In the startup world, cash is often scarce, but equity is "infinite" (at the cost of dilution). To attract the "best and brightest" talent from established giants like Google or Apple, startups offer Employee Stock Options (ESOs) . An ESO is a type of equity compensation that gives an employee the right to buy company stock at a specified price (the "strike price") for a finite period . The "Option Pool" is a block of shares—typically 10% to 20% of the company—reserved specifically for these future grants.

Why Option Pools Matter to Investors

For an investor, the option pool is a "double-edged sword." On one hand, you want the company to hire great people who are motivated to grow the business. On the other hand, the creation and expansion of the option pool is a major source of dilution.

The "Option Pool Shuffle"

This is a critical concept for any beginner to understand. When a VC invests, they usually require that the option pool be "fully topped up" before their investment .

The Result: The dilution from the new option pool falls entirely on the founders and existing early investors, not on the new VC.
Example: If a company has a $10M pre-money valuation and the VC requires a 10% option pool, the "effective" pre-money valuation for the founders is actually $9M. The founders are paying for the talent that will help the VC’s investment grow.

Key Concepts in Employee Equity

To navigate the "Option Math" of a cap table, you must understand these four terms:

Grant Date: The day the company gives the options to the employee. No tax is due on this day .
Vesting Period: The length of time an employee must work before they "own" the right to exercise the options . A typical schedule is "4-year vesting with a 1-year cliff." This means if the employee leaves before 12 months, they get nothing. After 12 months, they get 25%, and the rest vests monthly.
Exercise (Strike) Price: The fixed price the employee pays to buy the shares. This is usually set at the "Fair Market Value" on the grant date .
Exercise: The act of paying the strike price to turn the options into actual shares of stock .

Types of Options: ISOs vs. NSOs

The tax treatment of options significantly impacts how employees behave, which in turn affects the cap table's stability.

Feature	Incentive Stock Options (ISOs)	Non-Qualified Stock Options (NSOs)
Eligibility	Employees only .	Employees, board members, consultants .
Tax at Exercise	None (unless AMT applies) .	Taxed as ordinary income on the "spread" .
Tax at Sale	Capital gains (if held long enough) .	Capital gains on any appreciation after exercise .
Transferability	Generally cannot be sold .	Generally cannot be sold .

The "Bargain Element" and Opportunity Cost

The value of an option is the difference between the market price and the strike price—this is called the Intrinsic Value or the "bargain element" .

Example: An employee has options with a $10 strike price. The company is now worth $50 per share. The intrinsic value is $40 per share.
The Trap: If the employee exercises early, they might give up the "Time Value" of the option . Since most ESOs have a 10-year term, they have significant time value. Exercising early captures the $40 gain but forfeits the potential for the stock to go to $100 over the next few years without the employee having to risk their own cash yet .

Concentration and Counterparty Risk

Investors should monitor how much of the cap table is held by employees. While "pride of ownership" motivates productivity , having too much equity concentrated in one group can create "concentration risk" . If the company hits a rough patch, a large group of employees might try to sell their shares simultaneously (if allowed), putting downward pressure on the valuation.

Furthermore, employees face Counterparty Risk . Unlike options traded on a public exchange (which are guaranteed by the Options Clearing Corp), an ESO is only as good as the company that issued it . If the company goes bankrupt, the options become worthless, as many discovered during the dot-com bust .

Step-by-Step: How an Option Pool Dilutes You

Check the "Fully Diluted" Count: Look at the cap table and find the total number of shares including the unissued option pool.
Calculate the Pool Percentage: Unissued Options / Fully Diluted Shares.
Understand the "Expansion": If the company is hiring 20 new engineers, management may ask the board to "expand" the pool by 5%.
Calculate Your New Stake: Your Current Shares / (Current Total Shares + New Pool Shares).

The "Reload" Option

In some aggressive growth companies, they may offer a Reload Option . This grants an employee more options automatically when they exercise their current ones. For investors, this is a "dilution machine" that needs to be monitored closely, as it can continuously increase the share count without a new funding round.

Frequently Asked Questions About Employee Equity

1. What happens to options if an employee is fired?
Typically, unvested options are canceled and returned to the pool. The employee usually has a short window (e.g., 90 days) to exercise their vested options or lose them .

2. Are options the same as "Restricted Stock"?
No. Restricted stock grants give the employee actual shares immediately, but they "vest" over time. Options only give the right to buy shares later .

3. Why do startups use "Phantom Stock"?
Phantom stock pays a cash bonus equal to the value of a certain number of shares without actually transferring ownership . This avoids diluting the cap table's voting power.

4. What is "Backdating"?
This is the (now illegal/highly regulated) practice of setting the strike price to a date in the past when the stock was cheaper, giving the employee an instant gain .

5. How does the SEC regulate this?
Public companies must report option grants within two business days under the Sarbanes-Oxley Act . Private companies are less regulated but must still follow tax laws.