How to allocate the Option Pool?

The only currency a startup has other than cash which you need to run the daily experiments to find the Product to Market fit and to build a Minimum Viable Product is Equity. I find that many founders and technical team members struggle with understanding Equity believe me it took me a while to figure this out, however once you understand what Equity is and how it can be used, one stumbles on how you should allocate the equity.

As founder(s) I presume there is more than one, you own majority of the equity in your business although it is worthless at this time and you own all of it. If you are successful in raising money ie cash, the investor substitutes his cash for equity in your business, typically when companies are formed you have a said number of shares… in Iceland it is 500.000 (five hundred thousand shares) and usually you are suppose to post cash against it and show it in your Balance Sheet when you register the company or file with the company registry. The company can issue more shares and each share is valued either by the cash that you can generate operating the business or if an investor comes in with money and values the shares at a certain rate. If you have followed me so far, then you are doing much better than how I felt when this was explained to me a long time back.

Anyways, moving on… now you have equity ie. shares in your business and you need to hire a top talent, you want to conserve your cash because you are still iterating and have not yet reached break even i.e your expenses does not equal your income. You use the next currency to attract talent, i.e equity or option pool. You can either take a portion of the equity and allocate it to the role that you plan to hire as part of the compensation package or you can allocate a certain percentage of the option pool. Option pools are formed when the existing share holders decide to take a percentage of the equity and set it aside as a pool to attract talent into the business. The actual pool size depends on the shareholders etc me and my partners in AIP usually are generous with this allocation, we don’t scrimp on this because we believe in order to hire top talent you need to provide top potential upside for their time and effort. So, how do you determine the pool size or allocation within the pool? I have not found a better explanation than Paul Graham‘s post on “Equity Equation“, it is a long post but it is worth every word a read and a re-read. Here are some excerpts, all the answers to allocation comes to a simple equation:

1/(1 – n)

Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before.

For example, suppose you’re just two founders and you want to hire an additional hacker who’s so good you feel he’ll increase the average outcome of the whole company by 20%. n = (1.2 – 1)/1.2 = .167. So you’ll break even if you trade 16.7% of the company for him.

Let’s run through an example. Suppose the company wants to make a “profit” of 50% on the new hire mentioned above. So subtract a third from 16.7% and we have 11.1% as his “retail” price. Suppose further that he’s going to cost $60k a year in salary and overhead, x 1.5 = $90k total. If the company’s valuation is $2 million, $90k is 4.5%. 11.1% – 4.5% = an offer of 6.6%.

And more generally, when you make any decision involving equity, run it through 1/(1 – n) to see if it makes sense. You should always feel richer after trading equity. If the trade didn’t increase the value of your remaining shares enough to put you net ahead, you wouldn’t have (or shouldn’t have) done it.

You can see how this can be plugged into a performance management process within your team. The above equation and method is very effective. You allocate the options based on the level of contribution the team members make and if you make the measurements simple and visible, it makes the compensation system transparant, aligns and motivates the team as well. I have a philosophy when it comes to recruiting and compensation, all the benefits, salary, options etc is only for the team members to show up… in order to build a winning team everyone needs to volunteer their hearts and minds. The simple parts of making the team to show up is easy the hard part is to find a purpose or cause that is so important and bigger than each of us that it makes the team aligned and enables them to volunteer their most valuable resource which their hearts and minds. How are you making your team volunteer their hearts and their minds?