Employee Stock Option Pools: Your Guide to the Basics | Ledgy

Employee stock option pools are a critical component of your company's equity scheme. That's why it's so important to understand how an option pool can effect company valuations and the dilution of existing shareholders. Let's get started.

What is an option pool?

{{quote-1}}

An option pool is normally expressed as a percentage of fully diluted share capital, meaning they include shares and share options that haven't yet been granted as well as any shares and stock options that are already allocated to owners.

An option pool might be created when the company is very new, before it has even started to hire employees. But employee option pools can always be set up in more mature companies too. In particular, option pools are often adjusted when companies raise a new funding round from investors.

How an option pool is structured

By structuring your option pool carefully, you can keep things fair and preserve value for every stakeholder in the pool. This is particularly important for companies operating internationally, where participants in the option pool might be spread across multiple countries.

To manage this complexity, companies should consider breaking out the option pool into separate plans, each of which can cater to a specific country, share class, or type of share option grant.

For instance, here's how a dummy employee stock option pool can be subdivided into different plans on Ledgy:

In this instance, each plan represents a different type of share option, reflecting the fact that employees in different markets need different types of option grant. Having all grants coming from the topco (the original or parent corporate entity) and then split into different plans with specific purposes gives founders or finance leaders more granular oversight of equity plans and the company cap table.

{{usecase-cta}}

How large should your option pool be?

It's a question that occupies almost every leader in a startup or scaling business: what size option pool will work for me? How much equity should I give to the team?

In our 2023 State of Equity and Ownership report, we surveyed 1,200 founders and operators in the United States, United Kingdom, France and Germany. We found that in Europe, it's most common to offer between 10% and 15% of company stock to employees. In the US, on the other hand, option pools are more generous: it's most common to allocate employee option pools of between 15% and 20%.

How your option pool changes as you scale

At Ledgy, we often recommend that very early-stage companies allocate 10% of fully diluted share capital to employees. Past the Series A stage, companies should aim to increase the size of their employee option pools over time and aim to build up to an option pool worth 20% at a later stage.

Why 10%? If you restrict your employee equity pool to below 10% before Series A, the pool then has to increase very quickly in subsequent fundraisings. Aiming high even at an early stage lets you give a strong allocation to early employees, and it helps the pool steadily grow larger as you raise more money and continue to grow.

To some European founders, an employee equity pool of 20% sounds very ambitious. But a growing number of companies in Europe are choosing to bring their option pools in line with the benchmark set by companies in the US. In our State of Equity and Ownership report, we found that across the UK, France and Germany, 5% of companies already offer pools of 20% or higher to employees. We expect this proportion to grow in the years ahead. Any company that is motivated to offer all team members competitive equity should consider how its option pool will evolve over time.

Let's now move on to one of the key issues when dealing with an option pool: how to handle new investors coming on board in a fundraising round. We'll break down why you need to care about the different ways to account for the employee option pool in a new funding round: pre-money, or post-money?

What is a pre-money option pool?

During a funding round, founders and investors will discuss when to factor in the employee equity pool, whether it's just being set up or whether it's being enhanced as part of a new investment. What we call a pre-money option pool is when the employee option pool is set up or adjusted on the cap table before the new investor puts their money into the company. Doing this dilutes all existing shareholders but not the new investor. These clauses are seen as 'investor friendly'.

Pre-money option pools also benefit investors when it comes to the company valuation. If the employee option pool is calculated pre-money, it still has to be factored in to the fully diluted share capital of the business – i.e., post-money. So if you agree a funding round with a pre-money employee option pool of 10%, the price per share (and, therefore, the post-money valuation) will be reduced. This gives the new investors a bigger chunk of their new portfolio company compared to a post-money option pool.

What is a post-money option pool?

As you might imagine, in this scenario the employee option pool is set up or adjusted after the new investor(s)' shares are accounted for. Here, the new investors' shares will experience the same dilution as founder stock and the ownership stakes of existing shareholders. It's commonly seen as 'founder friendly' because the founders aren't the only stakeholders seeing their ownership stakes diluted to make room for the employee pool.

