Here is a short post with a lots of illustrations.
Remember when we talked about ESOP’s, how they are established and what topics they cover? No? You didn’t read that post? Okay, so run off, take three minutes (it’s short and simple) and then come back.
You are done? Fabulous! Moving right along! So let’s say that you have an ESOP and you want to issue options to your employees. So you make up a list—Oren gets 1% of the company’s equity, Yulia gets 3%, Meirav gets 10% and so on and so forth. And by the time you have finished, you are primed to award, like, 60% of the company’s equity. Because, hey, they rock and you love them and you want them to have a stake in the company and feel invested and all that. So now you write it up and send it to your Board of Directors to approve. And they read it and send it back to you with a giant coffee stain in the middle of the page where one of them snorted coffee out of his nose while reading it, he was laughing so hard. They don’t approve it, naturally.
You can grant options, but only out of the shares reserved as an option pool, and only up to the number of shares still available in the pool.
What is an option pool
An option pool is simply the portion of a company’s shares which have been set aside to be used to for option grants. Generally, this will be set up to represent a certain percentage of total equity, as opposed to a set number of shares. You and your co-founders might decide to set up an ESOP and allocate a pool early on, or this might be done as part of an investment round or at some other time. While the size of the pool will vary from company to company, they generally run between 10-20% of a company’s as converted, fully diluted equity.
Let’s run through an example.
So, this is your brain on drugs:
No, no…wrong example. Albeit one which is terribly familiar if you grew up in the US in the 1980’s (and if you didn’t, allow me to educate you).
Trying this again. This is your cap table without an ESOP Pool.
Not as lovely as the eggs, but more useful. In this case, 100% of the equity are owned by the founders and the investors. Now you need to allocate shares to an option pool. You will be able to issue these shares under the ESOP. The founders and investors agree that the pool should equal 10% of the company’s as converted, fully diluted equity.
Note that we haven’t changed the number of shares that the founders or investors have; we have simply added 11,111 shares to the total. In pictorial format, this looks like this:
A couple more comments:
- Allocating shares to a pool isn’t the same as issuing the shares themselves. The number of shares that have been issued hasn’t changed. This just means that, in addition to the issued shares, 11,111 shares have been reserved for issuance when someone exercises their ESOP grant and buys the shares.
- Issuing the options is also not the same as issuing the shares themselves (for more, see here).
- You are not required to issue options equal to all the shares in the pool
- In general you can only issue options to the extent that you have available shares in the pool. I say “in general” as companies can define different rules for themselves. But this is a good rule of thumb for understanding how these work.
- You can increase the pool. Option pools are generally increased as part of investment rounds, either to keep the ratio stable or to adjust the pool to a new, agreed-upon level. In addition, option pools may be increased when and as needed. Increases require shareholder and board approval