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 a written plan in order to satisfy Rule 701 which provides a registration exemption from Section 5 the 1933 Securities Act.
Via the written plan, a startup pre-authorizes a certain amount of the company’s common stock which will be issued by the plan’s administrator (usually the startup’s board of directors or a committee selected by the board). For example, if the startup has 5,000,000 shares of common stock outstanding, it may elect to authorize 1,000,000 shares to be issued pursuant to the plan.
A potentially confusing aspect of the option pool is how the option pool’s unissued portion is treated for financings relative to acquisitions. The unissued portion of the option pool is included in the fully-diluted capitalization of the startup, but the same unissued portion is not included in the outstanding share count upon an acquisition (or distribution). In other words, the entire option pool is included in a startup’s total share count at financings, but only the issued portion of the option pool is included in a startup’s total share count at acquisition.
Keep in mind that a startup’s original option pool will likely not be the last option pool the startup creates. The size of the option pool is typically negotiated at each round of financing, since at that time, the startup will likely need additional equity options to attract and motivate future hires.