By Fernando Berrocal
The Stock Option Pool at your business is one of the most powerful tools you have to attract great talent and improve your business. But, it's also a big concern for investors who want to know how you plan to use your stock option pool before investing. Here's what you need to know about stock option pools for startups.
What is my Stock Option Pool (SOP)? This is a collection of stocks reserved for your organization's employees. This pool consists of 10 - 20% of your organization's ownership, and it is often derived from founders' shares. Your SOP is calculated as a proportion of the organization's worth, not as a % of available shares. If you add shares to your business in later rounds of fundraising, you'll also need to add shares to your pool. Otherwise, regardless of the size of your SOP, the value of it will decrease as the number of shares in your business grows. As a result, early-stage employees might wind up with more shares than those hired later.
Why do you give your staff stock options?
- Stock option awards to employees are an important aspect of the startup culture. Starting a business is a high-risk, high-reward venture.
- Employees are encouraged to accomplish their best as a result of these incentives. When your business has a "big exit," stock option holders gain the most; when your staff own stock, they'll keep that goal in mind.
- When you're short on finances, it allows you to hire great staff. Stock options are a strategy to recruit personnel in the early stages of a business when salaries aren't competitive. Some of the top individuals out there may be willing to work for you for low pay in return for an equity incentive.
- It aids in the attraction of Venture Capital (VC). Businesses that employ stock remuneration are favored by venture investors. They want to see you invest in great talent while keeping costs down. One of the most effective methods to achieve this is to grant staff stock options.
- Employees will stay with you. If your employees want to purchase shares using these options, they'll need to stick around; they'll have a good reason to stick around when things become difficult.
Are Stock Option Pools the same as Stock Purchases by founders? Consider the parent stock of your stock options pool to be the founders' equity. When your business is formed, the founders buy common stock at a modest price. The stock is then divided into three "layers”:
- Founders: The founders receive a huge number of shares in the business as options.
- Early Employees: Additional shares of the organization's stock pool are distributed to the organization's initial workers.
- Later Employees: Future workers will be given stock options, although they will be less than those given to the first employees.
How does the Stock Option Pool (SOP) grow and evolve with a Business? As you progress through the rounds of financing, your organization's stock option pool will change.
- SOP in Series A: Because your business still can generate value, Series A stock option pools are often enormous. Your organization's shares aren't worth much yet, so you'll need to provide higher incentives to attract talent.
- SOP in Series B: Once you’ve granted most of your options from Series A, you'll need to expand your pool. A Series B funding round will increase the stock pool by around 5 to 10%.
- SOP in Series C: Your stock option pool should expand by one to two percent by Series C. Remember that as your company expands, you'll be giving new workers fewer stock options.
The value of the current stock must vary when new stock is introduced to the pool. This is known as "Dilution", and it's crucial to understand before beginning to arrange investment rounds.
Your S.O.P. and Dilution: During investment rounds, the value of existing shares in your business decreases as additional shares are issued. Assume that your organization's founders and workers hold 90 shares in total and that these 90 shares represent 100% of the organization's worth. Your organization offers 10 additional shares to investors after the next round of fundraising. Your firm now has a total of 100 shares; your founders and workers no longer control 100% of the company with 90 shares, but instead hold 90%.
Why issue additional shares if it lowers the value of your stock options? Why are you allowing dilution to occur? Your business is reevaluated with each fundraising round; as the worth of your business rises, so does the value of your shares. As your stake in the business dilutes, the value of your stock should rise.
Stock Options vs. Restricted Stock Units (RSUs): You don't have to issue Stock Options if you don't want to. You may decide to issue RSUs to your workers. RSUs are a commitment to the holder that you would issue shares to them whenever a specified milestone is reached. You can either issue the shares or the cash equivalent. The parameters agreed upon when they're employed determine who gets to choose between cash and stock—you or your employee. RSUs are usually only offered in the final phases of an organization's investment.
What is a Stock Option Plan Document? A stock option plan document lays out the rules around an Employee Stock Option Plan (ESOP). Employees can exercise their stock options through the ESOP, which allows them to purchase them according to a vesting schedule. Employees commit to the following when they sign a stock option plan document:
- A Vesting Schedule establishes the amount of time that must pass before employees can exercise their options.
- A Striking Price is an amount an employee will pay for a stock at a set price.
- The date on which the options are granted is also known as the issue date.
- The date on which an employee exercises their options is known as the exercise date.
- The date of expiry. The ability to execute stock options will expire after this date.
How do you set a strike price for stock options? Stock options often have a strike price that is a proportion of your company's 409a value. During each round of investment, a third party does this appraisal. As a result, if your business is performing well, the strike price on stock options you offer will rise as you progress through succeeding rounds of funding.
Issuing Stock Options to Contractors: You may want to consider compensating contractors using stock options but weigh the pros and cons first.
- The Benefits of Granting Stock Options to Contractors: You may keep inside your budget by providing contractors with alternatives as part of their remuneration. You might be able to obtain access to talent that you couldn't otherwise afford.
- Cons of Issuing Stock Options to Contractors: Giving stock options to freelancers may create a conflict of interest. You'll need to straighten this up before giving them choices. When your cap table has a lot of long-term employees, VCs like it. Stock options distributed across a group of contractors might cause problems for VCs looking to purchase more of your business later.