How Does a Startup Option Pool Work

What is a company option?

When a private startup is in its first stages, an option describes a form of future contract. An option is a right (but not an obligation) given to an employee or member of the company to purchase shares in that company. The number of such shares must be specified, together with a set price for them, and they must be purchased on or before a given date. The value set on the option is known as its strike price, indicating the share's stated value on the exact date when the option is granted.

What is a employee option pool?

As one might expect, a employee option pool is an available supply of such options that can be used by the company as an employee incentive. Employee Share Option Pools (ESOP) can be an important factor in a startup's recruitment strategy, helping to attract and retain key talent. A well designed ESOP will contribute significantly to the company's value, and ensure that such value is fairly attributed to those members who contribute significantly to its success.

What is an option grant?

Options are granted (not purchased) to employees or company members in the expectation of a future increase in share value. On the date when this happens, every option granted will be worth the amount gained over its initial value, or strike price. Options therefore allow their holders to share in the benefits from the increased value of the business, as if they had actually purchased the shares at the original strike price.

Why are options granted?

Options are usually granted as an employee incentive mechanism, for three main reasons:

1. Removing employees' cash investment risk

Options provide individuals with equity participation at no expense. Granting actual free shares would constitute a value transfer, so an employee would be liable for taxation on a capital gain, even though it can't immediately be realised. Investing significant capital in shares is hardly an incentive for new employees, but options provide for effective share ownership without complications.

2. Reducing company cash outlay on employee compensation

The company's outlay is also insignificant. Options granted on a percentage of the company’s equity could potentially multiply into millions if the startup succeeds. Offering options to boost salaries requires no cash outlay, but can be a valuable bargaining tool in the recruitment process, depending on what stage the company is at and how important the new personnel are.

3. Reducing problems with third party agents

Principal shareholders often delegate company management to third party agents. Incentivising them with option grants is an effective way to ensure that such agents do not prioritise their own interests, only granting them rewards on an equal basis to other shareholders.

To whom should options be granted?

Opinions differ on this, with one camp believing that option grants for all employees create greater value, ensuring collective ownership stakes in the business they are building. The other opinion holds that collective ownership dilutes the share value too much, and that concentrating the value among key employees generates better returns. What solution is best depends on what stage of development the company has reached.

The percentage of options granted varies widely, but frequently falls into a range of 0-8%, where non-founding CEO's generally get the most, and non-executive directors the least. When allocating options, the level of expected dilution should be weighed against the relative value brought to the business by a new hire.

Granting options

Option grants are not generally included in an employment contract, but set out in a separate agreement with its own governing rules. Options are awarded over specified time periods, called vesting, which is a safeguard against new hires moving on before they've made a significant contribution. The incentive is that options generally begin to accrue interest only after the first year of employment, and become progressively more valuable over subsequent years. Provisions are usually built in against people leaving before the vesting period is complete, when options can be turned into actual shares, especially if this is before the predicted exit.

Leaver Provisions

Discretion is given to companies as to how option grants are treated in respect of such early leavers, often incorporated in company Articles as Leaver Provisions. These leavers are often penalised by having to exercise their share options, and sometimes to give them up with no reward. There are pros and cons to structuring Leaver Provisions, but a more generous application recognises a startup's requirement to attract critical personnel at a crucial time, with a more positive motivation to retain them.

Why are option schemes important?

The short answer is that investors will probably require them in their term sheet, as they want you to have sufficient options set aside to be able to attract key members of staff and retain them as the business grows. The extent of this ESOP is dependent on many contributing factors, including how much founder equity is held by senior members, how many senior hires are projected to make the business grow, and its current stage of growth. In general terms, however, an ESOP in a post-first round invested business will commonly represent 10-20% of its fully diluted (100% exercised) equity.

Summary

Option pools for startups are key components of a startup's remuneration strategy – perhaps even a 'hygiene factor'. An ESOP's technical aspects will require careful consideration and professional advice, but a well-designed ESOP can help to align both owners' and employees' incentives, at the same time providing great motivation to increase value with no cash exposure on either side.