Managing your startup employee equity with an option pool

Startups are challenging opportunities that are a sink for time, money, and effort. Running one is rewarding when done right, but it requires good skills and planning to pull off. 

One demanding area that requires extensive effort is retaining and attracting talent, especially when you need to stand out from your competitors.

This is where option pools come into play. More than just a legal structure, option pools are invaluable in attracting talent, particularly when your startup’s capital is scarce. 

In our article below, we’ll walk you through the essentials:

• Defining option pools
• Covering the benefits of option pools for equity management
• Exploring the best practices

What are option pools?

The definition of option pools is simple: they are a portion of a startup’s shares specifically reserved for employee compensation purposes. Equity compensation is a popular tool startups often deploy to attract, motivate, and retain employees without needing to tap into their capital. This helps ensure that the burn rate is not affected. 

One example of an option pool is the employee stock option plan (ESOP). It grants employees the right—but not the obligation—to purchase a fixed quantity of shares at a predetermined price, though the specific terms of ESOP pools vary by startup. 

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Benefits of option pools for managing employee equity

Option pools, when correctly executed, offer an extensive range of benefits for startups in terms of equity management:

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Provide structure 

Giving away equity on an ad hoc basis, such as making verbal assurances to employees, is a slippery slope when done without an option pool. Disputes may arise, and you may lose track of how much you are giving away without any safeguards, leading to serious consequences (e.g., excessive dilution). 

Conversely, option pools provide a structured and transparent process for everyone involved, ensuring that equity grants are given according to an established framework.

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Help conserve cash

Cash will always be a scarce resource, especially during your startup’s early stages. Since startups tend to spend a lot on compensation, it is important to carefully monitor your finances as other areas also require funding, like product development, marketing, and legal. 

Using an option pool helps reduce immediate cash expenses, keeping cash outflow lower than it would be if equity is used instead.

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Improve employee morale

Possessing a transparent option pool is an effective way to incentivize and retain existing and potential employees.

It signals your commitment to rewarding hard work, innovation, and productivity, which, in turn, helps align the goals of your employees with your startup’s. This ultimately leads to a healthier and more cohesive work environment.
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3 option pool best practices

Constructing an effective option pool requires you to be aware of several key best practices. The most important ones are:

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1. Realize that option pools are not static

Thinking that option pools are static and fixed once they have been created is a misconception and cannot be further from the truth. Just like cap tables, you need to periodically update your option pools to reflect the changing circumstances of your startup as it grows.

Good equity management requires you to be familiar with the present situation of your startup and anticipate your startup’s future needs. For instance, if you plan to increase your startup’s headcount, you should evaluate whether you’re utilizing your existing option pool sufficiently, before deciding on increasing your option pool’s size.

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2. Use well-maintained cap tables to track equity

When it comes to option pools, cap tables are invaluable. As your startup and your option pools grow, equity structures can become increasingly complex. Cap tables cut through the noise, providing clear breakdowns of your ownership structure at any time.

However, you need to properly update and maintain your cap tables to effectively plan and navigate your equity structures. Not doing so often leads to poor and inaccurate decision-making that may cause disputes, legal issues, and above all else, unintended equity dilution.

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3. Closely monitor equity dilution

The biggest enemy of option pools is equity dilution. When you allocate shares for your option pool, dilution comes into play by affecting your startup’s ownership percentages. 

Founders must carefully manage dilution with their equity compensation plans to avoid needless consequences such as losing control over the startup and causing discontent among existing shareholders. Careful record-keeping and planning (e.g., using cap tables), can help you monitor dilution, but don’t hesitate to consult external counsel if necessary. 

Creating an option pool for your startup is only one side of the coin. The other comes in properly managing, executing, reviewing, and adapting it as your startup moves from seed to series.