Fundraising Jargon 08: Option Pool

Option pool is a term used to refer to a chunk of equity reserved for the future team expansion. Although it sounds quite simple, straightforward, and harmless, the size of the option pool, as determined during a round of funding, has a direct impact on the valuation of the company valuation and hence, the ownership of the entrepreneur in their business.

The option pool is often included in the pre-money valuation of a company. Let us understand this concept through an example. Say investors agree to invest INR 2Cr at an INR 10Cr pre-money valuation, implying an INR 12Cr post-money valuation. Option pools are expressed as a percentage of post-money valuation, so if the deal includes a 20% option pool, which means the pool is worth INR 2.4Cr. The INR 10Cr pre-money valuation is now effectively an INR 7.6Cr pre-money valuation. The investor will not be taking a larger percentage as a result — they will still own 16.7% (INR 2Cr/INR 12Cr) of the company in this case — but the stake of the entrepreneur will be substantially diluted because the option pool will come directly from management's stake. So, if the entrepreneur owned 100% and they are under the impression that they will now own 83.3% (100% original equity - 16.67% investor equity post-investment), the entrepreneur is mistaken. The option pool, reserved for future employees, is 20% and is contributed from the entrepreneur's end, which means the entrepreneur now owns only 63.3% of the company.

We see yet again how pertinent, and paramount, the understanding of these distinctions is in terms of retaining ownership of your company.