Reserve an Option Pool; Not an Ocean.
TL;DR The larger the pool reserved at formation, the more dilution founders are shouldering that would otherwise be shared with employees and investors. Take it seriously.
Here’s how much discussion usually goes into determining a startup’s option pool size at formation:
Attorney: What size of an option pool do you want to reserve?
Founder: I don’t know, what’s the usual size?
Founder: Ok, let’s go with that.
The reason so little thought goes into it is partially due to the fact that startup formations have (for good reason) become very standardized. Neither founders nor attorneys are interested in delving into any nuances beyond the core questions about equity distribution and founder dynamics. The founders want to focus on their product. The lawyers don’t want to burn time on a fixed-fee transaction.
But here’s why failing to take the time to think through your initial option pool size is a problem: reserving too large of a pool, even if it’s never used, means you’re giving away a larger amount of the company to future hires/investors than you want to.
“That can’t be!”, the founder says. How can an unused pool impact my dilution? Whatever doesn’t get used just gets canceled at an exit, right? While technically correct, this misses a very important issue: future employees and investors will rely on the term “fully diluted capitalization” in determining how much of the Company they want to ask for in the hiring or investment process. And “fully diluted capitalization” includes the unused part of the option pool.
The Hiring Example
You’re negotiating a compensation package for a rockstar developer, and they say they want 5% “of the Company.” What does that mean? The vast majority of the time it means 5% of the “fully diluted capitalization,” which means all outstanding equity AND all reserved but unused equity in the option pool.
Think this through a bit. 5% means having to give them more shares if your option pool size is 20% instead of 10% (because the pie is larger), even if none of the pool is in use. If you end up getting a good exit in a year without having used much of the pool, the unused pool will get canceled, but the “5%” shares the developer received won’t be reduced proportionately. The pie shrinks, but his slice stays the same size — which means yours shrinks. The 5% hire ends up with a much higher percentage of the cap table.
Nutshell: The larger pool you reserve, even if none of it is in use, the more shares you’ll have to give to early hires to get them to a % they feel comfortable with. Those extra shares mean, if the pool is unused at an exit, those hires own more of the Company than the % they bargained for.
Incubators-Accelerators also base their equity requests on a “fully-diluted” basis (%-based), so by having an excessively large pool, you’re giving them too many shares.
The Investment Example
This is a bit more nuanced, and I suggest you read the excellent Venture Hacks post: The Option Pool Shuffle.
- Convertible Notes with caps generally use “fully diluted capitalization” (remember, that includes an unused pool) in determining the conversion price. So a larger pool means the investor gets more shares to get them to the right %, producing the same issue as with employees: if the pool is unused at an exit, they end up with a larger chunk.
- In a Term Sheet, VCs generally make you “top up” the option pool to have a certain % of availability post-closing, but they make the pre-money cap table absorb all the dilution from it. The ask will look something like this:
“the total post-Closing available option pool (excluding granted options) represents 15% of the fully diluted shares of the Company.”
The Venture Hacks article gives a mathematical example, but the most important point is this: the higher % the VCs require as available (unused) post-closing option pool, the lower the price they are paying for their shares, and the more dilution the founders are absorbing.
How does this relate to the point of not going overboard in reserving your original option pool? The pool you reserve before your first VC financing will set the baseline for negotiating how much of an option pool “top up” VCs make founders absorb. If you have a 16% available pool pre-funding, it makes it look a lot more benign for a VC to demand a 15% post-money pool than, for example, if your pre-funding pool was only 5%. Getting from 5% pre-funding to 15% post-funding will require a very large increase in the pool size.
By having a smaller pool before your funding, it reveals a much bigger “hit” on the founders when the financing is modeled and the VCs post-funding pool “ask” is reflected. When both the VCs and the founders see the substantial dilution resulting from the pool increase, it forces a deeper discussion about what the post-funding pool should really look like. And that’s where the Venture Hacks wisdom comes in: have a hiring plan and a solid argument for how much of a pool you really need, and make the VCs argue for theirs.
Nutshell: By keeping your pool size small before funding, it requires a much larger pool increase to get to a VC’s desired post-funding unused pool, all of which is borne by the pre-financing cap table. This forces a necessary discussion with the VCs about what the appropriate pool size really is, instead of just accepting whatever number they pull out of thin air.
So what is the right formation pool size?
It depends. How many founders are there? Whom are you likely to need to hire in the next 12 months? These are details to discuss with your attorney. Whatever you do, don’t just accept 20% without thinking about it.
As a founder, your ownership is set at formation. Everything afterward is dilution. By reserving an unnecessarily large pool, you’re basically protecting future hires and investors from dilution, while absorbing it all yourself. It’s not that hard to increase your pool size if you run out of room, and when you do so, at least everyone on the cap table will absorb the dilution with you. By keeping your pool smaller, you’ll also make VCs think twice about casually dumping an unnecessarily large pool size on their term sheets in order to drive their share price down.
Originally published at Silicon Hills Lawyer.