What is an Equity Pool?
Also referred to as the Employee Pool or Option Pool, the Equity Pool is the number of shares a company sets aside or reserves from which it can grant stock options or restricted stock. Companies often use these forms of incentive equity to compensate and incentivize employees, directors and consultants.
As a company will be using the Equity Pool for compensation and incentives, a company needs to have a large enough Equity Pool to be able to attract and retain talent. At the outset, an entrepreneur’s tendency might be to make the Equity Pool as large as possible to cover any and all compensation and incentive needs, but companies must be careful as the Equity Pool can have a dilutive impact on the ownership interests of founders and other early shareholders when the company decides to raise more money.
For example, assume a situation in which the pre-money value of a company is $US4 million and investors are planning to invest $US2 million. Absent the existence of an option pool, one would assume that existing shareholders would end up with 66 2/3% of the company and investors with 33 1/3% of the company post-closing. However, if the company has a 20% Equity Pool outstanding at the time of the financing, investors will normally insist that the 20% be dilutive of only the pre-money valuation of the company, rather than the post-money valuation. In this situation, the existing shareholders would hold 53 1/3% of the company post-closing, 13 1/3% would be allocated to the Equity Pool, and the investors would own the final 33 1/3% of the company. For more information regarding how capitalization tables are prepared, see What You Need to Know about Capitalization Tables.
While an initial Equity Pool typically ranges between 10-20% of outstanding equity, companies should not choose the size of an Equity Pool without first creating a 12-to-18 -month plan for issuances of options and restricted stock. Creating the plan will involve determining the amount of compensation a company believes it will need for the employees and consultants hired and/or needed to be hired over that time-frame, and the directors it has brought on or expects to bring on during that time frame. The key is to make the Equity Pool only as large as it needs to be. A company can always increase the size of the Equity Pool at a later date if more shares are needed.