Equity Compensation Types

The four instruments a startup grants equity through: incentive stock options, non-qualified stock options, restricted stock units, and employee stock purchase plans, each with its own taxes, exercise mechanics, and traps.

An offer says “10,000 options” or “10,000 RSUs.” The numbers look alike. They aren’t. An option is a right to buy shares at a fixed strike price; exercising it takes cash and can create a tax bill before any sale. An RSU is a promise of shares with no exercise price, taxed as income when it vests or, at a private company, when a liquidity trigger fires. The instrument decides when the grant costs money and whether paper value becomes cash.

What It Is

Equity compensation is ownership paid alongside cash. Startup grants fall into two families: options, which let the holder buy shares later at a fixed price, and full-value awards, which deliver the shares themselves.

• Incentive stock options (ISOs) are employee-only options with favorable tax treatment. If the holder keeps the shares at least one year after exercise and two years after grant, the gain is taxed as long-term capital gain. The catch is alternative minimum tax. ISOs fit early employees while the 409A valuation is low.
• Non-qualified stock options (NSOs) are options without ISO tax status. They can go to employees, advisors, contractors, and board members. The spread between strike and fair market value at exercise is taxed as ordinary income immediately, even if the holder sells nothing. Companies use NSOs for non-employees and for grant value above the $100,000-per-year ISO limit.
• Restricted stock units (RSUs) promise shares, or the cash value of shares, when vesting conditions are met. There is no strike price and nothing to buy. RSUs dominate at public companies and late-stage private companies whose share price has made options awkward; private-company RSUs need special vesting triggers to avoid tax before liquidity.
• Employee stock purchase plans (ESPPs) let employees buy public-company stock through payroll deductions, at up to a 15% discount and often with a lookback that uses the lower price at the start or end of the purchase period. Tax can split between the discount and sale gain. Private startups rarely use ESPPs because employees have no liquid market for the shares.

A fifth form, restricted stock, sits nearby: shares purchased at grant, common for founders and the earliest hires and often paired with an 83(b) election. It is mostly a founding-team instrument, not the employee-offer instrument this entry covers.

The strike price of an option is not arbitrary. Private companies set it at the fair market value established by a 409A valuation, an independent appraisal usually refreshed once a year and after any priced round. A low 409A early in a company’s life is the cheapest equity an employee will ever be offered; the same percentage granted after several rounds carries a much higher strike.

Why It Matters

The worst equity outcome is not always “the grant was worth nothing.” Sometimes it is “the grant cost money.” An option holder can pay the strike price, owe tax on a paper gain, and then watch the company fail before the shares sell. An RSU holder at a private company can vest into ordinary income with no liquid shares to sell for the tax bill. Knowing the instrument is the first step in reading the offer’s real value.

The instrument is also a founder-side pricing decision. ISOs cost the company nothing extra and usually give employees the best tax outcome, which is why early startups default to them. But the employee-only rule, the $100,000 annual ISO limit, and a rising 409A valuation push growing companies toward NSOs and eventually RSUs. A founder who grants RSUs too early can create a tax-with-no-liquidity problem; one who keeps granting options after the share price has climbed can give employees a strike too expensive to exercise. The instrument has to match the company’s stage.

The most expensive misunderstanding is the AMT trap. When an employee exercises ISOs while the company is still private, the spread between strike price and 409A value is not regular income, but it does count for alternative minimum tax. The employee can sell nothing and still owe tax in April on a gain that exists only on paper. If the company later declines or fails, the shares lose value but the tax was already due. The dot-com collapse made this trap visible when employees who had exercised into high paper valuations owed AMT on gains that vanished.

How to Recognize It

The instrument and its traps are visible before signing if the holder asks for the grant document, not just the recruiter’s summary.

• Read the word, not the number. “Options” and “RSUs” have different tax timing. If an offer says only “equity” or “shares,” get the instrument in writing. The stock plan and award agreement name it precisely; the summary often doesn’t.
• For options, find the strike and current 409A. The spread between them is the tax exposure. A strike near fair market value means little gain to tax at exercise; a strike far below it means more potential value and more AMT risk.
• For options, find the post-termination exercise window. The standard term gives a departing employee 90 days to exercise vested options or lose them. Some companies extend the window to years, which can be worth more than a larger headline grant.
• For private-company RSUs, find the trigger. Private RSUs usually use double-trigger vesting: time-based vesting plus a liquidity event, such as an acquisition or IPO. That structure avoids taxable shares arriving before cash can.
• Watch the $100,000 line. ISOs that first become exercisable in any year above $100,000 in value, measured at the strike price, convert to NSOs for the excess. One large grant can be partly ISO and partly NSO.

How It Plays Out

A product designer joins a Series A startup and receives 20,000 ISOs at a $1.00 strike, the company’s current 409A. Two years in, having vested half, she leaves. The 90-day clock starts. Her 10,000 vested options cost $10,000 to exercise. The latest 409A is $4.00, so exercise creates a $30,000 paper gain that counts toward AMT, on shares she can’t sell, in a company whose next round is uncertain. She decides the $10,000 plus a possible four-figure AMT bill is too much to risk, lets the options lapse, and walks away with nothing from two years of vesting. The grant was real; the exercise economics made it unreachable. An extended exercise window would have let her wait for a liquidity event before deciding.

The RSU version stings differently. An engineer at a late-stage private company receives RSUs because the share price has climbed past where options make sense. The grant has a double trigger, so the units vest on schedule but deliver nothing until a liquidity event. When the company goes public, four years of RSUs deliver at once, all taxed as ordinary income in one year, and the company withholds shares to cover it. The outcome is valuable. The lump-sum timing still produces a tax year the engineer would have planned for differently if they had understood the instrument.

Consequences

What understanding it changes. A candidate who reads the instrument knows whether they must fund an exercise, whether tax arrives before cash, and what the 90-day window demands if they leave. They can compare an ISO offer against an RSU offer on the dimension that actually differs instead of treating “shares” as one thing. A founder who chooses the instrument deliberately matches it to stage: ISOs while the 409A is low, NSOs when ISO rules no longer fit, RSUs when options get awkward. Anyone who understands the AMT trap runs the exercise math before exercising.

What it costs. The mechanics are complicated, tax treatment depends on holding periods and elections with hard deadlines, and future 409A values and liquidity events are unknowable. This is where general literacy ends and a qualified tax advisor begins: the instrument types are knowable, but an individual’s move depends on personal finances and current tax law. The vocabulary tells the holder which questions to ask and which deadlines exist, early enough to act on them. The recurring loss is a grant whose instrument the holder never decoded until the tax bill or exercise deadline forced the issue.

Related Articles

Sources

• The US Internal Revenue Code’s treatment of statutory and non-statutory stock options (IRC §422 for ISOs, including the $100,000 limitation and holding-period rules) and the alternative minimum tax — the statutory basis for the distinctions that drive every choice here.
• Carta’s equity-compensation education — the widely-used practitioner reference for how ISOs, NSOs, RSUs, and ESPPs differ in practice, including double-trigger RSU vesting at private companies and the early-exercise and 409A mechanics startups actually administer.
• Y Combinator’s startup-equity and 83(b) guidance — the canonical early-stage articulation of why instrument choice and timing matter for founders and first employees.
• The post-dot-com AMT episode, documented in contemporaneous coverage of employees bankrupted by alternative minimum tax on exercised options whose underlying shares later collapsed — the historical case that makes the AMT trap concrete rather than theoretical.