following:

• A vesting schedule, which determines how much time must pass before an employee can exercise their options
• A strike price, the predetermined amount the employee will pay per stock
• The issue date, the date when the options are granted
• The exercise date, the date at which an employee exercises their options
• The expiration date. After this date, the opportunity to exercise stock options expires

The strike price for stock options is typically a percentage of your company’s 409a valuation. This valuation is made by a third party during each round of funding. Hence, if your company is doing well, as you go through subsequent rounds of funding, the strike price on stock options you issue will increase.

The process of determining strike price looks like this: Let’s say your company is valued at $2 million, and the company is divided into four million shares. Each stock is worth 50 cents, so when you issue stock options, the strike price will also be fifty cents.

When your company is next valued, it comes to $4 million total. Assuming a dilution of 10%, your shares are now worth just shy of 91 cents each—a significant increase.

You may consider paying contractors with stock options, but before you do so, consider the pros and cons.

Pros of Issuing stock options to contractors

You can stay within your budget—by offering options as part of their compensation, you pay contractors less cash

You may get access to talent you would otherwise be unable to afford. For instance, why settle for subpar web design when you can hire a more skilled professional by partially paying them with options?

Cons of Issuing stock options to contractors

Since freelancers have multiple clients, giving them stock options may create a conflict of interest. You’ll need to clear this up in advance of issuing them options.

VCs like it when your cap table has lots of long-term employees. Scattering stock options among a bunch of contractors can create headaches later on for VCs who’d like to buy more of your company.

Talk to your lawyer before deciding whether to issue options to employees. If you do decide to go ahead with it, we make it easy; Capbase automatically updates your cap table with any options you issue employees.

Acquisition - When you take control of more than 50% of a company in stock and/or assets.

Administrator - The individual on your board of directors in charge of managing your company’s stock option plan.

Capitalization table (cap table) - A document listing all equity in your company and who holds it. Capbase automatically builds and updates your cap table for you.

Director - The member of your board, elected by shareholders, who contributes to decisions on when to hire or fire executives.

Dilution - The reduction in share value due to more stock being issued.

Fully diluted capitalization - The current number of shares in your company that have been issued.

Stock option pool - The percentage of a company set aside for founders and employees.

Pre-money valuation - The value of a company before outside (409a) valuation.

Post-money valuation - The value of a company after outside (409a) valuation.

Round - A funding event for your startup. Funding rounds include a new valuation and result in the issue of additional shares.

Capbase makes it easy

With Capbase, you can quickly and easily buy founder shares, issue options to employees and contractors, and automatically update your cap table. Want to see it in action? Sign up for the Capbase today.