How to Create an Employee Stock Option Pool: A Founder's Step-by-Step Guide

Here's an amazing story - a graffiti artist took $60,000 worth of stock options to paint Facebook's building in 2005. Those shares from the employee stock option pool turned into $200 million when Facebook went public in 2012.

This incredible tale expresses why your option pool needs to work well to attract and keep talented people in the startup world. An employee stock option pool sets aside shares specifically for your team members. Most companies reserve 10% to 20% of their total outstanding shares, though numbers differ by location. European companies usually set aside 10% to 15%, while US companies typically allocate 15% to 20%.

Founders must think over option pool dilution carefully. Carta's data shows that most companies see their equity diluted by about 20% at the seed stage. Companies in early stages should set aside 10% of fully diluted share capital for their employees at first and plan to bump it up to 20% as they grow.

Your company's future depends on how well you structure your employee equity pool, whether you're getting ready for your first funding round or growing your team. This piece walks you through everything founders should know to create, size, and manage an option pool that serves both your business and your team's needs.

Understand What an Option Pool Is

An employee stock option pool is a block of company shares kept aside to give to future employees and service providers. This isn't a type of equity itself - think of it as a pool of shares ready to be given out as various equity grants. Companies usually set aside 15-25% of their outstanding shares for these pools, which they create mainly from founder stock rather than investor shares.

My experience with early-stage startups shows that 10% of fully diluted share capital works best to start with. The plan should include growing this to about 20% as the company expands. Investors often want to discuss the pool size during funding rounds since it affects company valuation.

Early employees tend to get bigger chunks of the option pool than those who join later. This makes sense - you want to reward people who take a chance on your vision before you have much to show. Senior management might get whole percentage points while junior employees receive smaller fractions of a percent.

What is an employee stock option pool?

The name "option pool" might be misleading because these shares aren't just for stock options. Companies can use them for different types of equity and give them to anyone helping the business - advisors, consultants, and contractors included. Recipients usually need to wait several years before they can fully benefit from these shares through vesting periods.

How it differs from ESOPs and RSUs

Watch out for mix-ups with terminology. "ESOP" sometimes means option pools in startup talk, but it can also refer to Employee Stock Ownership Plans - retirement accounts with tax benefits that venture-backed startups rarely use.

RSUs work quite differently from options you get from the pool. Employees with RSUs automatically receive real shares after vesting without buying anything. Stock options are different - employees must buy their shares at a price that's set ahead of time.

RSUs make more sense when companies are 20+ years old or in later stages with valuable stock. Young companies prefer options because they could be worth much more if the company's value takes off.

Plan Your Option Pool Strategy

Your option pool strategy needs a thoughtful plan that will substantially affect your company's equity structure and help you attract top talent. The employee option pool's size directly changes your startup's valuation and the ownership percentages of existing shareholders.

Estimate your hiring needs until the next funding round

You must figure out your hiring requirements before your next financing round. Funding rounds usually happen every 18 months to 2.5 years. Your pool should cover hiring needs during this time. Most founders take a "bottoms-up" approach:

• Identify key positions needed for your growth timeline
• Develop a realistic recruiting plan
• Think about new hires and equity refreshes for existing employees

Companies typically allocate 10-20% of shares to their option pool. The exact size depends on your specific hiring needs. A hiring budget that matches your business goals helps prevent founder equity from getting diluted unnecessarily.

Decide who will be eligible for equity

Early employees deserve larger equity portions because they take bigger risks by joining an unproven company. You'll need to reserve substantial equity for C-suite executives hired before Series A. A CEO hired at seed stage usually gets 6-8%.

Clear guidelines for equity grants based on role and seniority should be in place. This helps avoid making decisions case by case that could create internal equity problems or use up your pool too quickly.

Choose between pre-money and post-money setup

The timing of your option pool creation changes dilution levels substantially. A pre-money option pool comes before new investments and mainly dilutes existing shareholders instead of incoming investors. This setup reduces your company's pre-money valuation.

A post-money option pool created after investment dilutes all shareholders including new investors. Founders often prefer this arrangement because all stakeholders share the dilution.

Whatever you choose, don't create pools larger than necessary. A well-researched hiring plan presented to investors often helps negotiate a smaller, more realistic pool size that saves valuable ownership points.

