What startup employees need to understand about equity compensation
Stock options and restricted stock are central to startup compensation, but their tax treatment and vesting rules are complex. Here's what California startup employees need to know.
Startups use equity compensation—primarily stock options and restricted stock—as a way to align employee and company interests and to conserve cash. But unlike salary, equity is complex: it comes with vesting schedules that lock up benefits over time, tax rules that change based on option type and holding periods, and legal mechanics that can catch employees off guard.
Understanding these rules is essential before accepting equity, exercising options, or leaving a startup.
How stock options work
A stock option is a contractual right to buy company stock at a set price, called the exercise price or strike price. The company grants options to employees, usually specifying how many shares, what price to buy them at, and when the employee can exercise—meaning actually buy the stock.
Options are worthless if the company's stock price stays below the exercise price. If the company is worth more later, the option becomes valuable: an employee granted options at $1 per share can exercise and buy stock worth $10, locking in a $9 gain per share (before taxes).
Startups typically grant options rather than shares for tax reasons: options are not considered property until exercised, so they don't trigger immediate income taxes. An employee who received shares directly would owe income tax on the shares' value immediately, even without selling them.
Vesting and the cliff
Options vest—become exercisable—according to a schedule.
The cliff structure protects companies from paying out equity to employees who leave immediately. An employee who departs after 11 months forfeits all options. One who stays 13 months keeps 25 percent and can exercise those shares. This structure is not required by law but is standard in the industry.
Vesting is controlled by Section 83 of the Internal Revenue Code, which defines when property transferred for services becomes taxable.
Incentive vs. non-qualified options
The IRS recognizes two types of stock options with different tax treatment. Incentive stock options (ISOs) receive favorable tax treatment but come with strict requirements. Non-qualified stock options (NSOs) have looser rules but are taxed as ordinary income.
With NSOs, an employee recognizes taxable income when the stock becomes substantially vested. The taxable amount is the difference between the stock's fair market value when it becomes substantially vested and the exercise price. If an employee exercises an NSO with a $1 strike price when the stock is worth $10, that $9 difference is ordinary income, taxed at the employee's marginal rate. The employee owes this tax even if they haven't sold the stock yet.
ISOs are treated differently.
“An employee who receives restricted stock without making a 83(b) election doesn't recognize income until the shares vest, but one who exercises a non-qualified option owes tax on the spread immediately, even if the stock isn't sold.”
Tax timing and 83(b) elections
Vesting and taxation timing can be separated. Normally, an employee doesn't recognize income until shares vest. But Section 83(b) of the Internal Revenue Code allows employees to elect early: recognize the taxable income immediately, even before vesting, based on the current stock price.
A 83(b) election must be filed within 30 days of the stock transfer. An employee might make this election if the stock price is low at grant, expecting it to rise. By recognizing income early at the low price, the employee pays tax on a smaller amount. Future growth above that price becomes capital gain, taxed more favorably. The risk: if the stock value drops or the company fails, the election cannot be revoked.
For private companies, Section 409A of the tax code imposes strict rules on deferred compensation. If an equity arrangement doesn't meet 409A requirements, the employee owes ordinary income tax plus a 20 percent penalty tax and interest. Employees should verify 409A compliance before accepting equity at a company.
What to clarify before accepting equity
An employee should understand the option plan terms: how many shares, the exercise price, vesting schedule, and option type (ISO or NSO). Ask for a copy of the company's stock option plan and the individual option grant agreement, which can be dense but contain critical terms.
Understand what happens if you leave. Can you exercise vested options after departure, and for how long? Some companies allow 90 days; others allow years. This affects the value of your equity if you're considering leaving or job-switching.
Consider the tax bill. If exercising NSOs, the employee owes ordinary income tax on the spread (fair market value minus strike price), typically due April 15 of the following year. An employee should plan for this cash outflow, especially if the strike price is far below the stock's current value. For ISOs, holding the stock for the required periods lets the employee defer selling until favorable tax timing.
Related coverage: How a startup option pool works, and who it dilutes; How California taxes capital gains, and why it differs from federal.
