Startup Best Practices 16 - Option Pool Planning

Much information is available on the web. Many companies use employee stock options plans to retain and attract employees, [3] the objective being to give employees an incentive to behave in ways that will boost the company's stock price. How does a startup choose its employee's options pool? Browse startup jobs from over 5, of the world's best startups on AngelList. Our attorneys have experience with these types of option agreements and the initial consultation is free!

An option pool consists of shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a startup company - if the employees help the company do well enough to go .

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The purpose of the stock option is to reward employees, advisers and other team members by giving them the right to buy shares in the business sometime in the future at a price lower than its then fair market price.

It should be noted that stock options are not shares they are simply the right to buy shares. A business grants stock options to an employee to purchase 20, shares at a strike price of 0.

The strike price is based on the fair market value FMV of the shares at the date the options were granted to the employee. After one year the business has done well and the fair market value of the shares increases to 1. The employee exercises the stock option and buys the shares at 0. The increase in value to the employee is calculated as follows. The employee now owns 20, shares in the business and will hopefully at sometime in the future sell these at an even higher value.

It should be noted that the example is highly simplified and that in practice to avoid a new employee simply exercising all their options and leaving the business before they have completed their job, they would gain the right to exercise their options over a period of time. In the above example the 20, options would still be granted to the employee but they might have to wait a year before they can exercise any options known as a one-year cliff , and then might only gain the right to exercise them known as vesting at the rate of say 4, shares a year over the next 5 years.

If the employee leaves before the cliff they have no rights to exercise any options and will receive no shares, if they leave before any of the stock options are vested they will forfeit the right to excise those options. Stock options are particularly important for a startup using bootstrapping finance methods as they provide a mechanism to recruit, reward and retain key members of the team without using cash.

In addition the stock options create loyalty and incentivize the team to perform to increase the value of their stock options and in doing so enhance the value of the business.

Although stock options are not the same as shares, only the right to purchase shares, they can be included in the cap table to show the impact on the percentage shareholdings on the basis that all options are eventually exercised and converted into shares.

The cap table including the stock options is referred to as a fully diluted cap table as the effect of the stock option is to dilute the existing shareholders.

For example, suppose a business has the following existing shareholdings these are the shareholding used in our earlier post on pre-investment cap tables. The business now grants the 20, stock options referred to in the example above and the effect on the shareholding percentages is shown in the fully diluted cap table below. The effect of granting the stock option is to dilute the percentage shareholding of the existing shareholders.

Although the number of shares held by each existing shareholder has not changed, the total number of shares including the stock option is now 1,, and therefore the percentage ownership of each shareholder reduces.

The existing shareholders who previously held To do this, the board votes to add more shares to the current share count. Each pool expansion dilutes the existing shareholders.

Because the value of shares increases substantially with the growth of the startup, new invested capital and diminished risk of the business, new employee grants should offer fewer shares over time. However, the smaller number of shares will be worth the same or more now. Often at or after the Series B, startups will split their shares. Series A companies typically have 10M shares outstanding and after the Series B, those 10M shares will split 1: At some point after the Series B, the startup should create a compensation committee that includes the head of HR and two board members who are not employees of the company.

Among other responsibilities, the compensation committee establishes standard offer ranges, which include salary and equity, for all the levels of new hires. In addition, the compensation committee is responsible for creating an annual ESOP budget - the total number of shares the company will grant to new hires to achieve its hiring plan each year.

The committee sums the theoretical equity grants according to hiring plan to calculate the budget. Using this figure, the startup can determine when to expand the pool.

How an Option Pool Works

An option pool is an amount of a startup’s common stock reserved for future issuances to employees, directors, advisors, and consultants. The option pool is created pursuant to . In this tool -- as of the writing of this, we have modeled the worst deal for the founders to illustrate what stance your investors will likely begin the negotiations with. In the tool, ALL of the dilution from the option pool allocation comes from the founders stock -- meaning none of it comes from the investors. The stock options set aside from the unissued authorized capital is referred to as the stock option pool. For instance suppose the business in the example above decides it needs a 5% stock option pool, it will calculate the .