An equity incentive pool is a pot of shares that are set aside for stock options or restricted stock to help a startup recruit, retain, incentivize and align key talent for long term value creation and success. Startup companies often use these shares in lieu of cash to compensate employees, directors, advisors, and consultants.
As you grow your startup and onboard key players, you will constantly need to evaluate your equity pool, how much to grant, how much to keep as dry powder for your team. Sizing an equity pool correctly is a balancing act. One that founders inadvertently get wrong.
Why do I need an equity incentive pool?
Equity incentive pools affect everything. They are a current reflection on how much of your company you can retain. Each time a grant is made, the board adopts a fair market value as the exercise price (for options) or valuation (for restricted stock), and you are making a statement about your company’s compelling valuation and its perception as being discounted or under water. So carefully estimate how big you need your pool to be, and how to position its value.
Simply put, equity pools are to attract, retain and incentivize talent. You are offering employees an opportunity to own part of the company, which should align them to act like owners.
Why does the size of my equity pool matter?
Suppose your company is using the equity pool for compensation and incentives to attract and retain early hires. In that case, a company needs to have a large enough equity pool to make enough grants to fill out the team. Be careful that the equity pool doesn’t have a dilutive impact on the ownership interests of founders and other early shareholders when the company decides to raise more money.
In an ideal world, you want your equity pool to be big enough to fill the equity budget of key hires through your next round of funding. If the pool is too big, you’ll dilute your ownership, and too small, and investors might not be on board. Here are tips for determining how much you need.
Careful with benchmarks
Benchmarks can help ensure your pool size is in range. However, you don’t want to rely on them. There’s an extensive range in the typical percentage founders set aside from less than 5% to 30% or higher. A rule of thumb is that a startup will create a 20% equity pool at formation, and that at a seed round, a seed investor will insist on upsizing the equity pool to equal 15% or greater in the pre-money. A Series A investor will look to see that there is at least 10% of the outstanding share capital set aside in an equity pool and accounted for the in pre-money. Investors will count promised but ungranted options in this calculation.
While some startups will need a large equity pool to fuel their growth, others will be less equity intensive. It’s essential to be realistic and strategic about your hiring needs.
Every startup should have an equity budget that rolls up to the total size of the equity pool . To do that, you need to understand which positions you need to fill in the next 18 to 24 months and how many options you’d need to attract these critical hires. You’ll need to offer early employees more equity since they take a more significant risk of joining a relatively unproven company, and for usually below market salary and no bonus.
A good startup lawyer with experience in your space can help you plan ahead, and can share relevant data points about how much the market will demand for each key hire.
Investors prefer larger option pools, they will price it in the “pre-money”, to minimize the risk of dilution for them. Investors may pressure you into creating a larger pool than you need by reference to some benchmark in relation to the stage of your financing. This is why your hiring plan will help you create a more realistic pool.
Remember, a company can always increase the size of the equity pool at a later date if more shares are needed.
Currency for founder equity
As you approach each round of financing, consider what will be the likely size of the round of your next funding, and what will be the likely valuation, and your percentage equity on a fully diluted basis. Consider using the equity pool to top-up key hires, including the founders. A top-up to the equity pool and top-up grants can be promised in connection with a new financing to offset dilution for the founders.
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Louis Lehot is an emerging growth company, venture capital, and M&A lawyer at Foley & Lardner in Silicon Valley. Louis spends his time providing entrepreneurs, innovative companies, and investors with practical and commercial legal strategies and solutions at all stages of growth, from the garage to global.