An equity incentive pool is a tranche of shares of common stock that are set aside for stock options, restricted stock or other equity instruments to help a business recruit, retain, incentivize, and align key talent for long term value creation and success. Startup companies often use these shares in lieu of cash to compensate employees, directors, advisors, and consultants.

Why do I need an equity incentive pool?
Equity incentive pools reflect how much of your company you can retain. Each time a grant is made, you are making a statement about your company’s valuation.

Why does the size of my equity pool matter?
Suppose your company is using the equity pool for compensation and incentives to attract and retain early hires. In that case, a company needs to have a large enough equity pool to make enough grants to fill out the team. Be careful to assess the dilutive impact on the ownership interests of founders and other shareholders when the company decides to raise more money. Benchmarks can help ensure your pool size is in range. However, you do not want to rely on them. There is an extensive range in the typical percentage founders set aside from less than 5% to 30% or higher. A rule of thumb is that a startup will create a 20% equity pool at formation, and that at a seed round, a seed investor will insist on upsizing the equity pool to equal 10-15% or greater in the pre-money valuation. A Series A investor will look to see that there is at least 10% of the outstanding share capital set aside in an equity pool and accounted for in the pre-money valuation. Investors will count promised but ungranted options in this calculation.
How does hiring affect the pool? Every startup should have an equity budget that rolls up to the total size of the equity pool. To do that, you need to understand which positions you need to fill in the next 18 to 24 months and how many options you would need to attract these critical hires. You will need to offer early employees more equity since they take a more significant risk of joining a relatively unproven company, and for usually below market salary and no bonus.
A good startup lawyer with experience in your space can help you plan and can share relevant data points about how much the market will demand for each key hire.

How do I prevent dilution?
Investors prefer larger option pools, they will price it in the “pre-money,” to minimize the risk of dilution for them. Investors may pressure you into creating a larger pool than you need by reference to some benchmark in relation to the stage of your financing. This is why your hiring plan will help you create a more realistic pool. Remember, a company can always increase the size of the equity pool later if more shares are needed.