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Updated September 15, 2023You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.
Option pools are usually agreed upon and allocated before a financing takes place. Companies usually create an option pool before the first employees are hired, but option pools also get refreshed, or new option pools get created, before subsequent financings. This is important, because if the pool is allocated after an investment, then the new investor(s) will be diluted with the founders and prior investors.
important Investors will almost always negotiate for the pool to be allocated before the investment takes place. Founders should make sure to understand how the option pool will impact their ownership* (visit our primer on ownership for more details). Founders should also be sure investors aren’t using the option pool to manipulate the optics of the deal.*
Option pools are part of the pricing dynamic in a negotiation, and founders should be clear whether they are required to create or refresh an option pool prior to or after the round of financing they’re raising.
important You must communicate with your investor about whether the option pool is being calculated pre-money or post-money. Investors often require companies to “refresh” or “true up” the option pool to some target allocation (depending on the deal, often 10–15%) of a company’s fully diluted capitalization, but factored into the pre-money valuation or prior to an investment. If this isn’t taken into account when expressing the pre-money valuation, a founder may think they’re getting a better deal than they are.
When negotiating the size of an option pool, it can be tempting to pick a round number like 10%, 15%, or 20%. Investors will almost always encourage you to pick a higher number, as it reduces the chances they’ll get diluted soon. Instead of picking a round number, founders should budget out the hires they anticipate making over the next 12–24 months (you can usually get away with a 12-month plan at the early stages, but later-stage investors will want 24) and create an anticipated budget for the equity you’ll need to give those employees. Use that bottom-up number to benchmark how large your option pool should be. A typical size for the option pool is 10% at the earlier stages and 20% at the later stages.
For a deep dive into employee equity, visit our Holloway Guide to Equity Compensation.
Aspects of your company’s vesting policies may be negotiated in your term sheet. Depending on what the investors are hoping to affect, this term may appear as “founder vesting,” “founder and employee vesting,” or simply, “vesting.”
For more on the basics of vesting, visit our primer on ownership.
dangerWhen getting started, many founding teams delay legally outlining the terms of their vesting. Often this is because the founding team trusts each other and believes it is safe to figure out the terms of their ownership later. This is always a mistake. Founders also get into trouble when they decide not to use a vesting schedule but instead give each founder a share of the company that is fully vested on day one. This practice is the cause of endless headaches and can ruin long-held relationships. Consider the following scenario. Three founders start a company, they’ve been friends since high school, they trust each other, and everyone says they’re committed for the next ten years. As a result, they agree not to utilize a vesting schedule. Two years later, two founders agree to fire the third founder for inappropriate behavior. Since they didn’t utilize a vesting schedule, the third founder will continue to hold their full share of the company; had they used a standard vesting schedule, they would hold half as much. This failure to utilize vesting is why investors usually require founders to all be on a vesting schedule, just like employees.