What is an option pool? What are the implications of creating one for your startup? How does the size of your option pool affect negotiations with venture capitalists?
In their book Venture Deals, Brad Feld and Jason Mendelson break down the complexities of option pools and their impact on company valuations. They explain how this reserved pot of shares can both attract talent and affect ownership stakes during fundraising rounds.
Keep reading to discover how to navigate option pool negotiations and protect your equity as a founder.
The Option Pool
The option pool is a key component in a term sheet. So, what is an option pool? The authors explain that it’s like a reserved pot of shares of stock in your company that you can offer to employees as part of their compensation package. Option pools provide an incentive for employees to join your team or stay with the company because they stand to benefit if the company does well.
Think about your company as a pie and shares of stock as slices. The more people getting a slice, the smaller each slice has to be. Thus, creating an option pool increases the total number of shares (slices) your company has. This dilutes the value of existing shares—including those owned by you and any investors—because now each share represents a smaller percentage of ownership in your company. The authors note that the size of this dilution effect could affect your company’s valuation.
This can impact negotiations with investors since they’ll be looking at what percentage (or slice) they get in exchange for their investment. A larger option pool could mean that you as a founder end up owning less of your own company. The authors explain that VCs often insist on expanding the option pool before investing. This move dilutes the founders’ equity and lowers the pre-money valuation because it increases the number of shares without adding any new capital.
Let’s illustrate this with an example: Assume you have a startup valued at $4 million (pre-money) with an existing 10% option pool. You’re seeking $1 million in investment for what you expect would give VCs 20% ownership of a $5 million post-money company. However, if your VC insists on expanding your option pool to 20% before investing, it changes things. The expanded pool comes out of your pre-money valuation, effectively reducing it to $3.6 million (that is, $4 million – $400,000 for the expanded option pool). Now, when the VC invests their $1 million, they get roughly 22% (that is, $1 million/$4.6 million) instead of 20%.
The authors suggest that entrepreneurs should negotiate both their valuation and their option pool size simultaneously since they are interrelated. If a VC insists on a large option pool, you might counter by asking for a higher valuation to offset your dilution. They also note that another option is to keep your initial option pool as small as reasonably possible while still being able to attract talent. You can always increase it later in subsequent funding rounds when, hopefully, your company’s increased value would mean less dilution for you.
| Stock Options and Executive Risk In addition to considering how big your option pool will be, it’s also important to analyze the different types of stock options and how they might impact your company. For example, one type of stock-based employee incentive is CEO stock options. Scholars warn that these options come with their own unique dynamics and potential risks. Some scholarship exploring the link between CEO stock options and illegal corporate behavior suggests that executives with a high proportion of stock options in their compensation packages may be more likely to engage in illicit activities. Stock options can motivate CEOs to take risks with the goal of increasing share prices. While risk-taking sometimes leads to innovation and growth, it can also push some executives to cross legal boundaries to boost their company’s stock value. This is because stock options create a “high-reward, low-penalty” environment for CEOs. If risky decisions lead to increased share prices, CEOs stand to gain significantly from their stock options. However, if these decisions result in legal issues or financial losses, the personal financial consequences for CEOs are typically limited. |
