Stock Option Grant Planning

As the founder/CEO of multiple venture-backed startups, I vividly remember feeling a bit baffled the first time I was asked to share my stock option grant plan with my investor-laden Board of Directors as we prepared for fundraising. Since then, I have had the opportunity to tackle this task repeatedly, so I thought sharing an outline of lessons learned might help other founders/CEOs leading and fundraising for high-potential organizations.

Founder’s Equity

The first allocation of a startup’s equity occurs when the startup is founded. The founder(s) are taking on the bulk of the risk of starting something new and must expect and plan for taking substantive dilution over time (assuming they plan to raise outside equity capital). Typically, founder(s) allocate “founders’ equity,” nearly always common stock in a C-corporation, to reflect roles and responsibilities, risk, and other factors. Most often, there is only a single or a small number of founders at this stage. The best practice for founding teams is establishing an equity vesting schedule to incentivize long-term commitments and avoid potential “dead equity” problems. This blog will not unpack all the considerations that go into founder’s equity, but instead focus on the next stage of equity grants when the startup leaders seek to motivate and reward their team with stock options.

Stock Option Pool

As you begin to build your team, you need to develop a stock option grant plan that is consistent, fair, and aligned with motivating team members to make long-term contributions to the growth of the venture. Sophisticated early-stage investors will insist that founders establish an option pool when they take their first outside investment, and refresh that pool as needed to attract and motivate talented employees to work on building a successful venture. An option pool is a block of common shares set aside by a company so that equity can be issued to people in the future. The pool size is negotiated as part of the terms of a fundraising round, and is dilutive for both founders and previous investors. However, investors know its importance so that they will insist on it.

Because the pool size is a subject of fundraising negotiations, this is often the point at which the early-stage founders/CEO is first confronted with the need to develop a stock option grant plan. Basically, a stock option grant plan describes how and at what level the startup CEO plans to allocate their option pool to effectively attract and motivate the team they need to grow the business. The plan you create is a key tool in negotiating the option pool size.

How to Outline a Stock Option Plan

Here are some of the essential steps to outline a stock option plan for your startup:

1. Big Picture Plan:  Start by thinking about your fundable milestones, how to achieve them, and how long you estimate it will take. Remember that this should be consistent with your overall business plans, use of proceeds for fundraising, and the team implied in those plans. For example, suppose you are planning to raise a $7M Series A round requiring you to add fifteen people to your team to achieve a significant milestone in 18 to 24 months. In that case, the critical variables are that you should plan for your stock option pool to provide enough options for fifteen to twenty new hires over the next 24 months. Note that I took the upper end of the range, while keeping it reasonable because, from an investor’s perspective, they want to know you have enough options in the pool to hire everyone you need to hire, with some margin in case you need to hire a few more.
   
   
2. Estimate the Shares Available in Your Option Pool: This is a capitalization table calculation and depends on what valuation you think you will get, the total number of shares, and the percentage of your total shares that will be in your pool (a decent approximation will be 10-20%, although this will be negotiated, so make it a variable). Get help from your corporate attorney if you aren’t sure how to create a pro forma cap table for the priced round you are trying to raise. At the end of this process, you should have an estimate of the total shares in the option pool.
   
   
3. Layout Your Hiring Plans: Again, make this consistent with what you are saying elsewhere in your fundraising pitch about what you plan to do and how. Identify all the new hires you anticipate making by job title, estimate the cash compensation range for each position, and identify which quarter in your timeline you think you might hire them. Lay this out in a spreadsheet with the positions organized into “bands” by approximate level (cash compensation is a good approximation for determining whether you are talking about a C-level hire, a senior team member, a junior team member, etc.) and with the planning period quarters laid out across the columns.  Include the role/position title, target FTE compensation, and hiring date (to the quarter), and sum up the total number of shares across time to create a total for each position that you can sum to know how much of your pool you have allocated in your plan.
   
   
4. Allocate your available shares across your planned new hires: Using some of the rules of thumb below, estimate how many shares you anticipate awarding to each new hire:
   
   
5. Generally, each band should get the same share allocation. For example, if you have six professionals getting paid $65,000 to $80,000 even if they are in different departments in the company, they should all get the same stock option grant. The exception here is the C-suite, where the comparable bands will be more related to functional discipline and experience and more likely to be individually determined.
   
   
6. It is reasonable to keep share grant levels per band the same for the whole major milestone period.  You can step down the allocation a bit over time to reflect the company’s progress. However, I keep the share grant levels per band for at least a year or two. Remember that vesting ensures that later hires have less of their grant vested, so some of this does not require overengineering, and keeping it the same helps with the perception of fairness.
   
   
7. Use round numbers when allocating stock option grants. Awarding 100,000, 50,000, or 10,000 shares makes more sense than coming up with some weird number like 15,476 shares. It also fits the model of having standardized award levels for different staffing levels.
   
   
8. Remember that unless you have not raised money yet, it is very reasonable and expected for employees below C-level to have less than 1% of fully-diluted equity grants. This changes as the company raises more money and spreads its shares to more people. It is not unusual to have lower-level employee grants that are, say, 0.1% or less as the company grows.
   
   
9. Total your grants and see how much of your pool you have allocated in your plan. This is where you iterate to see what makes sense. You are seeking to allocate most of your pool, while leaving some cushion for the unexpected. Refreshing your pool between fundraises is a true challenge so avoid putting yourself in that position.

Considerations of Stock Option Pools and Fundraising Negotiations

You and your potential investors should be able to agree that incentivizing your new hires is a goal, so do not make the mistake of saying that you do not need a stock option pool, as that reflects poorly on fundraising founders. Note that there are norms for what percentage of the cap table should be allocated to a stock option pool at various stages, with 10-20% being a common range, so you will likely face resistance if you are not reflecting common norms for this. Your corporate attorney should be able to guide you on typical fundraising market stock option pool percentages for your industry, stage, and the fundraising environment.

Because the dilution of a stock option pool refresh is entirely borne by existing shareholders (founders plus existing investors), it is in the incoming investors’ best interest to get the pool to be at the highest end of the range they can convince you to accept. As the startup’s founder/CEO, you want to have a sufficient but not excessive number of shares in your pool, as this gives you an important recruiting tool. This is where your plan comes into play because this is the analysis that shows that you have actually thought through how many shares you need and can enable you to argue for the lower end of the acceptable range for your option pool percentage when negotiating with your potential investors. Note that you do not need to account for every hire you might ever make in the lifetime of the startup because it is typical for there to be a stock option refresh at each new priced round. This is why your stock option plan only extends to the next major fundraising milestone.