It is very common for startups to implement an Employee Share Option Plan for their company, otherwise known as an ‘ESOP’. ESOPs can help companies to incentivise and reward team members by allowing them to earn an ownership stake in the company. Companies who wish to implement an ESOP may decide to reserve a portion of the company’s shares to issue to their employees or contractors in the future. This is known as an ‘options pool’, or an ‘ESOP pool’. It is common for startups to reserve between 5% and 20% of their company for an options pool.  

Startups often use options pools and they are an incredibly important consideration for a startup’s shareholders and investors. However, they can be a confusing and frequently misunderstood concept. This article explains: 

  • what an options pool is; 
  • how to create one; and 
  • how an options pool may affect a company, its shareholders and its investors.

Options Are Different From Shares

Under an ESOP, employees receive ‘options’. Options are a right to purchase shares in the future. If a person only holds options, rather than shares, they do not yet own part of the company and do not have the rights that shareholders have. These rights include the right to dividends or to vote at shareholder meetings.

Options are beneficial for the company and founders because they do not have to give up part of the company upfront. Instead, their employees will have to stay with the company for a prescribed time period or meet certain performance milestones (called ‘vesting conditions’) before those employees can exercise their options and purchase shares.

What Is an Options Pool?

An options pool is a theoretical reservation of a company’s shares. The company’s shareholders can create an options pool by agreeing that, in the future, the company may issue a number of options and shares to employees and team members under an ESOP.

For example, if a company wishes to create an options pool of up to 10% of the company, the options pool is created by the shareholders agreeing that the company may later issue shares to employees equal to 10% of the company. Usually, this agreement is set out in the company’s shareholders agreement.

Because the reservation is theoretical, the company does not need to issue all of its options upfront in order to reserve an options pool. For example, if a company’s options pool allows it to issue 100 options to employees in the future, the company does not need to issue all of the 100 options immediately. Instead, the company issues the options as the need arises. In fact, it may never end up issuing its 100 options. 

You also do not need to issue shares upfront to create an options pool. It is a common misunderstanding that you create an options pool by issuing additional shares, which remain unowned until they are allocated to employees. However, this is not possible. Shares that are issued must be owned by a shareholder and cannot exist unowned and unallocated. Shares do not need to be issued to an employee until the particular employee exercises their options.

Fully-Diluted Share Capital

‘Undiluted’ Share Capital vs. ‘Fully Diluted’ Share Capital

An options pool is calculated as a portion of the company’s ‘fully diluted share capital’. A company’s ‘undiluted’ share capital refers to the number of shares which currently exist and are on issue.

By contrast, a company’s ‘fully diluted share capital’ refers to its current shares on issue plus its options pool. The term ‘fully diluted’ refers to the options that may be exercised into shares in the future. When this happens, there will be a dilution of the company’s current shareholders. 

For example, if your company currently has 1,000 shares on issue, its undiluted share capital is 1,000 shares. If your company has an options pool that allows it to issue another 100 shares to employees, your fully diluted share capital is 1,100 (i.e. your 1,000 current shares plus the 100 shares you can issue in the future).

How to Calculate Your Options Pool

To work out how many options you can issue in your options pool as a portion of your company’s fully diluted share capital, use the following formula.

A x B ÷ C = D
A being the number of shares your company currently has on issue
B being the maximum percentage of your options pool
C being the percentage of the company the other shareholders will have after your options pool is fully issued
D being the number of options you can issue under your options pool

For example, if your company currently has 1,000 shares on issue, and has reserved a 20% options pool (leaving other shareholders with 80% of the company), you can work out the number of options available for issue using the above formula as follows: 1,000 x 20 ÷ 80 = 250

This means the company is able to issue a total of 250 options under its options pool. Assuming all of its 250 options are issued and exercised into shares, the company will end up with 1,250 shares (i.e. 1,000 existing shares plus 250 ESOP shares), resulting in those 250 shares equating to 20% of the total 1,250 shares.

Options on Your Cap Table

Your options pool is theoretical and does not need to be fully issued upfront. However, it is an important factor for shareholders to consider. This is because it indicates how their shareholding might dilute in the future. 

For example, if the company has reserved a 20% options pool, then its shareholders know that the company is able to dilute their shareholding in the future by issuing additional shares of up to 20% of the company.

This is why an options pool will feature as part of the company’s ‘cap table’. A company’s cap table outlines all of the company’s shares, options and other securities which may convert into shares. This allows shareholders to understand what percentage of the company they:

  • own now; and
  • might own in the future.

The ‘ESOP Shuffle’

A company’s options pool may also affect its capital raising. Investors will often want a company to reserve an options pool so that it can incentivise and retain key staff. However, investors may not want the options pool to dilute their future shareholding. For this reason, investors might include the options pool as part of the pre-money valuation of the company. This results in the investors getting more shares upfront (to protect against future dilution). The dilution effect is ‘shuffled’ to the founders and other existing shareholders.

Your company has a pre-money valuation of $10 million, and currently has 10,000 shares on issue, and the ability to issue 2,000 options under an ESOP.

Example A: the investor calculates the share price of the company by dividing $10 million by 12,000, resulting in a share price of approximately $833

Example B: the investor calculates the share price as $10 million divided by just the 10,000 shares on issue (excluding the 2,000 options), resulting in a share price of $1,000

In Example A, including the options pool in the company’s pre-money valuation calculations gives the investor a lower share price. This allows them to:

  • get more shares for their investment amount; and 
  • Protect themselves against future dilution by shuffling the dilution effect to founders and existing shareholders.

The ESOP shuffle is often an unavoidable part of doing business with sophisticated investors, and it is an important consequence to be aware of when you reserve an options pool.

Key Takeaways

An options pool is a commonly used, but often misunderstood, aspect of an ESOP. It is a theoretical concept that shareholders create by agreeing to reserve a part of the company’s future share capital. Although it is not issued upfront, an options pool is still an important:

  • part of the company’s cap table; and
  • consideration for the company’s shareholders and investors.

If you need assistance with creating an options pool or implementing an ESOP, contact LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.
Sophie Mao
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