An essential component of the equity structure of a start-up is an employee option pool. It is a percentage of the company’s shares reserved in the form of stock options for loyal employees.

This encourages workers and aids in bringing in and keeping talented individuals for the business. When a startup receives funding from outside investors, employee option pools are frequently created.

Why Do Startups Want To Have An Employee Option Pool?

1. Attract And Retain Talent

Startups can encourage long-term employee retention, by giving employees stock options that give them a stake in the company’s success. This way, startups hope employees will be more loyal and stay longer at the company. 

2. Boost Morale

Employee stock options allow employees to benefit from the company’s success. It enhances their sense of ownership and pride in their work, as well as their understanding of the company’s goals and objectives. In other words: it boosts morale. 

3. Aligns Employee And Company Goals

Having an employee option pool helps employees and startups align their goals. Employees can be encouraged to put in extra effort to help the company grow and succeed in order to maximize the value of their stock options.

4. Reduces Cash Outlay

For startups, offering stock options rather than cash payments can be far more cost-effective. Startups can reduce their cash outlay while still rewarding their employees for their hard work and dedication by offering stock options.

How Do You Structure An Employee Stock Option Pool?

An employee stock option pool (ESOP) is a portion of a company’s stock set aside for the purpose of incentivizing employees. Most ESOPs are structured as a percentage of the company’s total outstanding shares. Each employee receives a set number of options to be exercised at a set price and under certain conditions.

The company size and stage determine the size of the option pool. Typically, larger pools are found at scaleup companies or companies that are more mature. Companies typically allocate 10% to 20% of their total shares to the option pool, though this varies depending on the circumstances.

Various Types Of Equity And Employees In ESOP

Most option pools are divided into different types of equity, for example, common stock, preferred stock, and restricted stock units. Each type of equity is distributed by its own set of rules and has different conditions for employees to be able to exercise their right to buy the specific stock. 

Not only is the option pool divided into different types of equity. The pool includes several types of employees as well. In general, senior executives will be given the most options, while junior employees may only be given a small portion.

Therefore, it is important for companies to consider how the structure of the ESOP will fit into their overall corporate strategy. For example, when will the options vest and how will the pool affect future fundraising rounds?

After a pool is established, it’s best to review it periodically to ensure it still meets the requirements and goals of the company. Or whether any changes in taxes or legislation impact their employee option pool.

How Does An Employee Stock Option Pool Result In Dilution?

An ESOP is a pool of stock options made available to employees by a startup company. An ESOP allows employees to purchase a certain amount of company stock at a predetermined price.

This practice enables startups to attract, motivate, and retain employees without paying large sums of money. However, there is a disadvantage to this practice: dilution.

When a startup establishes an ESOP, the total number of outstanding shares increases. This supply increase dilutes current shareholders’ equity, lowering their ownership stake in the company.

The larger the ESOP, the more current shareholders will be diluted. Therefore, startups must carefully consider how much of their equity should be allocated to an ESOP. A pool that is too large can cause massive dilution and may not be worth the benefit of attracting talent.

How Does A Pre-Money Option Pool Work?

In a pre-money option pool, a portion of a company’s equity is set aside for employee stock options, before any outside investments are made and before the company raises venture capital.

For example, if a startup has 5 million shares of common stock, the founders may choose to reserve 10% of the stock in an option pool (or 500,000 shares). When new employees join the company, they will be given stock options from the option pool shares. When a venture capitalist or angel investor makes an outside investment, they will purchase their equity from the remaining shares. 

How Does A Post-Money Option Pool Work?

A post-money option pool is established after the company receives a series A round of funding. Due to the equity being already purchased by investors, the total amount of shares available for the option pool is lower than in a pre-money option pool. 

A Post-Money Option Pool works by the company allocating a certain percentage of its total outstanding shares to the ESOP. This percentage is usually between 10% and 15% and is agreed upon between the company and the investors.

Assume a startup raised $1 million in its Series A round and has a total of 10 million shares outstanding. In this case, the company can set aside 1 million shares (10%) for an Employee Stock Option Pool.

Conclusion

When it comes to employee stock option pools, it’s important to decide how to structure such a pool and when to establish it, without losing sight of the company goals. 

Employee options are mainly established as either pre-money or post-money option pools and companies should consider carefully what the dilutive effect is when the pool is set up.

A well-structured ESOP will ensure that employees remain loyal to the company and are adequately compensated for their contributions.