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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
The stock option pool is a specified number of shares set aside and reserved for issuance on the exercise of stock options granted to employees under a stock option plan or an equity incentive plan. Equity incentive plans have more awards available under them to issue than stock options (they also have stock bonuses, restricted stock awards, and sometimes other types of awards as well). The shares reserved under an equity incentive plan should be reflected on the cap table. Options are granted out of the pool via grants that are approved by the board. Each grant reduces the remaining available pool, until it is topped up again by the board authorizing the reservation of additional shares under the plan from the authorized shares. The strike price is the exercise price of the stock option.
important Because stock options can be executed to purchase stock, they need to be accounted for in the cap table; and the stock option pool impacts both the percentage ownership calculation and potentially the price per share, as we will see below.
founder When a company is founded, the founders are wise to set aside 10–15% of the equity in an option pool for future new hires, contractors, and advisors. Over the first few years that equity gets allocated to the new hires, members of the board of directors, advisors, and independent contractors. When the company goes to raise money, savvy investors will want to see that option pool topped up to 10% or 15% again in anticipation of the company hiring many more employees.
Why does the stock option pool need to be so big? The earlier the stage of the company and the more senior the employee, the more equity that employee will demand. Bringing in a seasoned CEO to a very early-stage company (if one of the founders is no longer going to be the CEO) may require giving them 10% of the equity, likely vesting over four years. That is the high end, but even an experienced senior engineering lead or sales executive might command 2%-3% of the equity.* Steve Ballmer received 8% of Microsoft stock when he joined as the 30th employee, and now owns more of the company than Bill Gates. Smart CEOs track a budget of equity for employees, directors, and advisors. That stock gets allocated via stock option grants approved by the board of directors. As the company matures it needs to give out less stock to each employee, even senior ones, but the number of employees it is hiring is also increasing.
When investors are doing diligence on a company, one thing they check is how many shares (options) are left in the stock option pool. A case is often made that this pool needs to be topped up before the investment or as part of the investment. We will see the impact of this as we follow our example company.
exampleAfter agreeing on their relative proportionate stock ownership in the company (60% to Pete and 40% to Joe), Joe and Pete also set aside 15% in an equity incentive plan (commonly referred to as a stock option plan) for future advisors, contractors, and employees. Pete and Joe allocated a total of 10M shares to the cap table, including 1.5M for the stock option plan. They did not issue all of their authorized shares, because they needed to reserve out of the authorized but unissued shares at least enough shares to cover potential future co-founders, investment rounds, and a possible topping up of the stock option pool. Pete and Joe each bought their respective shares of stock from the company at a fraction of a penny per share. Immediately after these stock issuances, there were 8.5M issued and outstanding shares, and 10M shares on a fully diluted basis (counting the entire option pool share reserve).
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Pete | 5,100,000 | 60.00% | 51.00% |
| Joe | 3,400,000 | 40.00% | 34.00% |
| Issued and Outstanding | 8,500,000 | 100.00% | |
| Option Pool | 1,500,000 | 15.00% | |
| Total Fully Diluted | 10,000,000 | 100.00% |
You can see in the table the difference in the ownership percentages based on the two different ways to calculate it (bold numbers represent the inputs driving the calculations). The first column represents calculating a founder’s ownership as a percentage of shares outstanding; the second column shows the calculation on a fully diluted basis taking into account the option pool. While this may seem like a mundane distinction, we make a point to call it out because it comes up in terms sheets for priced rounds. You do not measure someone’s percentage ownership by reference to the total number of shares the corporation is authorized to issue. The various different approaches to calculating ownership will come up when discussing how much of the company investors are going to own after they put their collective money in. Thus, the fact that the company is authorized to issue as many as 25M shares of common stock is irrelevant to determining a founder’s percentage ownership. The company could be authorized to issue 1B shares; it would not matter.
The simplest example of dilution comes from adding another co-founder. This is different from adding another employee, which we will explore below. It is similar to the impact of selling shares in a priced round, but we will save that discussion for further on in our example so that we don’t tackle too many variables at once!
exampleJoe and Pete decide to add a technical co-founder, Rachel. After negotiation, the parties agree that Rachel will receive 15% of the company. Rachel buys her shares directly from the company out of the corporation’s authorized but unissued shares.