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When seeking equity investment, the investor will generally require that a pool of stock (generally common stock) be set aside from the authorized shares to compensate new and current employees. This is known as an option pool. More specifically, the shares are used as a method to attract new talent that is only interested in joining the startup venture as an equity owner. The shares (or sometimes options to buy the shares) will vest over a period of time. These shares will be forfeited if the employee leaves the startup prior to vesting. Further, these shares will be part of a buy-sell agreement where the startup either has the option or is obligated to repurchase the vested shares at the time that a shareholder leaves the firm.
Options Pools and the Effect on Capitalization
As explained in previous lectures, an investor will determine the pre-money valuation of the firm. That is, she will determine the value of the startup venture without the investment funds. Let’s say for example that the pre-money valuation is $2,000. If she invests $200, then after the investment the total value of the startup is $3,000 ($2,000 + $1,000). As such, she will require 1/3 ownership of the company for the investment of her $1,000. If there are $3,000 authorized shares, she will receive 1000 for her $1,000. This will give her the 1/3 ownership. If, however, there is need to reserve an option pool, this could affect her ownership interest.
There are two ways to approach the option pool. The option pool can come from all shareholders (entrepreneurs and investors) equally, or it can come solely from the entrepreneur’s shares. In the above example, let’s say that there is intention to reserve an option pool of 300 shares (10% of ownership). If the shares come from all shareholders, then this will reduce the investor’s percentage of ownership by 10%. She will own 900 of the outstanding 3,000 shares. This reduces her ownership percentage from 33.3% to 30%. The entrepreneur’s ownership percentage is also reduced by 10%. If the total option pool comes from the entrepreneur’s ownership, the investor will receive 1,000 shares, the option pool will reserve 300 shares, and the entrepreneur will receive 1,700 shares. In this situation, only the entrepreneur is affected by the option pool. This is typically the arrangement demanded by the investor.