Whenever I’ve been involved in reviewing a Term Sheet with entrepreneurs, the how do option pools work topic needs to be addressed.
Employee Stock Option “ESOP” is an allocation of shares, usually “common stocks”, that are reserved by early-stage founders for their employees. It is used as a means for retention and to attract talent, especially if the company is not able to pay market-competitive salaries.
ESOP helps founders retain their team by preventing them from leaving for higher salaries. Usually, these options are tagged to the company’s valuation, so as the company grows in its valuation so does the employee’s net worth. They have been the most-used form of compensation during the last decades, commonly used by startups to the point that unexercised pools are valued at several billion dollars.
In my last article “Basic Rules on Founders Dilution”, I promised I’d share some insights on this topic. Here, you'll find the most important aspects I consider should be taken into account when discussing an ESOP.
Option pools will dilute all the shareholders’ positions
As mentioned, ESOP is about reserving some shares to be granted or acquired by employees, so as the Company has to issue these shares, the former shareholders will be diluted in their positions.
Although it will dilute all shareholders, Venture Capital firms (VCs) usually look for an option pool on a pre-money valuation when negotiating the financing round. This means that the shares for the option pool are coming out from the old shareholders, instead of being shared between old and new shareholders (including interested VCs). This, for the dilution, to affect the company and not the VC's position (investor-friendly position). However, Investors should analyze on a case-by-case basis to determine whether the ESOP should be issued pre or post-money. In cases where founders need to be incentivized further, it can benefit all parties for investors to take a more founder-friendly position and issue a post-money ESOP.
VCs, pay much attention to this because it may result in ownership percentages different than projected. It is not the same for a VC to buy 20,000 shares over a base of 100,000 total and then issue 10,000 additional shares for the ESOP (in which case the new base will be 20k/110k) than to buy 20,000 over 100,000 (including an ESOP issued prior to the financing).
Having this in mind, when the investor requests an option pool of 5% post-money (only for illustrative purposes), it means you (founders and/or current shareholders) have to issue (pre-money) enough shares to be subscribed by the investors on a financing round and set aside some amount of shares to achieve the agreed option pool percentage.
Sizing your option pool
Ideally, the size of the pool will be big enough to attract the most capacitated employees to implement the plan presented to investors. The problem is: if it is too big, founders get diluted more than they have to; and if it is too small, investors do not feel aligned.
Since each company differs from another, giving you an exact number is complicated. Although investors lead this conversation, it will depend on the founders. The key is to consider your hiring needs until your next financing round (i.e. next 12-18 months) and the stock packages you will need to attract the talent needed to reach your milestones.
What I usually see is an option pool of around 5% in a Series A. The pool will increase with each round (since you will be needing more employees for your company to grow) so that at Series C financing the option pool will probably be around 15-20% of the total capitalization. Size your pool carefully since option pool leftovers do not count as fully diluted capital and may affect your company’s valuation. It is key to set the correct amount of shares so you don't leave shares unissued that may affect your company’s value. For more information about this, you may see Index Ventures: Rewarding Talent.
Company’s valuation (and price per share) is affected by the size of the pool
When you get a pre-money valuation, it usually includes an option pool, which affects your price per share. Therefore, the bigger your pre-money option pool, the lower your price per share. In other words, when the investor requests an option pool of 5% post-money, it means you have to issue (pre-money) enough shares to be subscribed by the investors on a financing round and to have 5% reserved for ESOP. As a result, your price per share might be a little bit lower than you are expecting.
The goal is to find the right size for your pool so the valuation and share price will fairly represent your company.
The whole point of an ESOP is to give the employees the right to participate in the company’s upside. The more productive their contributions to the company, the higher these contributions could be compensated through higher share pricing. Common shares give employees certain economic benefits and restricted legal rights, while managerial decisions and certain preferences are commonly reserved to preferred shareholders (investors).
There are many ways to design an optimal equity compensation, option pool is one of them but not the only one. For example: (i) give employees the right to buy future equity at a discount; (ii) pay an amount of cash attached to the value of a number of shares, without giving them legal ownership (commonly known as “phantom shares”), or (iii) give employees the right to acquire or receive shares subject to vesting schedules. All of these have differences in tax treatment as well as legal issues and formalities, but share the fact that they give employees the incentive to build the company and the right to participate in the upside.
The way options are granted may have a huge impact on both the company and the employee. It is important that they are well understood by the grantor and the grantee, so as a founder please make sure your employees understand their rights (e.g. exercise period, strike price) and make sure you have the right option and a vesting scheme for your goals will be pursued.
Finally, with Thanksgiving in mind, I wanted to ask you which has been the most relevant business advice you received during this year. Can you share it? I’ll be eager and grateful to read them and discuss them in future articles. You can also share with me through direct message if you prefer!