Set Up the Option Pool Legally

Your employee stock option pool strategy needs a proper legal framework. This step will give a solid foundation that keeps option grants valid and compliant with regulations. Both the company and employees stay protected from potential risks related to tax and legal matters.

Create a formal stock option plan

A formal stock option plan document forms the foundations of your employee option pool. Private companies must have this plan to legally issue securities to service providers under Rule 701 of the Securities Act. The plan typically remains valid for 10 years. This complete document should specify:

• Total shares reserved in the option pool
• Eligibility criteria for recipients
• Vesting schedules and exercise procedures
• Terms for option grants and exercise
• Rules for handling corporate events

The plan guides your equity distribution through your company's growth stages. Legal counsel plays a vital role, though sample documents help you understand the simple framework.

Get board and shareholder approval

The board must unanimously approve before any option awards. Your board needs to formally approve the option pool creation and adopt the plan first. Shareholder approval follows next, which usually needs a 75% majority of company shareholders.

Stock exchanges like NYSE and Nasdaq have specific requirements for shareholder approval of equity compensation plans. These apply to public companies or those planning to go public. The UK requires companies to file the Shareholder Resolution with Companies House within 15 days after approval.

Determine strike price using 409A valuation

IRS rules require stock options to be priced at or above the fair market value (FMV) of company shares during grant time. This needs an independent 409A valuation from qualified third parties with relevant experience.

These valuations stay valid for 12 months or until a material event like a funding round occurs. Companies that use reputable valuation firms receive "safe harbor" status with the IRS. This status protects them against tax penalties.

Model the Dilution and Finalize the Pool

Understanding how your employee stock option pool affects dilution should come before deciding its size. You need to know how different ways of allocating shares change ownership percentages and company value.

Calculate dilution impact on founders and investors

The timing of your employee stock option pool creation determines how dilution affects different stakeholders. A pre-money option pool (created before investment) affects existing shareholders—especially founders. Investors get a discount on their investment because the option pool dilution reduces the pre-money valuation.

To name just one example, your company's value drops by 10% if investors ask for a 10% pre-money option pool. This works in investors' favor since they dodge the dilution from creating the option pool. A post-money option pool spreads the dilution among all shareholders including new investors, which helps founders more.

Use cap table tools to simulate scenarios

Modern cap table software makes it easy to model different scenarios. These tools show you how various option pool sizes change ownership percentages through multiple funding rounds.

You should run these simulations before talking to investors to understand:

• How different pool sizes change your ownership percentage
• What happens with pre-money versus post-money pools
• The effects through multiple funding rounds

Good cap table management platforms let you predict hiring needs, monitor equity grants, and see dilution scenarios in one place. Many include data that helps measure appropriate grant sizes for different roles.

Avoid over-allocating unused shares

An option pool that's too large can hurt founders' interests by a lot. Studies show all but one of these startups set aside 10-20% of their cap table for option pools, but you should match the size to your hiring plans.

Unused options stick around for future rounds and create "reverse dilution" that helps investors most. This happens because founders already took the hit from creating the oversized pool.

Make a detailed hiring plan for the next 12-18 months to avoid this problem. Show this plan during investor talks to support a realistic pool size instead of accepting standard percentages.

Conclusion

A thoughtful plan, strategic implementation, and careful management throughout your company's growth trip create an effective employee stock option pool. Your option pool works as a powerful tool to attract talented team members who will bet on your vision before you gain substantial traction.

The size of your strategic pool substantially affects your company's valuation and your ability to recruit essential personnel. Founders must balance investor expectations with their own interests while creating pools that address hiring needs realistically. Detailed hiring forecasts work better than accepting arbitrary pool sizes that might dilute your ownership unnecessarily.

Your option pool's legal structure carries substantial weight. A properly executed plan protects the company and recipients from tax complications or regulatory problems. Board approval, shareholder consent, and accurate 409A valuations are the foundations of a compliant equity incentive program.

Different dilution scenarios modeled before finalizing your pool size give critical insights into long-term ownership implications. The difference between pre-money and post-money pools helps founders make informed decisions during investor negotiations. Cap table management tools make this process easier and let you visualize different scenarios before committing to specific allocation strategies.

Your option pool means more than numbers on a spreadsheet - it shows your company's values about sharing success with those who help build it. The process might seem technical, but human elements remain central. A well-laid-out option pool arranges everyone's interests toward one goal: building a successful company that rewards those who contributed to its growth.