Stock options have long been a powerful tool for creating wealth for holders and attracting talent. Today’s workforce increasingly gravitates toward companies that offer stock options as part of their compensation package. As the number of startups has surged in recent years, equity compensation has become a standard practice. Startups often face resource constraints that prevent them from offering competitive salaries, and stock options provide a way to bridge that gap. By granting options, companies can offer future equity stakes to their employees, which convert to actual shares once certain conditions are met.
But how do you determine the ideal size for your stock option pool? This blog aims to guide founders in understanding the concept of a stock option pool, the factors that influence its size, and its impact on the company’s cap table.
What is a Stock Option Pool and Why Do Companies Create It?
A stock option pool is a reserve of shares set aside for issuance to employees, advisors, and consultants in the future. This pool plays a crucial role in managing the dilution of equity and maintaining balance in the company’s cap table.
While there is no legal requirement to create a stock option pool, it is a common practice for companies to record the pool on a fully diluted basis. This approach helps avoid a sudden drop in shareholding percentages when options are exercised. Essentially, the stock option pool ensures that future equity grants do not disproportionately dilute the ownership stakes of existing shareholders.
When Should a Stock Option Pool Be Created?
A stock option pool can be created either before or after an investment round, each with its own implications:
- Before an Investment Round: Most investors prefer this approach. By establishing the option pool pre-investment, the dilution impact falls on existing shareholders rather than new investors. This approach maintains the investor’s equity stake.
- After an Investment Round: This approach is less common and means that the new investors’ equity stake will also be diluted due to the creation of the option pool.
Let’s explore these scenarios with examples:
Scenario 1: Creating the ESOP Pool Pre-Investment
- Pre-Money Valuation: INR 20 crores
- Existing Shares: 10,000 shares
- Investment Round Size: INR 1 crore
- ESOP Pool Requirement: 10% of the post-money shares
To calculate the number of shares for the 10% option pool, use the formula:
Number of Shares in ESOP Pool
Existing Shares* Pool Percentage/(1-Pool Percentage)
= 1,111 Shares
Price Per Share
Company Valuation/Total Shares
= 18,000 Shares
New Shares Issued
Investment Round Size/Price Per Share
=1,00,00,000/18,000 shares
= 555 Shares
| Shareholders | Existing Shares | % | Pre-Investment Shares | % | Post-Investment Shares | % |
|---|---|---|---|---|---|---|
| Founder 1 | 5,000 | 50% | 5,000 | 45% | 5,000 | 42.86% |
| Founder 2 | 5,000 | 50% | 5,000 | 45% | 5,000 | 42.86% |
| Stock Option Pool | - | - | 1,111 | 10% | 1,111 | 9.52% |
| New Investor | - | - | - | - | 555 | 4.76% |
| Total | 10,000 | 100% | 11,111 | 100% | 11,666 | 100% |
Scenario 2: Creating the ESOP Pool Post-Investment
- Pre-Money Valuation: INR 20 crores
- Existing Shares: 10,000 shares
- Investment Round Size: INR 1 crore
- ESOP Pool Requirement: 10% of the post-money shares
Total Shares Before Pool
Existing Shares +New Shares
10,000+500
= 10,500 Shares
Total Shares Including Pool
=Total Shares Before Pool/(1- Pool %)
=10,500/(1-0.90)
= 11,667 Shares
Pool Size
Total Shares Incl Pool−Total Shares Before Pool
=11,667-10,500
= 1,167 Shares
| Shareholders | Existing Shares | % | No Pool Shares | % | Post-ESOP Pool Shares | % |
|---|---|---|---|---|---|---|
| Founder 1 | 5,000 | 50% | 5,000 | 47.62% | 5,000 | 42.86% |
| Founder 2 | 5,000 | 50% | 5,000 | 47.62% | 5,000 | 42.86% |
| New Investor | - | - | 500 | 4.76% | 500 | 4.28% |
| Stock Option Pool | - | - | - | - | 1,167 | 10% |
| Total | 10,000 | 100% | 10,500 | 100% | 11,667 | 100% |
How to Decide the Stock Option Pool Size
Determining the appropriate size for your stock option pool involves several factors:
Dilution Considerations: A larger option pool means more dilution for existing shareholders. The pool should be sized based on the options required for a set period, typically 18-24 months, to avoid excessive dilution.
Company’s Growth Stage: For early-stage companies, a larger pool (8-20% of stock) might be necessary, while more mature companies with stable revenue might focus on cash compensation rather than equity.
Buffer for Future Hires: Consider your hiring plans and include a small buffer for unplanned hires.
Existing Employees and Special Grants: Factor in the options for current employees and any potential special grants for advisors or consultants.
Market and Sector Practices: Research common practices in your industry and sector to ensure your pool size is competitive.
Investor Discussions: If you are in negotiations with prospective investors, keep them informed about your proposed stock option pool to align expectations.
Adjusting the Stock Option Pool: Common Scenarios
Certain corporate actions can impact the stock option pool size:
| Corporate Action | Impact on the Stock Option Pool |
|---|---|
| Issue of Convertible Securities/Share Split/Conversion of Loan to Equity Shares | Increases the number of equity shares, which may reduce the option pool percentage. Adjust the pool size to maintain the desired percentage. |
| Buyback of Options | Cancelling options reduces the pool size, necessitating adjustments to maintain the pool’s percentage. |
| Buyback of Shares | Decreases the number of shares, potentially increasing the percentage of the option pool. Adjust the pool percentage to maintain consistency. |
A stock option pool is a strategic reserve of shares for future issuance, designed to manage equity and balance the cap table. Whether you’re creating or adjusting the pool, it’s crucial to consider how it affects existing and new shareholders. Strategic planning and informed decision-making can help ensure that the stock option pool supports your company’s growth without causing undue dilution.
By understanding these dynamics and applying these principles, you can effectively manage your stock option pool to benefit your company’s growth and attract top talent.
