How Do Option Pools Work?

Option pools are synonymous with startups. Founders, investors, and employees expect the company to have some sort of option pool arrangement. It provides startup companies with some much-needed leverage required to compete with established companies in the labor market. However, a large number of entrepreneurs are not clear about what option pools are and how they need to be used to increase the chances of a startup succeeding.

This article explains the concept of option pools in detail. It also explains how option pools need to be used in order to obtain maximum benefits from them.

What are Option Pools?

Option pools represent a pool of shares that the founders of the company set aside for the sole purpose of attracting and retaining top talent. These options typically come out of the founder’s stock. It is important to understand that option pools are generally created based on a certain percentage of the company’s value. This means that option pools are immune to the dilution of stock. For example, let’s assume that a company has created an option pool that represents 20% of the total value of the firm. In such cases, if the valuation of the firm is increased by issuing more stock then more stock will also have to be added to the option pool to ensure that it still amounts to 20% of the total shares outstanding.

It is important to note that some investors will insist that the option pools be created from the founder’s shares. They may also want assurance from the founders that at no point in the future will the addition of shares in the option pools will lead to dilution of their stake.

Why are Option Pools Required?

Option pools are very important for startups where skilled human resources are required. This includes startups in sectors such as technology as well as pharmaceuticals and other such domains. Now, it is common for individuals in these sectors to have niche skills that are highly compensated in the market. Hence, if they join a startup company and put their careers at risk, they would like to obtain higher returns.

The problem is that startup companies do not have the money required to pay high salaries to these skilled workers. At the same time, their success is highly dependent upon the quality of these human resources. Option pools provide entrepreneurs with an option to attract the best talent from the market despite their current financial limitations.

How do Option Pools Work?

As mentioned above, option pools are created in order to provide stocks to employees. However, it needs to be understood that these stocks are not evenly distributed amongst employees. Instead, the employees who join earlier get a much larger portion of the stock pool as compared to the employees which join later. This is because the employees joining earlier are taking a larger risk as compared to the ones who are joining later. Also, the number of shares issues varies with the designation of the employee. For instance, the clerical staff may get fewer shares as compared to the manager employed by the startup firm.

Another important point to be noted is that the stocks do not vest all at once. The option pool is a potential pool of shares. All of these shares are not allocated at the same time. Instead, these shares have a vesting schedule which means that they are available to employees after they have spent a certain amount of time in the company. It is also possible to have performance-based clauses which influence the number of shares being vested.

Why are Option Pools Important?

  • Just like investors and founders, employees are also attracted to the start-up genre since they believe that they can generate a significant amount of money in a relatively short period of time. The option pools allow the employees to realize this dream. They can be a part of the success of the company and earn much more money than their counterparts in the less risky companies will earn. This helps the company attract the best talent even though they may be short of funds for the time being.

  • The allure of potentially high returns in the future not only attracts the best minds but also makes them more responsible. It has been observed that startups that offer stock options have more motivated employees who take more ownership of the tasks that they perform. They are not just performing their tasks to obtain a salary. Instead, they are performing tasks that help the firm build wealth as it ultimately leads to their own wealth being built

  • Not only do stock options attract the best talent, but they also help in retaining this talent. As mentioned above, start-up companies have a vesting schedule wherein they provide an incrementally large number of shares as employees spend more time with the company. This means that startups that offer option pools have a much lower employee attrition rate as compared to other startups

  • Lastly, option pools are part of the entire new-age start-up culture. Since they have benefitted several companies in the past, investors are also more comfortable investing in companies where option pools are being used to compensate employees.

In other words, it can be said that option pools can positively influence almost all the human resource issues which a company is facing. Given the fact that human resource issues can be strategic in a start-up, this company, option pools help the founders solve a great problem!

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