An old startup saying states that cash is the king. I'm not so sure.
Options are more valuable in today's cash-rich environment than cash. While there are many resources available to founders on how to raise capital, not enough information has been published about how to safeguard your startup's option pool. The most important thing for founders is to recruit talent. Managing your option pool can be a great way to recruit and retain talent.
However, managing your options pool can be difficult. It is possible to avoid common pitfalls by planning and using foresight.
This article will cover:
The mechanism of the option pool across multiple funding rounds.
Common pitfalls that can trip up founders on the way.
How to preserve your option pool and correct early mistakes
A minicase study of option pool mechanics
Before we get into the details, let's review a brief case study. This example shows three co-founders who are equal in their decision to leave their jobs and become founders of a startup.
The trio decides to start with a 10% option pool as they are aware they must hire talent. The trio then raise enough money through pre-seed, seed and angel rounds (with 25% cumulative diluting across those rounds) in order to reach product-market fit (PMF). They raise Series A with PMF, which gives them a further 25% dilution.
It is best to begin with a larger pool to ensure that you don't run out of options quickly.
They are running out of options after hiring some C-suite executives. The company offers a 5% option pool pre-money and also gives up 20% equity in exchange for the cash injection. The company is on its way to an IPO when the Series C and D rounds are completed with dilutions in the range of 15% and 10%. Success!
To simplify, I'll assume that a few things don't normally occur but it will help me illustrate the math here.
After their initial investment, no investor is eligible to participate in the pro-rata. The pool's remaining half is used to hire new employees and/or for refreshes each round.
Every situation is different and every person's mileage will be different. This is an approximate representation of what happens in real life to many startups. This is how the available option pool will change over time and across rounds.
It is amazing how quickly the pool shrinks, especially in the beginning. Although 10% may sound like a lot at the beginning, it is difficult to hire the first few employees when there is nothing to show the world or cash to pay salaries. Additionally, early rounds not only dilute your equity, but also all your options, both allocated and unallocated. The available pool will be less than 1.5% by the time the company raises Series B.
