The option pool is the amount of common stock a startup reserves (typically at each series of financing) for future issuances to employees, directors, advisors, and consultants.
For example, if a startup has 5,000,000 shares of common stock outstanding immediately before the Series A round, a condition of the Series A round
may will be the creation of an option pool, likely in the 10-20% range of the post-financing fully-diluted capitalization.
At the Series A round, the option pool only dilutes the founders and not the new investors, since the option pool is put into the pre-money. The higher the percentage, the greater the dilutive effect for the founders.
After the Series A round, as the startup develops and adds human capital, it will use the option pool reserve to provide equity compensation to such hires.
If the startup gets acquired, what happens to the unissued amount left in the the startup’s option pool ?
The answer is pretty intuitive — the unissued options get wiped out. But this is still probably a relief to some founders, since founders suffer a dilutive effect from the entire option pool when raising capital.
“We want to have 30% of the startup company at exit.”
-Anonymous Startup Founders
Occasionally, founders will plan out their startup’s lifespan to the point of pre-determining their final equity figure after all hires and investments have been made. Usually, a set of founders want to end up with a final equity percentage in the 25% – 51% range. I call this number founders (mentally) reserve for future issuance the “Issuance Pool.”
While an Option Pool is a key tool for a startup in order reaching the next level, creating an Issuance Pool is of no tangible benefit.
First, the Issuance Pool creates the potential hazard that founders will operate and make equity issuance decisions, whether for a developer or angel investment, as though the Issuance Pool is pre-authorized like an Option Pool. A common mistake made by founders is acting as though they own the 25% to 51% they plan on owning instead of the 100% they actually own as a group after incorporation and before any other equity issuances. Thus, there is the tendency for founders at future issuances to think “This 10% issuance leaves us with 39% left for our (planned) future issuances.”
Your startup could over-issue equity to consultants, advisors, employees, and investors simply because you believe there’s a large amount of equity left in your Issuance Pool. Alternatively, your startup could turn off new hires and investors if you attempt to under-issue equity because your Issuance Pool is running low.
Second, the Issuance Pool should not be used as a barometer of success. Is your startup any more successful because it only issued 75% of your Issuance Pool? Maybe. But the goal should be that all equity issuances work to increase the value of the startup and generate great returns– not that your equity percentage is greater than what you planned months, if not years, ago.
While the Issuance Pool doesn’t show up on your startup’s cap table, it can still be harmful to your startup. There’s nothing wrong with planning, but an Issuance Pool should be discarded quickly after incorporation.
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.