Understanding Option Pools: Protecting Founder Equity

Part 1: The Illusion of Ownership — Where Founders Lose Ground Quietly

If valuation is the headline of a fundraising round, the option pool is the fine print — and it is often where founders give up more than they realize. Rarely contested with the same rigor as price or board seats, the option pool quietly but significantly reshapes the cap table. It is not just a talent incentive. It is a structural concession. And in many early-stage negotiations, it is the instrument through which founders are subtly diluted.

To understand the option pool’s power, one must understand how it is defined, where it sits in the capital stack, and how it is treated in valuation negotiations. Most investors will insist that the option pool be included in the pre-money valuation. What this means in practice is that new investors avoid dilution from future employee grants — while the founders absorb that dilution upfront.

It is an elegant strategy, one that seasoned VCs deploy as standard practice. For first-time founders, though, the implications are often misunderstood. A 10 percent option pool included pre-money does not mean the company loses 10 percent. It means the founders do.

The CFO’s role, especially at the Series A or B stage, is to protect founder equity not just by negotiating valuation, but by managing the size, timing, and structure of the option pool. That requires understanding how it flows through the cap table and how to model its impact across multiple rounds.

Part 2: Pre-Money vs. Post-Money Option Pools — A Structural Sleight of Hand

Let us unpack the mechanics with a concrete example.

Assume a company is raising $5 million at a $20 million pre-money valuation. The investor wants a 15 percent unallocated option pool as part of the round.

Scenario A: Option Pool Sized Pre-Money

• Pre-money: $20 million
• Post-money: $25 million
• Investor receives 20 percent of post-money ownership
• The option pool is 15 percent of post-money

But here’s the catch: that 15 percent must be carved out of the pre-money valuation. In effect, the founders are giving up 15 percent of the company — not to the investor, but to future employees. The investor still gets their full 20 percent.

Resulting ownership:

• Investor: 20 percent
• Option pool: 15 percent
• Founders: 65 percent

Scenario B: Option Pool Sized Post-Money

In this alternative, the 15 percent option pool is created after the investor comes in.

Ownership:

• Investor: 20 percent of $25 million = $5 million
• Option pool: 15 percent carved out post-money
• Founders: 65 percent of pre-money, which is now diluted by the new pool

This distinction sounds minor. It is not. The timing of option pool sizing affects ownership outcomes significantly. In Scenario A, the investor avoids dilution. In Scenario B, everyone shares in the dilution.

The Term Sheet Language Trap Investors rarely write in bold letters “we want you to absorb the dilution.” Instead, they embed this preference in language like:

“Company will have a 15 percent unallocated option pool on a fully diluted basis immediately prior to closing.”

That phrase — “prior to closing” — is what places the dilution burden squarely on the founders.

The solution? Negotiate the option pool size after investor ownership is calculated, or at least reduce the size to what is actually needed, not an arbitrary 15 percent default.

Part 3: Sizing and Refreshing the Option Pool — Balancing Strategy and Signaling

The option pool is not just a mechanical concept. It is a strategic lever. Too small, and you cannot hire the talent needed to grow. Too large, and you dilute yourself into irrelevance.

1. Right-Sizing the Pool

Instead of defaulting to 10 or 15 percent, CFOs should build a bottom-up hiring model:

• What roles do we need over the next 18–24 months?
• What equity ranges are appropriate for each role?
• How much slippage (unexercised or expired options) can we anticipate?

With this information, you can justify a pool that reflects actual hiring plans — and reduce unnecessary dilution.

2. Timing the Refresh

Many term sheets require a pool refresh as a condition of financing. But that does not mean it must be excessive. The refresh should cover hiring through the next round. Anything more creates unused equity, which dilutes current shareholders without strategic benefit.

3. Allocating Wisely

Equity should be allocated based on contribution and risk. Early engineers may get 0.5 to 1 percent. Senior executives may receive 1 to 3 percent. Advisors typically fall below 0.25 percent. Equity grants must be benchmarked, documented, and tied to vesting.

Too many startups over-allocate equity early, leaving nothing for future growth hires. Others hoard equity, under-incentivizing key talent. The CFO’s job is to find the optimal balance.

4. Refreshing for Retention

As the company matures, it must revisit the option pool to issue refresh grants — especially for employees who joined early and are nearing full vesting. Without refreshes, retention suffers. But refreshes must be modeled carefully to avoid unanticipated dilution.

Part 4: Modeling, Communication, and Governance — Best-in-Class Practice

1. Cap Table Modeling

Every financing round should include a detailed scenario model:

• Pre- and post-money ownership
• Option pool sizing effects
• Future rounds with assumed dilution
• Exit scenarios with preference stack analysis

This model is not just for internal clarity. It is a tool to drive investor alignment and board confidence.

2. Transparent Communication with Employees

Option pool mismanagement is one of the leading causes of employee disillusionment. Employees need to understand:

• How their options convert to equity
• What the strike price and exercise window mean
• How preferences and dilution affect their payout

The CFO, alongside HR, should own equity education. It is not enough to grant options. You must explain their value.

3. Strong Governance

Every option grant must be documented, board-approved, and updated in your cap table software. Equity promised verbally or without paperwork is a legal and ethical liability. Equity administration is not a back-office task. It is a governance function.

4. Aligning Incentives Across Stakeholders

The goal of the option pool is not to minimize founder dilution at all costs. It is to ensure the company can attract and retain the talent required to create value. A well-structured pool balances founder ownership, investor return expectations, and employee incentives. It reflects not just mathematical optimization, but strategic coherence.

In high-functioning companies, the option pool is not an afterthought. It is a core component of organizational design. It signals how the company values talent, how it prepares for scale, and how it allocates the rewards of success.

Disclaimer: This blog is for informational purposes only and does not constitute legal, financial, or investment advice. Please consult your professional advisors before making equity, compensation, or cap table-related decisions.