Option pool

An option pool is created to assign stock options to employees or stakeholders in the company. Options are an effective mechanism to offer shares to an employee if the employee fulfils certain pre-defined conditions — revenue targets, technical achievements, or the scale of growth of the company. If the conditions are not met, the options lapse without any share allocation.

Why an investor cares is arithmetic. The extent of the pool is critical to investors because it directly impacts their ability to invest in the same company: if employees exercise their options, the result is dilution of the investor's stake as well.

What a pool percentage means. An option pool of 15% of the total capital means that all employees in the company can potentially own 15% of it, if they satisfy the conditions. Within the pool, different levels of employees get different stakes — a Chief Marketing Officer might be granted 3% and a Chief Technology Officer 2%. Those grants sit inside the pool; they do not add to it.

What determines the size. The stage of the company, the collective strength and skills of the team, revenue targets, growth expectations, and — most importantly, in the workbook's ordering — the lack of initial funding to pay employee salaries. A start-up that cannot pay market cash compensation pays in options instead.

The Indian benchmark. An ideal option pool for a start-up in India should be between 5% and 10% of the capital. Negotiating the extent of the option pool is crucial for the investors as well as the founders.

And the protection. Creating or altering an ESOP pool is one of the standard matters on which investors insist on affirmative rights — corporate actions requiring investor approval regardless of shareholding, so that even something achievable by ordinary resolution cannot be carried without the investor's express consent. The same subject appears again among protective provisions: establishing a new option plan or authorising new shares as part of an option plan requires the approval of the preferred stockholders. An investor who has negotiated the pool at the term sheet holds two separate locks on anyone quietly enlarging it later.

Nirvana Ventures, a Rs 380 crore Category I AIF, invests Rs 30 crore in a SaaS company at a Rs 150 crore post-money valuation.

Stake acquired   Rs 30 crore / Rs 150 crore  =  20%

At closing the company has an existing option pool of 8% of capital — inside the workbook's 5% to 10% range — of which grants to the CTO (2%) and the VP Engineering (1.5%) are already made.

Eighteen months later the board proposes expanding the pool to 18% to hire a CEO and a sales leader, issuing the extra 10% as new shares.

The company's valuation did not change. Nirvana simply owns less of it — and it paid nothing for the two executives the pool is buying.

This is exactly why the creation or alteration of ESOP pools sits on the affirmative-rights list. Nirvana can require its express consent, and typically trades that consent for either a smaller expansion or a valuation adjustment. Note also what the 8% pool is not: options that lapse because a target is missed never dilute anybody. Only exercised options do.

Chapter 11 section 11.6.7 covers the extent of the option pool, with the 5% to 10% Indian benchmark and the 15% illustration; section 11.6.4 lists creation or alteration of ESOP pools among the affirmative rights; section 11.6.9 repeats it as a protective provision. Expect a 'what is the ideal option pool in India' question and a dilution computation.

• 5% to 10% is the workbook's ideal for an Indian start-up. The 15% figure in the same section is an illustration of what a pool percentage means, not a recommendation.
• Individual grants sit inside the pool. A 3% CMO grant and a 2% CTO grant come out of the pool, they do not enlarge it.
• Only exercised options dilute. Options that lapse for failure to meet pre-defined conditions never reach the cap table.
• The pool is a protected matter twice over — an affirmative right and a protective provision — so an investor can block an expansion.
• Pool size is negotiated at the term sheet, before the money moves. Afterwards the only lever is consent.
• Dilution from a pool expansion costs the investor value at an unchanged valuation, which makes it easy to miss in a headline 'no change in valuation' announcement.