Founders at Silicon Valley style technology startups offer their employees stock options. The percentage of the company available to grant to employees as options is called the “option pool.” Modeling the size of an option pool becomes incredibly important when a startup is raising a round of financing, as the VCs will expect the option pool to be large enough to provide options to all new employees who are hired until the next fundraising.
We’ve created a free spreadsheet that founders can use to model out the number of options that they will need. This free option pool model is available on our startup financial modeling page here. Click and then scroll down to see the “Employee Stock Options - VC Negotiation Model” file.
Stock options dilute a startup’s founders’ ownership when the options are exercised and converted into shares of the company’s stock. When employees exercise their options, the number of outstanding shares in the company increases, meaning that each existing share represents a smaller percentage of the total ownership. This reduction in ownership percentage is referred to as dilution.
For example, if a founder originally owns 50% of a company’s shares, and the company grants stock options to employees for 20% of the business (and the options are eventually exercised),, the founder’s ownership percentage will decrease by 20% to 40% of the company.
Therefore, when considering the creation or expansion of an option pool, founders must balance the benefits of providing employees with incentives and the potential dilution of their ownership. And that’s why VCs have founders increase the size of the option pool BEFORE their investment happens.
What about SAFEs and converts? Well, those documents typically have language that have them covert in a way that they are not diluted by the increase in share count from the option pool.
VCs expect founders to set up an option pool that is big enough to assign to all the employees who will be joining a company after the financing round. Founders, on the other hand, would be better off (from an equity dilution standpoint) if the option pool was ONLY increased as new employees were hired.
This sets up a pretty serious conflict of interest. This is a hidden decrease to the effective valuation at a venture round, as the existing investors are forced to decrease their ownership by the amount of the increased option pool PRIOR to the new VC investing in the round.
Founders need to pay special attention to this hidden valuation impact, and should be prepared to negotiate around the size of the option pool needed, just as they negotiate the pre-money valuation!
So the size of an option pool is a negotiation between the founders, the new investors (and usually the existing investors and/or board of directors). From the founders point of view, the smallest to get the round done is best. The VCs will think of the pool as setting aside a portion of the company’s ownership to be distributed to new hires. Therefore, the inventors will say that the size of the option pool should be directly linked to the company’s hiring plan, as it provides a solid foundation for determining its size.
This is the best way to negotiate with VCs about the size of the pool - getting them to agree that the size should be based on the number of hires and how many shares they need.
Then, a smart founder will show a model that allocates options to each new, projected hire. That’s what our free stock option pool model does - it allows founders to list every new hire, by month and title, and then to estimate the amount of options that they will need.
The VCs expect the founders to ‘eat’ the dilution from the new option pool creation. This effectively decreases the valuation that the VCs offer the founder. For example, if the founder has to create a 10% option pool (pre-money), the valuation is 10% less than what’s on the term sheet! So the modeling of the option pool has a real economic impact on the startup’s valuation.
Don’t forget - many startups already have an ungranted option pool when they are negotiating their next venture round. These ungranted options can be used too, so the option pool doesn’t usually need to be made out of NEW shares, you can use ungranted ones as well.
Steps to model an option pool
Get our free option pool model here.
Enter details of your funding round. You’ll need to enter your desired round size and pre-money valuation. This will be used to calculate the dilution impact of the new shares issued in the fundraise.
Create a hiring plan for the new employees.
Assign an estimated number of options that each employee will need - it’s easiest to think about this as a percentage of the company.
Figure out if you need to top off any existing employees with additional shares (again, think in terms of percent of the company).
You now have percent of the company that will need to be granted to new and existing employees after the financing round is completed.
Gross up the percent of the company, taking into account the fact that the new investors will dilute the option pool percentage down to the targeted amount. Example math: if you are raising $10 million at a $40 million pre-money valuation, then you are selling 10/(10+40) of the company, or 20%. If you need a 20% sized option pool post investment, you therefore need a 25% sized option pool pre-close. (20% option pool / (1-20% round size) = 25% pool.
Know the size of your existing, ungranted option pool. The existing ungranted option pool will reduce the amount of new options you need to create.
Subtract the existing pool size from the new pool size needed to come up with the new shares that you’ll need to issue. Use pre-funding percentages. This will be how much extra dilution you’ll get from the new options.
If you don’t know what options are, check out our stock options Q&A. Stock options are a type of benefit that startups often offer to their employees as a form of compensation. They give the employee the option to buy a certain number of shares of the company’s stock at a set price, known as the “strike price”.
The idea behind stock options is to incentivize employees and align their interests with those of the company’s shareholders. If the company’s stock value increases, the employee can exercise their options and buy the stock at the lower strike price, potentially making a profit.
Use a capitalization table - hopefully not in Excel, but instead in a piece of software. We recommend the best cap table software we see startups use here.
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