What Is an Option Pool?

K. Kinsella

An option pool contains corporate stocks that a firm's directors intend to distribute to employees, shareholders or other parties on a future date. Many firms use option pools as a tool to keep upfront costs low, while investors often use pools to drive down the price of corporate stock during the initial public offering (IPO). In many instances, stocks inside an option pool are awarded to long-term employees or given to retiring workers as an alternative to cash pensions.

In many instances, stocks inside an option pool are awarded to long-term employees.
In many instances, stocks inside an option pool are awarded to long-term employees.

Before a firm can become publicly listed, investment bankers have to establish the market value of the entity. This process involves calculating the total value of the firm's tangible and intangible assets and subtracting the company's liabilities. Thereafter, these bankers attempt to persuade investors to buy shares in the firm and the capital infusions from these individuals add to the company's value. Including an option pool into the equation complicates the pricing during the IPO because the creation of the pool dilutes the shareholder's equity.

If 20 percent of a firm's shares are held in an option pool then the shareholders only own 80 percent of the company stock. Typically, options are factored into the equation before capital infusions. This means that while the firm is technically valued at one price, the investors only have to invest a sum of capital into the firm that amounts to the difference between the stated company value and the market value of the stocks that are being held in the option pool. If the stocks were put into the option pool after the cash infusion from the investors, then the investors would have to invest more money into the company because they would have to invest a sum of money that equals the company's actual value.

Options are a useful tool for small but expanding companies because such firms have unlimited growth potential. These companies may offer stock options to new employees as an alternative to cash signing-on bonuses and employees are often willing to accept such deals because the stocks are potentially more valuable than a fixed sum of cash. Additionally, options make it more difficult for a rival firm to complete a hostile takeover of a company since fewer of its stocks are available on the open market.

Stocks are only of value while a firm remains solvent and these securities drop in value when a firm performs poorly. Securities in option pools can lose value over time since the market value of these securities is tied to the current value of publicly available stock. Consequently, conservative individuals are often more inclined to accept cash payments and bonuses rather than options contracts.

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