What is an option pool?
An option pool is a block of company shares reserved to be issued later as stock options (or other equity awards) to employees, advisors, contractors and sometimes board members. Startups use option pools to attract and retain talent by offering the potential upside of company equity if the company grows or exits. In private companies the shares in the pool are set aside in advance and allocated over time according to grant agreements and a vesting schedule.
Key takeaways
– An option pool is shares reserved for future equity compensation—common sizes at formation or at early financing rounds range roughly 10%–25% of the company’s fully diluted capitalization. (Investors and stage of the company influence the size.)
– The pool usually comes out of founder equity (diluting founders) unless otherwise negotiated; investors often insist on creating or expanding the pool as a condition of investment.
– How the pool is created (pre-money vs post-money) and whether it’s sized before or after an investment materially affects who absorbs dilution and the effective price paid by investors.
– Options typically vest over time (common schedule: four years with a one-year cliff), have an exercise price equal to the fair market value (FMV) at grant (private companies typically rely on a 409A valuation in the U.S.), and may have limited exercise windows after termination.
– Startups may “refresh” the pool in later rounds to attract new hires or retain key employees.
How option pools are structured
1. Size and composition
– Typical early-stage pool: roughly 10%–25% of the company on a fully diluted basis (exact size depends on hiring plans, stage, and investor expectations).
– The pool represents authorized but unissued shares. When options are granted and later exercised, those shares convert to outstanding shares.
2. Where the shares come from and who is diluted
– Shares for the pool are commonly taken from founder equity, which dilutes founders’ ownership. Investors often require a pool sized to cover hires needed until the next financing.
– Whether the pool is treated “pre-money” or “post-money” is a key negotiation point: asking for the pool to be created pre-money increases founder dilution; asking for it post-money means existing shareholders (including founders) will dilute less relative to the investor’s percent.
3. Vesting and cliff
– Standard vesting for employees: four years with a one-year cliff. That means no vesting until the one-year mark (when 25% vests), then monthly or quarterly thereafter.
– Other arrangements: accelerated vesting on change-of-control (single- or double-trigger), shorter vesting for senior hires, or custom cliffs.
4. Option types and tax/treatment
– Types: Incentive stock options (ISOs, typically for employees) and non-qualified stock options (NSOs/NSQs, for employees, contractors, advisors). Tax consequences differ—ISOs have favorable federal tax treatment but are subject to alternative minimum tax (AMT) complexity; NSOs create ordinary income on exercise.
– Exercise price is generally set at FMV at grant; private U.S. companies obtain a 409A valuation to set a defensible FMV.
5. Grant mechanics and administration
– Board-approved stock option plan (or equity incentive plan) authorizes the pool and the mechanics for granting options.
– Option grant agreements specify vesting, exercise price, expiration (often 10 years from grant), post-termination exercise window (commonly 90 days for many plans), and repurchase/forfeiture terms.
– Companies need cap table management, an equity administration process, and compliance for securities and tax reporting.
Other considerations
– Dilution dynamics: option pools dilute existing shareholders. Investors negotiate pool size partly to avoid having to approve a large pool later and to protect their ownership percentage.
– “Option pool shuffle”: when investors insist on increasing an option pool at the time of investment, it is important to analyze whether that increase is applied pre-money (diluting founders) or post-money (diluting existing shareholders less).
– Refresh pools: companies replenish pools as hires increase or upon Series B/C raises. New pools also dilute existing shareholders.
– Liquidity and exercise risk for employees: private-company options are illiquid until an exit. Exercising pre-exit involves paying the exercise price and possibly incurring tax consequences.
– Tax and valuation: use a qualified 409A valuation in the U.S. to set option strike prices; failing to do so can create tax liabilities. Consult tax counsel on ISO vs NSO treatment, AMT risk, and state rules.
– Board and legal approvals: option plans and subsequent grants usually require board approval and, for material grants, sometimes shareholder approval.
Practical steps — founders (before and during fundraising)
1. Determine hiring plan and pool size
– Forecast hires for 12–24 months (senior hires cost more equity). Translate hires into an estimated pool size (rule of thumb: 10%–25% depending on pace of hiring and seniority).
2. Model cap table scenarios
– Build a simple cap table showing founders’ ownership, current authorized shares, and how various pool sizes affect dilution.
