We often counsel both early stage companies as well as investors looking to make venture capital investments in growth companies. One of the recurring issues is how the size of the company’s option pool should fit into the capitalization table of the company.

First, some background on an option pool: An option is a right to purchase a quantity of a company’s stock at a set price for a period of time (in an earlier post, I explained the difference between various types of options). The options provide the optionholders (usually the employees, officers, and directors) with the right to receive a form of equity of the company for a locked-in price (the exercise or strike price). Options have been proven to be an effective way to recruit, compensate, and retain talent in the company. The options are granted pursuant to an Equity Incentive Plan, which also provides for the maximum number of options that can be issued pursuant to the plan.

For an early stage company, the size of the option pool is typically around 10-20 percent of shares of the company on a fully diluted basis, depending on the specific hiring needs of the company. If there are a large number of executive or key employees to hire, the pool may be closer to the 20 percent range, and a times even increasing up to 25 percent. Subject to the hiring needs, the pool is usually increased with each significant equity financing. A recently published analysis by J. Thelander Consulting reviewed the size of the option pools of 200 companies, and found that they ranged from 10 percent to 18 percent.

The company should be mindful of the dilution of the other shareholders’ equity in the event that the options are exercised, and maintaining a reasonable cap on the size of the option pool may prevent excessive dilution. Investors should also consider the timing of the creation of the plan, as they may benefit by having the plan established before the financing round, as this will effectively lower the stock price of the shares of the company as the stock price will take the option pool count into account. For instance, if a company has 1,000 shares that have been issued to the founders and the pre-money valuation of the company is $100,000, the share price is $100. Assuming that in addition to the 1,000 shares, the company has an option pool of 200 shares, with a pre-money valuation of the company at $100,000, the share price is now $83.33, and the investor will prefer having the company be diluted prior to the investment.