Equity and stock options at startups

Equity is the currency of Palo Alto. Founders split it, investors buy it and nearly every startup offer letter includes some. It can also be confusing. Two offers with the same number of options can be worth very different amounts. A missed 30-day deadline can cost a founder a large tax bill years later.

This guide explains the main kinds of startup equity, how vesting works, what 409A valuations and 83(b) elections are and the tax concepts to raise with a professional. For selling shares before an IPO, see our guide to secondaries and tender offers. For short definitions, see the venture capital glossary.

The main kinds of equity

Employees hold common stock or options on common stock. Investors hold preferred stock, which gets paid first in many sales. Our term sheet basics explain liquidation preferences and why they matter to what common stock is worth.

Vesting and cliffs

Vesting means earning equity over time. The most common startup schedule is four years with a one-year cliff:

• Nothing vests for the first 12 months.
• At the one-year mark, 25 percent vests at once.
• The rest vests monthly or quarterly over the next three years.

Founders usually accept vesting on their own stock too. It protects the company and the other founders if someone leaves early. Investors often insist on it. Some agreements include acceleration, which speeds up vesting on an event. Single-trigger acceleration happens on a sale of the company. Double-trigger acceleration requires a sale plus termination without cause. It is the more common form.

Exercise prices and 409A valuations

An option's exercise price, also called the strike price, is set when the option is granted. To avoid penalties under Section 409A of the tax code, a private company generally sets it at or above the fair market value of its common stock on the grant date. Options priced too low can bring the holder income tax as the options vest, an extra 20 percent federal tax and interest. California adds its own additional tax.

Most venture-backed startups get an independent 409A valuation at least once a year and after any event that changes value, such as a funding round. A valuation from a qualified independent appraiser, done within the past 12 months, gives the company a presumption that the price is reasonable. The 409A price for common stock is usually well below the price investors pay for preferred stock, because common stock has fewer rights.

ISOs and NSOs

The IRS calls incentive stock options statutory options and nonqualified options nonstatutory. The rules differ in ways that matter:

Incentive stock options

• Only employees can receive them.
• Exercising them generally creates no regular federal income tax, but the spread can count for the alternative minimum tax.
• If you hold the shares at least two years from grant and one year from exercise, the gain on sale is generally taxed as long-term capital gain.
• Only $100,000 of stock, measured at the grant price, can first become exercisable as ISOs in any calendar year. The rest is treated as NSOs.
• To keep ISO treatment, options generally must be exercised within three months after you stop being an employee. Many plans let options stay open longer, but they then become NSOs.
• After exercising, your employer sends Form 3921 with the dates and values you need for your return.

Nonqualified stock options

• Employees, advisors, contractors and board members can receive them.
• The spread at exercise is generally taxed as ordinary income. For employees, the company withholds payroll taxes.
• Later gains or losses are capital gains or losses, depending on how long you hold the shares.

83(b) elections and early exercise

When you receive stock that is still subject to vesting, the default tax rule taxes you as it vests, on its value at each vesting date. Section 83(b) of the tax code lets you choose instead to be taxed when you receive the stock, on its value then. Founders who buy shares for a fraction of a cent at formation commonly file one, because the taxable amount is close to zero.

• The election must be filed with the IRS within 30 days of the transfer. There are no extensions.
• The IRS has published Form 15620 as an optional form for making the election.
• Keep proof of filing. Investors and acquirers will ask for it.
• If you leave before vesting and the company buys back unvested shares, you generally cannot recover tax already paid.

Some startups allow early exercise, letting employees exercise options before they vest and then file an 83(b). This can start capital gains holding periods sooner. It also means paying the exercise price and possibly tax for shares you might never fully earn. Get advice first.

The alternative minimum tax

The alternative minimum tax is a parallel federal tax calculation with its own exemption amounts and rates. Exercising ISOs and holding the shares past year-end can add the spread to AMT income even though no cash came in. People who exercised large ISO grants in a year when the stock later fell have faced tax bills on gains that disappeared. California has its own alternative minimum tax as well. The IRS sets AMT exemption amounts each year. The 2025 federal tax law also changed how they phase out. Model any large ISO exercise with a tax professional before December.

Qualified small business stock

Section 1202 of the tax code lets some holders of stock in qualified small C corporations exclude gain from federal tax. The 2025 federal tax law expanded it for eligible stock issued after July 4, 2025, according to published summaries of the law:

• 50 percent of eligible gain can be excluded after three years, 75 percent after four years and 100 percent after five years.
• The per-company cap rose from $10 million to $15 million, indexed for inflation starting in 2027.
• The company's gross asset limit at issuance rose from $50 million to $75 million.

Stock issued earlier stays under the old rules, which generally required five years. California does not follow the federal exclusion, so California residents may still owe state tax on the gain. Only C corporation stock can qualify, which is one reason our guide to incorporating recommends talking to counsel before choosing an LLC.

Questions to ask about an equity offer

1. How many shares are outstanding on a fully diluted basis? A share count means little without it.
2. What is the exercise price? When was the last 409A valuation?
3. What price did investors pay in the latest round? How large are the liquidation preferences?
4. What is the vesting schedule? Is there any acceleration?
5. How long do I have to exercise if I leave?
6. Are the options ISOs or NSOs? Is early exercise allowed?
7. Has the company run tender offers, or does it restrict share transfers?

Companies are not required to answer every question, but most will share enough to compare offers. Our hiring guide covers the cash side of compensation. Our jobs guide covers the local market. The law firms guide lists counsel who draft equity plans.

Frequently asked questions