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3 minute read / Aug 13, 2015 /

Startup Best Practices 16 - Option Pool Planning

No matter the stage of the business, startups need to manage the size of their Employee Stock Option Pool or ESOP. The ESOP contains the shares set aside by the company for hiring and retaining employees. Like a financial budget, ESOP budgets help a startup plan how to finance its growth.

Most Series A companies create pools of 15-25% of outstanding stock. When a startup is young, the equity has the potential to be quite valuable, but isn’t worth very much at the time. To attract great employees, the startup has to provide large grants.

According to Leo Polovet’s terrific analysis of Angelist job offer data these grants vary from 0.25% to 3% for the first 34 or so employees. By taking the mid-point of the equity range, multiplying by the number of employees, and summing, we can estimate the equity requirement to hire the first 34 people totals to 22.8%. Hence the 15-25% rule of thumb.

At some point, the company will have granted most of the shares in the ESOP to employees, and will have to create new shares for the next wave of hiring. This is called expanding the pool. A Series A company would likely expand its ESOP as part of a Series B financing, adding perhaps another 5-10%, depending on the hiring plan of the company. Series C and later companies tend to add 1-2% each year to the pool; or more if they plan to hire executives who can command about 1% or more of outstanding shares.

Sometimes, a company expands the pool between financings. To do this, the board votes to add more shares to the current share count. Each pool expansion dilutes the existing shareholders.

Because the value of shares increases substantially with the growth of the startup, new invested capital and diminished risk of the business, new employee grants should offer fewer shares over time. However, the smaller number of shares will be worth the same or more now.

Often at or after the Series B, startups will split their shares. Series A companies typically have 10M shares outstanding and after the Series B, those 10M shares will split 1:3 or 1:4, creating about 40M shares plus those of the new round. There are many reasons to split shares, but I won’t go into them here.

At some point after the Series B, the startup should create a compensation committee that includes the head of HR and two board members who are not employees of the company. Among other responsibilities, the compensation committee establishes standard offer ranges, which include salary and equity, for all the levels of new hires. The compensation committee benchmarks the company’s offers against industry survey data and adjusts as necessary.

In addition, the compensation committee is responsible for creating an annual ESOP budget - the total number of shares the company will grant to new hires to achieve its hiring plan each year. The committee sums the theoretical equity grants according to hiring plan to calculate the budget. Using this figure, the startup can determine when to expand the pool.

Managing an ESOP well enables a company to achieve its hiring plan and minimize dilution to everyone else. When it’s time, be sure to elect a compensation committee and manage your startup’s pool diligently.

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