Options Pool For Startups Explained
Options pool is an extremely important factor during the startup phrase. An option pool is shares of stock saved aside for future employee and stock options. This is almost a mandatory thing in order for a legit Venture Capital firm to fund your startup. Quite often, newer entrepreneurs have a hard time understanding the concept and how the whole process works.
Pre Money Valuation
To understand options pool, we have to first understand pre money valuation for a startup. Pre money valuation is essentially the worth of your startup before the funding round.
The value of the whole company before the transaction, called the “pre-money valuation” (and similar to a market capitalization) is just the share price times the number of shares outstanding before the transaction:
Pre-money Valuation = Share Price * Pre-money Shares
Pre Money Valuation is pretty straight forward, pretty much the worth of your company before the new investment kicks in.
Post Money Valuation
Similar ato pre money valuation, post money valuation is the worth of your startup after your new investment round. If a company is worth $100 million (pre-money) and an investor makes an investment of $25 million, the new, post-money valuation of the company will be $125 million. The investor will now own 20% of the company.
Why is this important? Not only because the money valuation process is a must know for startup round funding, but also because most of the time the option pools belong to the pre money valuation. Usually most of the rounds will save around 15-20% in the option pool for later employee benefits.
An example of you using this example would be when you are hiring your early employees for your startup. Let’s say you attend a hackathon with the goal to scout a good talent. You find a bright new college graduate from an Ivy League school. You have the intention of recruiting him to your startup, however many other startups might have the same intention. Because you are bootstrapping or because your on seed funding, you might not be able to afford to pay him big bucks, so instead you can offer him value from the options pool. Usually the newer employees will take anywhere from 3-7% and then later on the employees will take less and less as the company becomes more valuable.
With each round of outside investment, the stock option pool is usually replenished with fresh options. These are used to attract additional team members and to potentially top up the shares held by key members of the team whose performance has been strong and whose efforts will be critical to achieving the business goals. Management should develop a forecast of option grants based on their hiring plan to ensure the company has sufficient options available for recruiting and retention purposes.
Startups should look into planning the options pool accordingly because as mentioned above a lot of VCs might include it into your valuation. The problem with that is that your dollar per share drops and you do not have as much equity in the company. Generally stocks grow as the company grow, so the option pool grows with the company.