There is an old Startup adage that says: Money is king. I am no longer sure that is true.
In today’s cash-rich environment, options are worth more than cash. Founders have plenty of guides on how to fundraise, but not enough on how to protect your startup’s options pool. As a founder, recruiting talent is the most important factor for success. In turn, managing your pool of options may be the most effective action you can take to ensure that you can recruit and retain talent.
That said, managing your options pool is no easy task. However, with a little forethought and planning, there are some tools at your disposal that you can take advantage of and avoid common pitfalls.
In this article, I will cover:
- The mechanics of the option pool over several financing rounds.
- Common pitfalls that trip founders along the way.
- What you can do to protect your options pool or to correct your course if you made mistakes early on.
A mini-case study on the mechanics of the option pool
Let’s review a quick case study that sets the stage before we dive deeper. In this example, there are three equal co-founders who decide to quit their jobs to become startup founders.
Since they know they need to hire talent, the trio go for it with a 10% option pool at the start. They then amass enough money between the investment, pre-seed, and seed rounds (with a 25% cumulative dilution on those rounds) to achieve product-to-market fit (PMF). With the PMF in the bag, they elevate an A series, resulting in an additional 25% dilution.
The easiest way to make sure you don’t run out of options too quickly is to simply start with a larger pool.
After hiring a few senior executives, they now run out of options. Thus, in series B, the company carries out an additional 5% of capital options before the purchase, in addition to giving up 20% of the equity linked to the new liquidity injection. When the Series C and D rounds arrive in 15% and 10% dilutions, the company has hit its stride and has an IPO imminent. Success!
For the sake of simplicity, I’ll assume a few things that don’t normally happen, but that will make the math illustration here a bit easier:
- No investor participates in their pro rata after their initial investment.
- Half of the available reserve is allocated to new recruits and / or used for refreshments each turn.
Obviously, each situation is unique and your mileage may vary. But it’s a pretty close proxy to what happens to a lot of startups in practice. This is what the pool of available options will look like over time across turns:
Note how quickly the pool thins, especially at the start. At first, 10% seems like a lot, but it’s difficult to make the first hires when you have nothing to show the world and no money to pay salaries. Plus, the early rounds don’t just dilute your equity as a founder, they dilute everyone’s capital, including your options pool (both allocated and unallocated). By the time the company increases its Series B, the available pool is already below 1.5%.