Who Pays for the Option Pool Depends on One Word
A funding round typically requires expanding the employee option pool, and the expansion is almost always calculated before the new money arrives. That timing decides who is diluted by it.
Why the Pool Gets Refreshed
A company raising a round will hire over the following period, and those hires need equity. Investors require that enough shares be reserved to fund that hiring before they invest, so they know the dilution they are accepting.
The term sheet therefore specifies an option pool, expressed as a percentage of the post financing capitalisation, commonly in the range of ten to twenty percent depending on the stage and the hiring plan.
That much is uncontroversial. The consequential detail is when the pool is deemed to be created.
The Timing That Decides Everything
Under standard practice, the new pool is included in the pre money capitalisation. It is created before the investment, out of the existing shareholders holdings.
The alternative, creating it post money, would dilute existing shareholders and new investors proportionally.
The difference is substantial. Consider a company agreeing a fifteen million pre money valuation, raising five million, with a fifteen percent post financing pool required.
| Pool Pre Money | Pool Post Money | |
|---|---|---|
| Who is diluted by the pool | Existing shareholders only | Everybody proportionally |
| Effective pre money valuation | Reduced by the pool value | As stated |
| Investor ownership | 25 percent | 25 percent |
| Founder ownership | Lower | Higher |
A fifteen million pre money valuation with a fifteen percent pre money pool is not a fifteen million valuation. The founders are funding shares for employees the investor will benefit from, which reduces the effective price paid per share.
The Effective Pre Money
The correct way to compare offers is to calculate the effective pre money valuation, meaning the stated pre money reduced by the value of the newly created pool.
On the example above, a fifteen percent pool created pre money out of a twenty million post money capitalisation represents three million of value. The effective pre money is therefore twelve million rather than fifteen.
An investor offering fourteen million pre money with a ten percent pool is offering a better deal than one offering fifteen with fifteen percent, and the headline numbers say the opposite.
This is the single most useful calculation a founder can perform on a term sheet, and it is routinely skipped because the headline valuation is what gets discussed.
Sizing the Pool Honestly
Because the pool comes out of founder ownership, the size is a genuine negotiation and the argument that wins it is a hiring plan.
An investor asking for a twenty percent pool is making an assumption about hiring over the next eighteen to twenty four months. A founder who can produce a specific plan, listing roles, seniority, and typical equity for each, can frequently argue the pool down substantially.
The reverse also happens. A founder who accepts a large pool without a plan has given away equity for hires that will not occur, and unallocated pool shares are not returned. They remain available for future grants, diluting the founders while the investor entry price was set assuming they existed.
Unallocated Shares Do Not Come Back
A related point catches founders who negotiated the size and then stopped paying attention. Pool shares that are never granted are not returned to the founders.
They remain in the pool, available for future grants, having already been counted in the pre money capitalisation on which the investor entry price was set. The founders funded them and the investor priced around them existing.
That is the argument for sizing the pool to an actual hiring plan rather than accepting a round number, and for revisiting the balance before the next financing tops it up again.
What Else to Watch in the Documents
Two related items deserve attention.
Whether the pool is fully diluted for other purposes. Anti dilution calculations, pro rata rights, and liquidation preference mechanics all reference share counts, and whether unissued pool shares are included changes the outcome.
Whether the term sheet specifies the pool as a percentage of post money capitalisation, which is standard, or as an absolute number of shares, which behaves differently if the round size changes during documentation.
The Bottom Line
The option pool is created out of the pre money capitalisation by convention, which means existing shareholders fund the equity for employees the new investor will benefit from. The correct response is not to object to the convention, which is entrenched, but to calculate the effective pre money valuation and negotiate the pool size against a real hiring plan. A founder comparing two term sheets on headline valuation alone is comparing the wrong number.