Equity is the compensation founders reach for when cash is short, and the one they understand least well when they grant it. The mechanics are not complicated, but they are unforgiving, and most of the expensive mistakes are made in the first two years by people who assumed it could be tidied up later.
What the pool is
An option pool is a block of shares set aside, not yet issued, reserved for grants to employees and advisors. It sits on the cap table as authorised but unissued, and it dilutes everybody who holds actual shares.
Investors will expect one, and they will expect it to be sized to cover your hiring plan through the next round. Ten to twenty percent is the usual range depending on stage and how senior the roles are.
The part that costs founders money
Here is the mechanic that catches people, and it is worth understanding before you see it in a term sheet.
When an investor asks for a pool to be created or topped up as a condition of the round, it is almost always created pre-money. That means the new shares come out of the existing shareholders' ownership, not out of the post-money pot everyone shares.
A ten percent pool created pre-money is not shared ten-ninety with your new investor. It comes almost entirely out of the founders and any existing holders. The investor's percentage is calculated after it exists.
This is sometimes called the option pool shuffle. It is standard, it is not a trick, and it is negotiable in one specific way: the size. If your investor wants a twenty percent pool and your actual hiring plan for the next eighteen months needs twelve, that difference is real founder ownership. Bring a hiring plan to that conversation and you are arguing from evidence rather than from feel.
409A, and why you cannot pick the strike price
Options are granted with a strike price, the amount the holder pays to exercise. Set it too low and you have created a tax problem for the employee, not a bargain.
A 409A valuation is an independent appraisal of the fair market value of your common stock. It exists so the strike price can be defended. Get one before your first grant, refresh it at least annually, and refresh it after any material event, which certainly includes a priced round.
Two things worth knowing. Your 409A value will be materially lower than your preferred share price, because common stock lacks the rights preferred carries, and that gap is normal. And a grant made on a stale 409A is the kind of thing that surfaces in diligence, which is the worst possible time.
Vesting, and the cliff
The standard is four years with a one year cliff. Nothing vests until the first anniversary, then it vests monthly or quarterly. The cliff is the mechanism that stops a bad three month hire walking away with a year of equity, and it protects the whole team, not just the founders.
Founders should vest too. Founder vesting feels absurd when there are two of you and total trust, and it is precisely the arrangement that saves the company when one of you leaves in month fourteen. Investors will require it if you have not done it, and doing it yourself first is a better look.
ISOs and NSOs, briefly
Incentive stock options can qualify for favourable tax treatment for employees who meet the holding requirements, and can only be granted to employees. Non-qualified options can go to anybody, including advisors and contractors, and are taxed as ordinary income on the spread at exercise.
The detail matters to the recipient more than to you, but two things affect the company. ISOs carry limits, including a cap on the value that can first become exercisable in any year. And what happens at departure is a decision you make once and live with: the standard ninety day post-termination exercise window is common, and extending it converts ISOs to NSOs after a point. Whatever you choose, put it in the plan documents rather than deciding case by case, because deciding case by case is how you end up treating two people differently for reasons you cannot explain later.
What to get right early
- A cap table you trust. Not a spreadsheet with a version number in the filename. Once there are more than about fifteen holders, use a system built for it.
- Signed documents for every grant. A promise in an offer letter is not a grant. Board approval and a signed agreement is a grant. Unsigned equity promises are one of the most common findings in diligence.
- 83(b) awareness for restricted stock. The election has a strict thirty day window from grant and cannot be fixed afterwards. Founders miss this and it is genuinely unrecoverable.
- A current 409A before you grant anything.
The honest summary
Equity is not free compensation, it is the most expensive currency you have, because you are selling it at today's price to pay for tomorrow's work. Grant it deliberately, document it properly, and know what a pool request is costing you before you agree to its size.
None of the above is legal or tax advice, and the specifics of your plan should be set with counsel. What we can do is keep the cap table and the grant records in a state where diligence is a document request rather than an archaeology project. There is a cap table and dilution model on the tools page, and more on building the data room before you need it.