– Model both pre-money and post-money pool scenarios to see investor and founder outcomes.
3. Negotiate with investors
– Make clear whether the pool will be created pre-money or post-money. Investors typically request that the pool be created pre-money (so it dilutes founders, not the investor stake). Be prepared to explain hiring needs and justify pool size.
– If investors push for a larger pool than you expect to use before the next round, consider negotiating a smaller pool with refresh rights later.
4. Implement the equity incentive plan
– Adopt a formal stock option (or equity incentive) plan; obtain board and, if necessary, shareholder approval.
– Establish grant approval processes, form agreements, vesting schedules, and post-termination rules.
5. Set valuation and strike price
– Arrange a 409A valuation (U.S.) or equivalent FMV determination prior to grants so exercise prices comply with tax rules.
6. Communicate and document
– Explain grants and implications to hires. Provide summaries of number of shares, percent of company if possible (fully diluted), strike price, vesting schedule, and exercise windows.
7. Maintain admin and compliance
– Use cap table software; track option grants, exercises, expirations, and tax reporting requirements.
Practical steps — employees evaluating an offer with options
1. Understand the grant mechanics
– Ask for: number of options, exercise (strike) price, total shares outstanding (or fully diluted share count), vesting schedule and cliff, expiration and post-termination exercise period, and whether options are ISOs or NSOs.
2. Convert options to percent of company
– Percent ownership = options granted ÷ fully diluted shares. Fully diluted includes outstanding shares + options in pool + warrants + convertible securities.
3. Consider strike price and valuation
– If you know the company’s current FMV and the strike price, you can estimate the potential gain if the company achieves a target exit value. Remember illiquidity risk and dilution from future rounds.
4. Understand tax and cash needs
– Exercising options may require paying cash for the shares and can create tax events (especially for ISOs and AMT). Consider whether early exercise or exercise-before-termination terms are offered.
5. Ask about acceleration and exit likelihood
– Ask whether there are acceleration provisions in the event of acquisition and what kind of exit the company is aiming for.
6. Seek counsel for material grants
– For significant grants, consult a tax advisor or attorney to understand tax timing and implications.
Practical steps — investors evaluating option pools
1. Require sufficient pool for hiring until next round
– Negotiate pool size to avoid having to approve large refreshes that would be dilutive later. Typical investor practice is to size the pool to cover hires through the next financing event.
2. Decide pre-money vs post-money treatment
– Investors usually prefer the pool to be carved out of founder shares pre-money to preserve their negotiated percentage; know the impact on founders and the effective purchase price.
3. Model dilution consequences
– Model cap table with and without the pool and simulate future financings and refreshes.
4. Include legal protections
– Add terms in the term sheet regarding option plan approvals, any restrictions on exotic equity, and refresh mechanics.
Simple numerical example (illustrating pool dilution)
– Founders: 10,000,000 shares outstanding.
– Investor wants a 15% option pool. If the 15% pool is set on a post-creation fully diluted basis, total shares after creating the pool = S such that pool = 15% of S. Let S = 10,000,000 + pool.
Solve: pool = 0.15 × S; S = 10,000,000/(1 − 0.15) = 11,764,706. Pool = 1,764,706 shares.
– Result: Founders’ ownership falls from 100% to 85% (10,000,000 / 11,764,706 ≈ 85%). This shows how creating a pool dilutes founders’ percentages.
Checklist for setting up and managing an option pool
– Forecast hiring and estimate pool size.
– Negotiate pre- vs post-money treatment with investors; model the impact.
– Draft and approve an equity incentive plan (board and, if needed, shareholder approval).
– Obtain an independent FMV/409A valuation before grants.
– Prepare standard grant agreements with vesting, exercise price, expiration, and change-of-control provisions.
– Track cap table and option grants with software and governance.
– Communicate clearly to employees about vesting, exercise costs, tax implications and liquidity expectations.
– Plan for pool refreshes at appropriate times; model dilution and stakeholder impacts.
Resources and further reading
– Investopedia — “Option Pool”: https://www.investopedia.com/terms/o/option-pool.asp
– Y Combinator — equity and option guides (startup-focused summaries of how option pools and vesting work)
– For U.S. tax/valuation rules: IRS guidance and 409A valuation providers for private-company FMV determinations
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.