VCs often require that portfolio companies maintain a certain amount of unallocated options (an option pool) for future distribution to existing or new hires. There is good reason for this as I note in my appropriately named post, Option Pools.

One important but often-misunderstood characteristic about options is that they do not necessarily dilute shareholders. Options only become shares and dilute existing shareholders if they are exercised. If options are not both allocated and exercised, the shares are never issued and the existing shareholders are not diluted.

This nuance is an important one. Entrepreneurs and investors may disagree about the amount of options required to expand the team and scale the business. By offering to create or increase an option pool before an investor invests, you mitigate the risk of dilution for investors that are concerned about the equity requirements of new hires. If, however, you don’t need as much equity to build your team as you set aside in the option pool, you don’t get diluted to the full extent of the option pool. Furthermore, even if you issue (allocate) options to employees, if they do not exercise the options, existing shareholders are not diluted.

It’s worth noting that because options, warrants and the like MAY be dilutive there are usually two ways to calculate your ownership percentage. You can look at your current ownership and your ownership on a fully-diluted basis. The fully-diluted basis assumes that all options and warrants are exercised – the capitalization table is as diluted as it can be.