In the dynamic landscape of startup culture, stock options have emerged as a powerful tool for fostering employee engagement and attracting top talent. As startups strive to compete in talent acquisition amidst resource constraints, understanding the intricacies of stock option pools becomes paramount. This blog serves as a comprehensive guide for founders/HRs, explaining the crucial role of stock option pools and providing strategic insights to navigate this essential aspect of company growth.
What is a stock option pool and why do companies create it?
A stock option pool is a reserve of notional shares set aside for issuance in the future. Giving out options affects how much of the company investors own. Without a pool, giving out options could lower investor ownership suddenly. So, companies often set up a pool to avoid this. It’s not required by law, but it helps keep things stable
When should a stock option pool be created?
A stock option pool may be created either before or after investment:
- Before an investment round – Most investors prefer this. This ensures that the pool is not eating into their stake in the company. However, this results in the existing shareholders’ stake being diluted to account for the pool.
- After an investment round – This is very rare. This would mean that the new investors’ equity stake is also diluting due to the pool.
Let us look at an example:
A company has two founders with a pre-money valuation of INR 20 crores. The company is in its talks to investors to raise its next round. The new investors are insisting on creating a 10% stock option pool pre-investment. The round size is INR 1 crore.
Scenario 1: Creating ESOP pool at a pre investment stage.
Shareholders | Existing | Pre investment | Post investment | |||
# Shares | % | # Shares | % | # Shares | % | |
Founder 1 | 5,000Â | 50% | 5,000 | 45% | 5,000 | 42.86% |
Founder 2 | 5,000Â | 50% | 5,000 | 45% | 5,000 | 42.86% |
Stock Option Pool | – | – | 1,111 | 10% | 1,111 | 9.52% |
New Investor | – | – | Â | Â | 555 | 4.76% |
Total | 10,000 | 100% | 11,111 | 100% | 11,666 | 100% |
Number of shares reserved in the pool= (10,000*10%)/(1- 10%)= 1,111 shares
Price per share for the new investor= 20,00,00,000 /11,111 shares = INR. 18,000
Share issued to new Investor = 1,00,00,000/18,000= 555 Shares.Â
Scenario 2: Creating ESOP pool after receiving new investment.
Shareholders | Existing | No Pool | Post investment | |||
# Shares | % | # Shares | % | # Shares | % | |
Founder 1 | 5,000Â | 50% | 5,000 | 47.62% | 5,000 | 42.86% |
Founder 2 | 5,000Â | 50% | 5,000 | 47.62% | 5,000 | 42.86% |
New Investor | – | – | 500Â | 4.76% | 500 | 4.28% |
Stock Option Pool | – | – | – | – | 1,172 | 10% |
Total | 0 | 100 | 10,500 | 100 | 11,672 | 100 |
Number of shares reserved in the pool= (10,500*10%)/(1- 10%)= 1,172 shares
Price per share for the new investor= 20,00,00,000 /10,000 shares = INR. 20,000
Share issued to new Investor =1,00,00,000/20,000= 500 Shares.Â
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How to decide the stock option pool size?
- Since stock option pool affects dilution, it is important to approach the pool size number in an analytical manner. The pool size should meet the options requirements for a set number of months. That does not mean you set too much aside in the pool. Â
- How much a company needs also depends on the company’s growth stage. The more mature a company is with a stable revenue, the company may think to pay compensation in cash to the employees without the need to offer equity and impact the cap table. Â
- Typically, companies need 8 – 20% of the stock as a stock option though in early years a 5% to 10% might still be sufficient. If the company is still in its seed stage, a pool that lasts for the next 18-24 months (usually until the next financing) is considered good.
What are the things to keep in mind when reserving the stock option pool?
- Create a reserve based on your hiring plan for a fixed amount of time. For example, if you plan to hire 15 employees in the next one year who belong to different pay scales and grades and you plan to offer options as part of their compensation, then create the pool based on these factors. Also provide for any unplanned hiring. Hence when deciding the size, allow a small buffer in the pool size.Â
- Number of existing employees to whom options will be granted. The number of options to be granted will depend on the number of years the employee has been associated with the firm and the designation.Â
- Will you make special grants i.e., will you grant options to advisors and consultants of the company? Companies often create separate pools for management employees, consultants, advisors etc.Â
- Check the market and sector practice.
- If there is an ongoing discussion with a prospective investor, it is advisable to keep them aware of the proposed stock option pool.
- Creation of stock option pool will have an impact on the shareholding dilution of the current shareholders proportionately.
Adjusting the stock option pool- What are the scenarios in which the pool is adjusted?
Sl No | Corporate Action | Impact on the stock option pool |
1 | Issue of convertible securities/ share split/ conversion of loan to equity shares | All three actions result in, increase in the number of issued equity shares. Thus decreasing the shareholding percentage and consequently the option pool size. Option pool may need to be re adjusted to maintain the same percentage. |
2 | Buyback of options | When options are bought back by way of cancelling them it often results in decreasing the size of the pool which requires an adjustment. |
3 | Buyback of shares | When shares are bought back, the number of issued and paid up shares decreases. This results in an increase in the shareholder’s stake on the company’s cap table. If the percentage of the pool is locked, then the pool may need to be adjusted accordingly. For example, if the pool percentage is locked at 10%, and the share buyback results in an increase in the pool percent, the company may need to adjust the pool percent back to 10%.  |
A stock option pool is a kitty that is created to reserve shares for issue in the future. If the company considers restructuring its stock (stock split, stock consolidation), then the pool will also get affected. Founders must be careful when negotiating the terms of a financing round to ensure they are not diluted unduly. Â
