one is old There is a startup saying: Cash is King. I’m not sure that’s true anymore.
In today’s cash-rich environment, options are worth more than cash. Founders have many guides on how to raise funds, but not enough has been written about protecting your startup’s options pool. As a founder, recruiting talent is the single most important factor to success. In turn, managing your options pool may be the most effective action you can take to ensure that you can recruit and retain talent.
That said, managing your option pool is no easy task. However, with some foresight and planning, it is possible to take advantage of some of the tools at your disposal and avoid common pitfalls.
In this piece, I’ll cover:
- The mechanics of option pools across multiple funding rounds.
- Common pitfalls that trip founders along the way.
- What can you do to protect your option pool or correct course if you made a mistake early on?
A Minicase Study on Option Pool Mechanics
Let’s go through a quick case study that sets the stage before we dive deeper. In this example, there are three identical co-founders who decide to quit their jobs to become startup founders.
Since they know they need to hire talent, all three have to go with a 10% option pool initially. They then raise enough money in angel, pre-seed and seed rounds (with a 25% cumulative dilution in those rounds) to achieve product-to-market fit (PMF). With PMF in the bag, they increase Series A, resulting in a 25% dilution.
The easiest way to make sure you don’t run out of options too quickly is to simply start with a large pool.
After hiring a few C-suite officers, they now lack options. So in Series B, the company pre-moneys a 5% option pool top-up – in addition to giving 20% in equity related to the new cash injection. When the Series C and D rounds come in with dilutions of 15% and 10%, the company has hit its stride and has an impending IPO in the works. Success!
For the sake of simplicity, I’ll assume a few things that don’t normally happen, but will make the math a bit easier here:
- No investor participates in their ratio after their initial investment.
- Half of the available pool is released to new employees and/or used for refreshes each round.
Obviously, every situation is unique and your mileage may vary. But in practice it’s pretty close to what happens with a lot of startups. Here’s what the available options pool will look like over time throughout the round:
Note how quickly the pool gets depleted – especially early. In the beginning, 10% seems like a lot, but when you have nothing to show the world and no cash to pay the salary, it’s hard to hire the first few people. Furthermore, early rounds don’t just dilute your equity as a founder, they dilute everyone, including your option pool (both allocated and unallocated). By the time the company expands its Series B, the available pool is already less than 1.5%.