An employee equity program is a compensation arrangement in which a company pays part of your wages in ownership of the business itself, usually through shares of stock or the right to acquire them. If the company grows, the equity grows with it, and you share in that upside. These programs are especially common in technology and other high-growth industries, where they help employers attract talent that might otherwise command higher cash salaries. The mechanics, the vesting schedule, and the tax treatment all depend on which type of equity you’re granted, and getting those details wrong is what turns a promising offer into an expensive lesson.
The Four Common Forms of Equity
Most grants fall into one of four categories. Which one you’re offered depends on the company’s stage, your role, and whether the stock trades publicly.
Restricted Stock Units
An RSU is a promise to deliver shares at a future date once you’ve met a vesting requirement. You don’t pay anything to receive them, and each unit converts into one share when the restriction lifts. Because the value equals whatever the stock is worth on the vesting date, RSUs always have some value as long as the stock does. That built-in floor makes them the most common equity award at large public companies.
Stock Options
A stock option gives you the right to buy a set number of shares at a locked-in price, called the strike price or exercise price. The option only pays off when the market price climbs above the strike; the gap between the two is the spread. If the stock never crosses the strike, the option is underwater and worth nothing. Options come in two versions, and the difference between them is almost entirely about taxes.
Incentive stock options (ISOs) are reserved for employees and offer potential tax advantages if you follow the rules. To qualify under Internal Revenue Code Section 422, the strike price must be at least equal to the stock’s fair market value on the grant date, the option can’t be exercisable more than ten years after grant, and it can only be transferred through a will or inheritance. There’s also an annual cap: if the fair market value of stock (measured at grant) becoming exercisable for the first time in any calendar year exceeds $100,000, the excess is treated as non-qualified options.
Non-qualified stock options (NSOs) are more flexible. Companies can grant them to employees, directors, advisors, and independent contractors, and they don’t need to satisfy the Section 422 requirements. The tradeoff is less favorable tax treatment at exercise.
Employee Stock Purchase Plans
An ESPP lets you buy company stock at a discount through payroll deductions. Under a qualified plan governed by Section 423, you contribute after-tax dollars during an offering period and then use the accumulated funds to buy shares at a discount of up to 15% off the market price. Your right to purchase stock under all of an employer’s ESPPs cannot accrue at a rate exceeding $25,000 in fair market value per calendar year.
The feature that makes many ESPPs unusually attractive is the look-back provision. The statute allows the purchase price to be based on the lower of the stock price at the beginning or the end of the offering period, with the discount applied to that lower price. If the stock rises during the period, you’re buying at a discount off a price that was already below market.
How Vesting Works
Vesting is the mechanism that keeps you at the company long enough for the equity to matter. Until your equity vests, it’s a contingent promise, and unvested equity is almost always forfeited if you leave.
- Time-based vesting releases shares on a fixed schedule tied to continued employment, such as 25% per year over four years.
- Cliff vesting holds everything until a single milestone is reached, often one year of service, then releases a chunk all at once. Many four-year schedules combine a one-year cliff with monthly or quarterly vesting afterward.
- Performance-based vesting releases shares when the company hits specific targets like revenue goals or product milestones. This is more common for executives and senior hires.
What Happens in an Acquisition
Unvested equity doesn’t automatically become yours when the company is acquired. What happens depends on your equity agreement. Single-trigger acceleration vests everything immediately upon the acquisition itself; it’s generous and relatively rare outside founder-level grants. Double-trigger acceleration requires two events: the acquisition plus your involuntary termination (or resignation for good reason, such as a pay cut or forced relocation) within a set window afterward, usually nine to eighteen months. Double-trigger is far more common because acquirers generally want the team to stay after the deal closes.
Exercising Options
Exercising means paying the strike price to buy the shares. It applies to options, not RSUs, which vest automatically into shares. Once your options have vested, you can exercise by paying cash out of pocket, using a cashless exercise where a broker sells enough of the newly acquired shares to cover the strike price and taxes, or swapping previously owned company shares equal in value to the strike price. Cashless is the most common approach when the immediate tax bill is large.
At public companies, expect a lock-up period after an IPO, typically 90 to 180 days, during which insiders cannot sell shares. Your options may technically be exercisable during that window, but you won’t be able to sell the resulting shares until it expires.
How Each Type Is Taxed
This is where most people get tripped up. The type of award, the timing of your decisions, and how long you hold the shares all interact to determine whether you owe ordinary income tax rates or the lower long-term capital gains rates.
RSUs
Nothing happens at grant. When RSUs vest and shares hit your account, the full market value of those shares counts as ordinary income. Your employer withholds taxes at that point, usually by holding back a portion of the vesting shares. Any gain or loss after vesting is a capital gain or loss, taxed at long-term rates if you hold the shares for more than a year after the vesting date.
ISOs
ISOs get preferential treatment if you follow the rules precisely. No regular income tax is owed when you receive or exercise the option. The catch is the Alternative Minimum Tax: the spread at exercise is an AMT adjustment item and can trigger AMT liability even though you don’t owe regular income tax on the exercise itself.
