What is option pool
Time to read: 8 minutes Not optional. A well designed option scheme will contribute significantly to attracting and retaining key talent and ensuring that value is attributed fairly to those that contribute.
In this article we attempt to outline some of the critical considerations around establishing an option pool, particularly for those companies approaching a Series A investment. Firstly, exactly what is an option? An option, as referred to in the context of an early stage private company is a contract that gives the holder the right, but not the obligation, to purchase a specified number of shares of that company at a specific price on or before a certain date in the future.
Dilution and Stock Option Pools
Option grants are made in the expectation that the value of the price of a given share will rise as the business grows and expands. At such point when the share price has increased, each option granted is therefore worth the difference between the price of the share at that time and the strike what is option pool at which it was awarded.
This is demonstrated graphically in figure 1 below. Fig 1. As such, an option contract is a mechanism that allows holders to participate in the upside value generated by the business as though they became a shareholder at the lower strike price, but without having to deploy any capital.
Not optional. Understanding startup option pools
Options are used as an incentive mechanism for employees of both public and private companies. However, in some circumstances agents may advantages of binary option reviews motivated to act in their own best interests, rather than in the best interests of the firm as a whole. Investors therefore generally like to see managers of their company incentivised with options as an effective way of aligning interests of shareholders and managers - the manager will only be effectively rewarded when the shareholder is similarly rewarded.
Secondly, an option scheme can pay huge dividends to an individual but carry an insignificant immediate cash cost to the company.
Granting such an award to a senior C-level hire would however cost the company nothing in terms of immediate cash cost as opposed to a larger salary that might otherwise be required. Thirdly, options are used to provide equity participation without any cash exposure to the individual to whom they are awarded.
New employees are what is option pool to relish the prospect of being invited to invest significant capital in their new role in order to buy their share allocation when they know relatively little about the company they are joining. Options are a vehicle to provide effective share ownership and therefore upside participation without any of these complications.
How large an option pool should you allocate? Here is some data to support your decision.
So how is the strike price set? The strike price of the option relates to the valuation of the company at the issue date. Often this is the last round price prior to the issue, but in order to be able to grant options to employees without them incurring a tax charge, the company will need to agree a share price valuation with the local tax authority, and the means by which the instrument will be treated for tax on eventual exit, for example with the HMRC in the UK.
Some schemes are available in the UK e. Given that by default the real value of a cash negative business to a minority investor is low or arguably zero, tax authorities may often accept a strike price for options which is below the last share price paid for the business, sometimes considerably so.
Options are more efficient the lower the strike price i. Who should options be awarded to?
There are two primary trains of thought when it comes to awarding options. The first theory is that options are applicable to all employees, and that greater value is created by ensuring that all have an ownership stake in what they are helping to create. The alternative view is that the value of the incentive should not be diluted so sharply, and that superior returns are generated when the value is concentrated around key employees. The reality of which model fits best is somewhat dependent primarily on stage of company.
The European tech industry landscape has matured to the extent that the majority of people seeking roles in early stage startups now understand and value an options package in much the same way that anyone in Silicon Valley would do the same. At around 50 employees a company starts to mature to the extent that extending the options scheme to increasingly more staff probably has a diminishing impact, and options awards can generally be preserved for hires into specific or particularly impactful roles.
Having said this, large publicly listed employers, particularly those in the US, use stock option grants widely to large groups of employees. In summary, when deciding who gets what what is option pool terms of option equity awards it is useful to consider both the level of expected onward dilution though often investors are willing to compensate for ESOP dilution by further awards in some circumstances and the relative value that an individual can bring.
Considering this pragmatic trade off may often help you to avoid destructive negotiations.
Terms of grant Options are awarded to employees according to rules which are normally set out in a separate option agreement and scheme rules. Option agreements do not generally form part of the employment contract. During the subsequent three years the remainder would generally then vest equally over either months or quarters.
Such arrangements serve both as an incentive what is option pool as a retention mechanism to ensure that key employees are locked into the business. Boards of private companies are usually granted significant discretion over the treatment of option grants to individuals in circumstances where individuals subsequently leave the business prior to an exit.
The application of tight leaver provisions varies and there are obviously pros and cons to looser and tighter application. In general, Forward Partners favours a more generous application of leaver provisions in its investments as the critical requirement for early stage companies is the ability to attract the right talent at the right time, and we prefer more positive motivations to retain this talent.
What Is an Option Pool?
What might a Series A investor require? If you have not put in place an ESOP scheme prior to Series A investment, it is very likely that a Series A investor, if not a seed investor before them, will look to require you to provide for one in their investment terms. Their aim is for you to have set aside sufficient options to be able to attract and retain key members of staff as the business grows.
The total size of an ESOP scheme depends on a great many factors, not least the level of founder equity held by the senior team, the projected number of senior hires that the business will need to make to grow, and the stage the business is at.
It is critical to ensure that you read term sheets carefully on this point.
Often a term sheet will insist that the option scheme is created or topped up to a given level prior to the investment. Effectively this is requiring that the existing investors and founders take all the dilution for the additional shares.
Looked at another way, it allows the new investors a discount to the value of the headline share price for the new shares that they are buying. Fig 2. Illustration of the impact on dilution of a pre and post round option adjustment In summary A share option plan is a key component of the remuneration strategy for an early stage private company, these days perhaps even a hygiene factor. The technical aspects of a scheme will require some careful thought and professional advice.
However, a well designed scheme helps align incentives of employees and owners, and at the same time provides potentially significant and therefore highly motivating returns with no cash exposure for either party.