Definition
An option pool refers to a set of shares of stock reserved for employees of a private company. The option pool is typically used to attract and retain talent within a company by offering them equity as part of their compensation. It is created from the company’s equity and the size of the pool can affect a company’s valuation.
Phonetic
The phonetics of “Option Pool” are:Option – /ˈɒpʃən/Pool – /puːl/
Key Takeaways
- The Option Pool is a chunk of equity set aside by a company’s founders for distribution to future employees, advisors, or other participants in the form of stock options.
- It is mainly used as an incentive tool to attract and retain high quality talent in the company. The size of the pool may vary, but it is typically between 10% to 20% of the total outstanding shares of the business.
- While having an option pool can dilute the ownership of the founders, it can prove to be beneficial in the long run as it can yield greater returns by attracting top-notch human resources that are motivated to grow the company, given their vested interest.
Importance
An Option Pool is a significant concept in finance and business as it refers to a block of equity set aside specifically for future employees and/or service providers. This is an attractive incentive often used by start-ups and growing companies to attract top talent and motivate them to contribute more effectively toward the company’s success. The size of the option pool determines how much company equity can be offered as part of compensation packages to employees. Essentially, it is a strategic tool used to align the interests of the employees with the company’s growth objective by making them partial owners. Hence, its importance lies in its ability to leverage human capital for the company’s overall benefit.
Explanation
The primary purpose of an Option Pool, typically seen in the context of start-ups and companies, is to attract and retain key employees and talents by offering them equity as a part of their compensation strategy. The concept was born out of the need to incentivize employees and stakeholders who could potentially play a crucial role in the growth and success of the company. This is especially significant in the early stages of a company where tangible monetary compensation may not be lavish. By providing employees the opportunity to have a stake in the company, they are, in essence, given a promise of a potentially higher reward in the future. Moreover, an Option Pool serves as a strategic tool for companies to align the interests of the employees with those of the company. When employees own a part of the company, they are likely to work a notch harder, and their actions and decisions are more likely to be in the company’s best interest. This is the guiding principle behind stock options and an Option Pool. To summarize, an Option Pool serves the dual purpose of attracting talented employees and aligning their interest with the company’s goals, thus fostering a unified and committed work environment.
Examples
1. Start-up Company Scenario: New age tech start-ups often create an option pool to attract talented employees. For instance, if a start-up is valued at $1 million and it has an option pool of 20%, it means there are shares worth $200,000 reserved for future employees. The employees would have the option to purchase these shares at a price that was set at the time of their hiring, thus benefiting if the company grows and increases in value.2. Venture Capital Funding Situation: When a company is negotiating with venture capitalists for a funding round, the venture capitalist might insist on an option pool shuffle. For example, they could invest $2 million into a company valued at $8 million, but insist on a 10% option pool. The option pool is created before the funding round, effectively lowering the company’s pre-money valuation to $7.2 million.3. Employee Compensation Plan: Large corporations like Apple, Google, or Microsoft also utilize option pools as a part of their employee compensation plan. They typically offer stock options to their employees in order to motivate and retain talent. If the company performs well, the stock price increases, and employees can buy stock at the lower price that was set earlier, leading to a profit. The option pool in such established organizations may be quite substantial and become a major part of their employee incentive programs.
Frequently Asked Questions(FAQ)
What is an Option Pool?
An Option Pool is a number of shares of stock reserved for employees of a private company. The Option Pool is a way of attracting talented employees by offering them a chance to share in the company’s success through owning part of the company.
Why is an Option Pool important?
Option pools can be vital for startups and small businesses to attract, hire, and retain talented employees and partners. Offering equity can be a powerful incentive and signifies a personal investment in the success of the company.
How is an Option Pool created?
An Option Pool is typically created at the same time the company is incorporated. It can also be created during a funding event. The size of the pool and the specifics of how the options will be distributed are typically detailed in a company’s shareholder agreement.
How is the size of the Option Pool determined?
The size of the option pool is often determined as a percentage of the total outstanding shares in the company. It can vary, but typically ranges from 10%-20% for young companies. The specific percentage can depend on a number of factors including how difficult it is for the company to attract and retain qualified employees without the option pool.
Who is eligible for the options in the Option Pool?
The options in the Option Pool are generally reserved for employees, particularly key personnel, advisors, and sometimes contractors. In many cases, company directors and executives also receive options from the pool.
Can the size of the Option Pool change?
Yes, the size of the Option Pool can be increased if agreed upon by the company’s shareholders. This can happen during a new round of funding or when the current pool has been fully allocated.
When can employees exercise their options from the Option Pool?
The time when employees can exercise their options varies depending on the agreement. Generally, options vest over a set period of time, often four years. Employees might also have to meet certain performance milestones before they can exercise their options.
What happens to the Option Pool if a company is acquired or goes public?
If a company is acquired or goes public, options in the Option Pool can often be converted into cash or into shares in the new company. The specifics depend on the terms of the acquisition or Initial Public Offering (IPO).
Related Finance Terms
- Stock Options: These are contracts that give employees the right but not the obligation to buy a company’s shares at a pre-specified price and time.
- Vesting Schedule: This refers to the timeframe that outlines when an employee can exercise their stock options. It often includes a cliff period after which a large portion of options becomes exercisable.
- Strike Price: This is the set price at which a company’s stock can be bought or sold by the holder of an option contract.
- Equity Incentive Plan (EIP): Also known as a stock incentive plan, it’s a program typically set up by employers to provide employees with company stocks or the cash value of company stocks.
- Dilution: This refers to a reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can occur when options from an option pool are exercised.
