Managing your startup option pool

One of the things you need to do as a CEO of a startup is manage the Employee Stock Option Pool (ESOP). This is the pool of options you use to attract and retain talent.

When pricing a financing round ESOP is typically included in the pre-money valuation and therefore it dilutes the existing shareholders and not the new investor. For example, a series-A investor might invest $4M at a $8M pre-money valuation “including an ungranted employee pool representing 10% of the fully diluted post-money”. This means that prior to the series-A the company should allocate a large enough option pool so that after the upcoming dilution it will still represent 10% of the company. If you run the math, the company should allocate a 15% ESOP before the financing round which is much higher than the stated 10%. For a series-A, the ESOP mainly comes out of the founders’ pockets since they hold most of the equity, but as the company continues to raise capital it will dilute all existing shareholders.

So what can you do? Too often startups don’t budget ESOP in advance or don’t manage it correctly. Planning the option pool helps you negotiate a better deal with investors. A detailed and well-planned ESOP budget can help reduce the amount of available options required by an investor which effectively raises the company’s pre-money valuation. It also helps ensure you don’t run out of options too soon and are forced to go back to your board to increase the pool. When you prepare your ESOP budget don’t forget to include employee refresh and promotion grants, and non-employees grants such as advisory board. Below is an example of how this is done in practice:

Another best practice is to agree with your board on options grant thresholds by seniority level or title. For example, new VP gets 0.8%-1%, junior developers gets 0.05–0.1% and so forth. This not only helps align expectations with the board upfront but also helps expedite options grant approval by the board. Grants which are within the thresholds should be automatically approved and the discussion would focus on grants which are outside the pre-approved thresholds.

In general, you should think about ESOP as another pile of cash the company has. It should be managed carefully.