How Option Pools Work
In the first post of our cap table series, we broke down a cap table into its most basic parts and defined each one. As a quick refresher, cap tables all of the shareholders in your business and lay out who owns what, how much each one owns, and what value is assigned to the stock they do own.
With a clear understanding of the structure, purpose, and makeup of cap tables, we can start layering on additional elements. Namely, we can focus on one of the most critical parts of your term sheet negotiations: option pools.
Option pools, simply put, are a percentage of shares in your company that don’t belong to you or your investors, but instead are set aside for future hiring and retention needs. The best way to understand option pools and how they work is to think about them in terms of shares.
When you start your business, you create a certain number of shares. At first, you and your co-founders own 100% of these shares. When you take on an investment, you are agreeing to exchange a percentage of these shares for the actual capital. However, VC term sheets will also often include a provision that assumes an option pool. Again, this is a percentage of shares that have not been granted to anyone at the time of the deal close.
The option pool is generally calculated out of the pre-money shares, because investors want to be able to simply calculate their post-money percentage ownership. Moreover, the investors do not want to dilute themselves immediately upon investment.
So let’s take a look at all of this information included in our original cap table. In this example we will assume that the agreed upon option pool is 15% post-money % ownership.
The first section of the table demonstrates the original shares and original % ownership as seen in previous posts.
As seen in the next section, the option pool will now be added to the pre-money shares. Since the agreed upon option pool percentage is 15% post-money the number of shares issues on the pre-money will have a higher pre-money % ownership, in this case 19%.
As seen in the last section, the investor makes an investment and receives shares. Now that the investment is complete, the option pool shares that were issued at pre-money equal 15%.
This post is part of the Hyde Park Angels Entrepreneurial Education Series, which brings together successful, influential entrepreneurs and investors to teach entrepreneurs everything they need to know about early-stage investment through events, articles, videos, and more. If you are interested in learning more about similar topics, register for “How to Work with Your Advisors, Board Members, and Investors” on November 12.