The very earliest group of people who start a company (and probably go without salary for quite a while) would typically purchase stock – founders stock. Once a company has made some headway, it usually shifts to a “stock option” approach. In other worlds, instead of employees purchasing stock (“founders stock”) they instead receive “stock options” which gives them a right to purchase a certain amount of stock at a certain price for some time into the future.
Stock options is a bit topic all by itself – and we won’t try to explain the details of a stock option plan here. But one practical question a CEO must answer is: how big of an option pool should be issued?
If a VC decides to make an investment, one of the terms that will need to be negotiated is the size of the option pool. This page reviews some of the basics you should keep in mind for that negotiation. (And, of course, get advice from your attorney and accountant.)
Why You Care
Prior to your first funding event, every share of stock allocated to the option pool dilutes the founders, not the investors (see “Your Capital (Stock) Structure”). So there are competing objectives. You want sufficient options in the pool to be able to attract employees. But you want fewer options in the pool because you’d rather limit the dilution. It’s a balancing act.
The reality is that additional options can (and will be) allocated later (at the next investment round, if not before). But that dilutes the first-round investors, so they’d rather see you allocate a larger number of options up front (when it dilutes the founders, not the investors).
Get Some Objective Data
It’s worth doing your homework to determine how many options you need in the pool to take care of the employees you expect to hire between the first financing round and the second financing round (because everyone will expect that the stock option pool will be revisited as a part of the next financing round).
So start with your Staffing Plan for the next year of operations. (The assumption here is that in one year, you’re likely to have another funding event, and the option pool can be enlarged at that time to cover the next year’s hires, and “refresher” options for this year’s hires.)
Develop a Compensation Strategy
Decide on an option strategy (e.g., will all employees get options, or only some employees?) which is a part of your overall compensation strategy. Then list out each position and how many stock options should be allocated for each person. Get inputs from your prospective investors as to the size of the option grant that is appropriate to different positions (e.g., VP vs clerical).
Note that it’s best to think in terms of “what percent of the company’s stock” should be allocated to each position, as opposed to “how many shares”. The “how many shares” question varies greatly depending on how many shares you created when you set up the original capital structure of the company.
When we say “what percent of the company’s stock” we mean “what percent of the fully diluted company stock”. In other words, look at your post-funding capital structure (see “Your Capital (Stock) Structure”). Add up all of the Common shares owned by founders, plus the Preferred shares that will be purchased by the investors, plus the total number of shares that are allocated for options or warrants. That’s the fully diluted amount of stock in the company.
Typical Option Percentages
Again, get input from your VCs (they will have to agree anyway, and different VCs have different biases on options). As a starting point:
- A Vice President might typically receive options equal to 1% of the company’s stock
- A VP of Sales might get less than 1% (their big bucks should come from commission)
- A highly qualified CTO might get more than 1% (perhaps 2% or 3%)
- CEO (assuming you hire a CEO who was not a founder) might get 5% to 10%, depending on the amount of experience and the track record
- A director or a very senior engineer would get less (perhaps 0.5% or 0.75%)
- A clerical position would receive less (perhaps 0.2%)
Note that founders who end up with a significant amount of stock (as opposed to options) typically do not receive options.