To lock in long-term capital gains treatment on the eventual sale, you must meet two holding periods: hold the shares at least two years from the grant date and at least one year from the exercise date. A sale that satisfies both is a qualifying disposition, and your entire gain (sale price minus strike price) is taxed at capital gains rates. Sell before meeting both, and it’s a disqualifying disposition. The spread at exercise gets reclassified as ordinary income, wiping out much of the ISO’s tax advantage.
NSOs
NSO taxation is more straightforward but less favorable. Nothing is taxed at grant. When you exercise, the spread between the strike price and the current market value is ordinary income, reported on your W-2 and subject to federal and state income taxes plus Social Security and Medicare. Any additional gain after exercise is a capital gain, taxed at long-term rates if you hold the shares more than a year after exercising.
ESPPs
For a qualified ESPP, the discount isn’t taxed at purchase. The tax event happens when you sell. Hold the shares at least two years from the offering date and one year from the purchase date, and it’s a qualifying disposition: you report the lesser of the actual gain or the discount amount as ordinary income, and any remaining gain is taxed at long-term capital gains rates. The statute specifically provides that no withholding is required on this ordinary income component. Sell before meeting those holding periods, and the discount is taxed as ordinary income regardless of whether the stock went up or down after purchase.
The Section 83(b) Election
If you receive restricted stock or early-exercise your options at a startup, the 83(b) election is worth understanding before you file anything else. Under the default rules in Section 83, you’re taxed when the restriction lifts, based on the stock’s value at that point. If you joined when shares were worth $0.10 and they’re worth $50 at vesting, you owe income tax on $49.90 per share.
An 83(b) election flips the timeline. You choose to be taxed immediately at the time of transfer, based on the stock’s current value. File the election when shares are worth $0.10, and you pay tax on $0.10 per share (minus whatever you paid). All future appreciation is treated as capital gains when you eventually sell.
The deadline is strict. The election must be filed with the IRS within 30 days of the transfer date. Miss that window and the election is gone permanently. There’s also a real risk: if you file an 83(b) and then forfeit the stock because you leave before it vests, you don’t get a refund on the taxes you already paid. The election makes sense when the stock’s current value is low and you believe it will appreciate significantly.
Early exercise, allowed by some companies, lets you buy shares before your options vest. Early-exercised shares remain subject to the original vesting schedule, and the company can buy back unvested shares if you leave. It’s most common at startups where the stock price is low, because it can unlock significant tax benefits through an 83(b) election.
Extra Complications at Private Companies
Equity at a private company comes with problems that public-company employees don’t face. The biggest is liquidity: you can’t sell your shares on an exchange. Your equity might be valuable on paper, but turning it into cash typically requires an IPO, an acquisition, or a company-sponsored secondary sale.
409A Valuations
Private companies have no public market price, so they must obtain an independent valuation to set the strike price on option grants. This is called a 409A valuation, after the tax code section that governs nonqualified deferred compensation. Setting the strike price below fair market value can cause the options to be treated as deferred compensation that violates Section 409A. The penalty falls on the employee: the deferred compensation becomes immediately taxable, plus a 20% additional tax and interest on top.
The IRS provides a safe harbor. A valuation performed by a qualified independent appraiser is presumed reasonable for 12 months, unless a material event such as a new funding round changes the company’s value. Most startups refresh their 409A annually or after each significant financing event.
The Cash Cost of Exercising
Exercising options at a private company means spending real cash on shares you can’t sell. The tax bill arrives on schedule regardless. For ISOs, exercising can trigger AMT. For NSOs, the spread at exercise is taxable income. In both cases, you’re paying taxes on value you can’t yet access. Employees have been surprised by six-figure tax bills on equity they couldn’t sell for years afterward. Before exercising, calculate the total cost (strike price plus taxes) and make sure you can absorb it.
What Happens When You Leave
Unvested equity is almost always forfeited on departure. The harder question is what happens to your vested options. Most stock option agreements give a post-termination exercise window of 90 days. If you don’t exercise your vested options within that period, they expire worthless. For ISOs specifically, the tax code adds its own constraint: to keep ISO tax treatment, you must exercise within three months of leaving. Exercise later, and the options are taxed as NSOs.
The 90-day clock creates a difficult decision at private companies. You may need to spend thousands of dollars exercising options for stock you can’t sell, with no guarantee the company will ever have a liquidity event. Some companies have moved toward longer post-termination exercise periods of one year or more, but most still use the 90-day standard. Check this term in your equity agreement before you accept the job, not after you leave.
RSUs are simpler on exit: unvested units are forfeited, and any shares that already vested and were delivered to you remain yours.
Reading an Offer: Dilution and Percentage Ownership
Your equity represents a percentage of the company, and that percentage can shrink. When the company issues new shares through a funding round, new employee grants, or option exercises, the total number of shares outstanding rises, and your ownership stake as a fraction of the whole gets smaller even though you hold the same number of shares. That’s dilution.
Dilution isn’t inherently bad. If a funding round doubles the company’s value but increases total shares by 20%, your smaller percentage is worth more in absolute terms. But at startups that go through multiple funding rounds, early employees can see their ownership percentage fall substantially before any exit. When evaluating an offer, the raw number of shares matters far less than what percentage of the fully diluted share count those shares represent and what the company’s current valuation implies each share is worth.