How to Model an Option Pool for Startup Employees

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.

If you are negotiating the option pool size with a VC, check out our article on “the option pool shuffle” which details how to negotiate the pool size. Don’t accidently sell more of your business! 

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.

What are 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.

How do you keep track of stock options?

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.

Factors influencing option pool size

1. Stage of the Company: Early-stage companies typically need larger option pools to attract and retain top talent, while more established startups may require smaller pools.
2. Anticipated Hiring Needs: The number and level of future employees, including C-suite level executives and key hires, will influence the size of the option pool.
3. Industry Benchmarks: Different sectors have varying norms for equity compensation. Startups should conduct their own research on industry standards.
4. Funding Round: The stage of funding (e.g., seed, Series A, B, etc.) can affect the option pool size. Investors in each round may have different expectations.
5. Existing Shareholders: The impact on current equity holders, including founders and early employees, must be considered when sizing the option pool.

Pre-Money vs. Post-Money option pools

When discussing option pool size, it’s crucial to specify whether it’s on a pre-money or post-money basis:

• Pre-money Option Pool: Created before the new investment round, diluting existing shareholders. This is typically how VCs want to do it!
• Post-money Option Pool: Created after the new investment, diluting both existing shareholders and new investors. Better for founders and existing team members, because the new investors share in the dilution. Pretty hard to get though!

Investors often prefer a pre-money option pool, as it doesn’t dilute their new investment. However, this effectively lowers the company’s pre-money valuation.

What happens to unallocated options if a company is acquired?

It’s pretty normal for a company to have some unissued/ungranted stock options just hanging out in the option pool. Here’s what typically happens to unissued options when a private company is acquired a generates a liquidity event:

1. Option Pool Dissolution: The unissued portion of the employee option pool is essentially wiped out. These unissued options, which were part of the company’s equity pool, simply cease to exist upon acquisition.
2. Cap Table Adjustment: The company’s cap table is simplified as unissued options are removed. This affects the final valuation and purchase price calculations in the funding round or acquisition.
3. Benefit to Existing Shareholders: The elimination of unissued options actually benefits existing shareholders, including early employees and investors. Their equity stake and ownership percentages effectively increase because the potential dilution from these unissued options disappears.
4. Employee Compensation: While unissued options disappear, companies often negotiate new retention packages or restricted stock units (RSUs) for key hires and C-suite level executives. These are separate from the previous ungranted stock option pool.
5. Future Equity Plans: The acquiring company may establish new equity incentive plans or stock option grants for retained employees. However, these are typically created from scratch and are not related to the previous unissued options.
6. Tax Implications: The treatment of the unissued options can have tax consequences for the company and its shareholders. It’s essential to understand these implications during the acquisition process.
7. Good Record-keeping Importance: A perfect understanding of the option pool size, what has been issued, what is vested, and outstanding shares is crucial before entering acquisition negotiations to ensure accurate valuation. Take care of your cap table!

Founders, early employees, and investors should be aware that ungranted options do not translate into additional value during an acquisition. Instead, they simply disappear, with the benefit implicitly distributed among existing shareholders based on their ownership in the company stock. It’s very important to work with an experienced startup attorney who has worked on exits - you want to avoid negotiation mistakes and tax issues when dealing with options. For example, if the acquiring company is paying you $50 per share, and they included the unissued options in their calculation, you want to make sure that you are able to capture that value and not have it simply disappear!