How option pools work in practice

Let's walk through an example of how an option pool is structured.

Setting up the cap table

John and Jane are two good friends who decided to co-found a company called SpaceBook, the social network for new communities on Mars. They originally split the company stock equally, but now they want to raise a seed round. They manage to get a deal with an investor, Pamela. Pamela will invest $500,000 in SpaceBook, and a pre-money valuation of $5 million is agreed. This means that Pamela will receive 9.09% of the company. How do we know that?

1. We know the share price: PricePerShare=PreMoneyValuationTotalPreMoneyShares=$5 million1 million=$5PricePerShare=TotalPreMoneySharesPreMoneyValuation =1 million$5 million =$5

2. We know that Pamela will receive the following number of shares: Pamela’s investmentPricePerShare=100,000 sharesPricePerSharePamela’s investment =100,000 shares

3. We then know the new total number of shares in the company: PostMoneyShares=PreMoneyShares+100,000=1.1 millionPostMoneyShares=PreMoneyShares+100,000=1.1 million

4. And we can find Pamela’s percentage: PreMoneySharesPostMoneyShares=9.09%PostMoneySharesPreMoneyShares =9.09%

Creating the employee stock option pool

Let’s say we want to create an employee option pool (PoolShares) representing 10% of SpaceBook's fully diluted share capital. This means that the PoolShares have to be equal to 10% of the total number of post-money shares. In this case, the following equation needs to be true:

(Jane + John + Pamela)’s shares=90%∗((Jane + John + Pamela)’s shares+PoolShares)

So to calculate the size of PoolShares, we have:

PoolShares=(Jane + John + Pamela)’s shares∗(190%−1)PoolShares=(Jane + John + Pamela)’s shares∗(90%1​−1)

Here we have an example of a post-money option pool calculation. Because the option pool is created after the round is agreed, everyone – including Pamela – is diluted equally.

But what happens if Pamela, for instance, says “A deal is a deal. With or without the option pool, I want to have my 9.09% for my $500,000 investment as agreed!”

In this case the PoolShares have to be created, so to say, before Pamela invests in the company so that she does not get diluted. In other words, the price per share that Pamela will pay will diminish:

PricePerShare=PreMoneyValuation(John + Jane)’s shares⟹PreMoneyValuation(John + Jane)’s shares+PoolSharesPricePerShare=(John + Jane)’s sharesPreMoneyValuation​⟹(John + Jane)’s shares+PoolSharesPreMoneyValuation​

This means that Pamela essentially gets more shares for her $500,000 investment. This is an example of a pre-money option pool in action!

Pre- or post-money option pools: which one will work for you?

Your employee stock option pool is a key business asset. The size of your pool could determine whether you hold on to your top talent as you scale, for instance. And the structure of your pool will help you keep things fair for the team if you're considering expansion into multiple geographies.

Be aware: when founders agree to a pre-money option pool, their ownership stakes will normally be diluted while investors' shareholdings are preserved. A post-money option pool is conventionally seen as being more founder-friendly, and it can be a strong expression of solidarity with the founders and the team if investors agree to be diluted alongside other shareholders when they come on board. But be sure to check the terms of any new investment,

If you need to model scenarios to sketch out the consequences of what a new investment might mean for your option pool, you can do this easily using cap table management software like Ledgy.

FAQs

1. What's better for founders: a pre-money or a post-money option pool?

It's generally accepted that post-money pools work better for founders and other pre-existing shareholders. If new investors account for the employee option pool after their shares are incorporated on to the cap table, other shareholders are diluted less compared to when the option pool is created pre-money. Additionally, creating the option pool pre-money means no unwelcome decrease in the post-money valuation. Make sure you model scenarios carefully when planning new investment, so you know what the consequences of your option pool strategy will be.

2. When should I create an option pool?

As early as possible! It's best practice to plan for growing your team and hiring new talent from the outset. At least, an option pool should be part of your discussions with investors as soon as you start to think about raising external investment. Culturally, being able to allocate share options to your employees helps them align behind the mission and vision of the business and boosts employee engagement.

{{usecase-cta}}