Company Structure, Formation & Corporate Basics

Reserving shares under the company’s option plan

The option “pool” represents the number of shares the company sets aside in reserve under its option plan to compensate its employees, consultants, advisors and directors. The size of the option pool depends on the company’s stage, circumstances and hiring needs. When the company issues shares under the plan, it dilutes the ownership percentage of the other shareholders proportionately. However, any shares reserved under the plan that are not used (i.e., that are not sold or issued by the company) do not dilute the actual ownership of the other shareholders. Therefore, the size of the option pool at the initial formation of the company doesn’t really matter all that much—if the pool is too small and you need more shares, it can always be increased; if the pool is larger than you actually need, any excess shares don’t have any negative impact on the actual ownership of the company. Most startups will initially reserve an option pool that is big enough to provide for the equity incentives needed to cover their anticipated hiring needs for the first six months to a year.

Once you are ready to raise money by selling stock, the size of the option pool becomes much more important. This is because the new investors will typically assume that the full pool will be utilized, and they will calculate their price per share and resulting ownership percentage in the company so that the full dilutive impact of that option pool will be borne by the existing shareholders. Here’s an example to illustrate how this works:

Assume the pre-money value of the company is $5M, and the new investors are going to invest $5M. At closing, the new investors would therefore own 50% of the company. Without an option pool, the existing shareholders would own the other 50%. However, the new investors will generally require the option pool to come out of the existing shareholders’ 50%. So if the target post-closing option pool is 20%, the existing shareholders would really only own 30% of the company post-closing.    

This creates an obvious tension: the company wants a large enough pool to give it hiring flexibility; at the same time, the company wants the pool to be as small as possible in order to limit the dilution on existing shareholders. In the end, you should develop a thoughtful and complete hiring plan covering the anticipated hires and equity awards needed between the current financing and the anticipated next financing. The pool should cover those anticipated needs with maybe a small cushion, but not much more than that.