What is an option pool, you ask? Yet another excellent question! Hint: it is not featured in the image above!
(If you’re wondering what an option is, click here.)
In this post, we’ll look at what an option pool is and how many options you should be allocating to the pool.
In search of a definition
Sometimes before you can define a term, it’s important to define what it is not. For example:
- An option pool is a not a “person”, so you can’t issue or transfer options to the pool. (But it’s a common misconception.)
- An option pool does not have any rights or obligations. But companies and option holders do!
- An option pool is not a synonym for an option plan. (That’s the document which determines the size option pool, participant eligibility requirements, terms and conditions of grants and exercise, etc.)
But in its most basic sense, an option pool is a term used to describe the number of options a company can issue pursuant to its option plan. It is composed of allocated and unallocated options, which can also be referred to as issued and unissued options, or granted and not granted options.
How many options go into an option pool?
There is no rule on how many options should go into an option pool. But when going about this, it is however important to keep some fundamental principle in mind, namely: the law of supply and demand, and market practice.
Supply will in part be dictated by how much dilution your shareholders are willing to suffer. Why are they being diluted? Well, options are usually exercised into common shares on a 1:1 basis, so each option you grant could one day be replaced by one new share. And if the company is sold, that means there’s less “pie” to share among the existing shareholders.
To think of it another way, let’s say you own 250,000 shares out of 1,000,000 shares issued. You therefore have 25% of the overall equity. Then the company adopts an option plan and reserves 111,111 options for allocation to eligible participants in the plan in its option pool. Assuming the options are exercisable on a 1:1 basis, that means you now have 250,000 out of 1,111,111 total securities. That’s 22.5% of the total equity, representing a dilutive impact of 2.5% on your equity stake in the company.
The trade off for the dilution is the presumption that the option holders are adding value and helping to grow your business. So although you may have 25% of a company when it is first incorporated, your company is presumably worth more then you start hiring employees and granting options. So keep in mind that 22.5% of something is better than 25% of nothing.
On the demand side of the equation, there is how many options your employees and new potential hires will expect to receive. And there is also the issue of how many options your investors will require you to set aside to make sure you can recruit top talent. The idea being that giving employees some “skin in the game” is a way to align their interests with the shareholders of the company.
Finally, there is the issue of market practice, or “what does everyone else do?” Typically, the number of options in an option pool will range from as low as 5% to as high as 20%. But it really depends on the company’s industry and its stage of development. 10% is usually a safe bet and option plans can usually be amended with relative ease to increase or decrease that number for the pool. But talking to your lawyer and your accountant in your local market is a great place to begin for reasonable comparables.