Employee Stock Options: How Grants and Vesting Work

Almost everything written about employee stock options is written for the person receiving them: how to read an offer, what the numbers mean, whether to exercise. This guide is for the person on the other side of the table, who has to decide whether to grant anything at all, how much and on what terms, and who then administers the result for the next decade.

That gap has a cost. A grant takes an afternoon and creates obligations that outlive most of the people who receive them. You are setting a price that has to be defensible to the IRS and choosing between two option types with different tax treatment and different eligible recipients. Through one clause about post-termination exercise, you are also quietly deciding whether the grant will ever be worth anything.

What follows is the employer view of all of that. It starts with what a grant is, how vesting and the cliff work, why the strike price needs a valuation before you can name it, and incentive stock options (ISOs) against nonqualified stock options (NSOs). Then come the tax at each of the three moments that matter, the ninety day window and what extending it does, the option pool and what it takes from your ownership, and what the administration really costs.

I run FirstHR, which handles onboarding, records and the people side of a small business rather than cap tables, so I am writing this as a founder who has been through the decision. This is general information and not tax or legal advice. Equity compensation is one of the few areas where the advice is genuinely worth paying for, and you should take it from a tax adviser and a lawyer before you grant anything.

What a Stock Option Is

A stock option is a contractual right to buy a fixed number of shares at a fixed price for a fixed period. It is not stock, and granting one transfers nothing until somebody pays the strike price.

The distinction between an option and a share is where most of the confusion starts. Granting somebody one hundred thousand options does not give them one hundred thousand shares. It gives them permission to buy one hundred thousand shares, at a price you set today, if they are still here and if they can find the money.

Six terms define a grant, and they sit in the grant agreement rather than the offer letter.

How a Grant Works

A grant becomes real when the board approves a specific number of shares at a specific price for a named person under a written plan that already exists. Not when you say it in an interview, and not when it appears in an offer letter.

The sequence runs in one direction, and skipping a step is expensive to undo. First you adopt an equity incentive plan, the document that states how many shares can ever be issued under it and who is eligible. Then you obtain a valuation. Then the board approves each grant. Then the grant agreement is signed and the cap table, your record of who owns what, is updated.

Incentive stock options add two time limits to that first step. Under 26 U.S.C. 422, the plan must be approved by shareholders within twelve months before or after it is adopted, and options have to be granted within ten years of the earlier of adoption or approval.

What goes into an offer letter, if anything, is a description of what the board will be asked to approve. It is worth being explicit about that in the letter itself, because a candidate who reads a share number as a promise and then receives a different number after a board meeting has a legitimate grievance.

One piece of housekeeping trips up small companies. A compensatory grant of securities by a private company still has to fit inside an exemption from securities registration, federally and in each state where a recipient lives. It is routine work for a lawyer, and it stops being routine two years later when nobody has looked at it.

Vesting and the Cliff

Vesting is the schedule that decides when an option becomes exercisable. The convention is four years with a one year cliff: nothing vests for twelve months, then a quarter vests at once, then the rest vests monthly.

The cliff has a specific job, and it is worth naming honestly: a hire who does not work out costs you nothing in ownership. Twelve months is long enough to know whether somebody is right, and the cliff means a departure at month ten leaves the cap table exactly as it was. For a small company where every point of ownership matters, that is a real protection.

It also produces the ugliest conversation in equity compensation, which is the person let go at month eleven. Whether you accelerate anything in that situation is a judgment call rather than a rule, and the time to think about it is when you write the plan, not in the meeting.

Two variations are worth knowing about. Accelerated vesting on a change of control, usually structured to require both an acquisition and a termination, is a negotiating point for senior hires rather than a standard term. Vesting start dates that predate the grant date are also common, for instance where somebody consulted before joining, and they are fine so long as the agreement says so.

Strike Price and the Valuation

The strike price is what the holder pays per share on exercise, and it must be at least the fair market value of the stock on the grant date. For a private company, establishing that number means obtaining a 409A valuation before any grant is made.

The reason is in the tax rules. A stock option is exempt from the deferred compensation regime of section 409A only where all of these hold: it is over service recipient stock; the exercise price is never less than fair market value on the date of grant; its exercise is taxed under section 83, the tax code's rule for property received for services; and it contains no additional feature for deferring compensation.

That test covers nonqualified options. An incentive stock option sits outside 409A under a separate rule for statutory options, and it keeps that status only while it meets section 422, which includes a strike price of at least fair market value. Both rules are set out in 26 CFR 1.409A-1.

Set the strike price below fair market value and the option is no longer exempt. At that point a set of penalties applies to the person holding it rather than to you.

In practice this means a valuation before your first grant, then a refresh roughly every twelve months, and an additional refresh whenever something material happens. A priced funding round is the obvious material event. So is a signed term sheet, a large acquisition offer, or a change in the business that would move the number in either direction.

ISOs and NSOs

Incentive stock options (ISOs) can be granted only to employees of the company, its parent or its subsidiary. Everybody else, meaning contractors, advisors and non-employee directors, can only receive nonqualified options (NSOs).

That rule settles most of the question for a small company. Your advisors get NSOs because there is no alternative. Your employees can get either, and the reason to prefer ISOs is that they are better for the recipient, not for you.

ISOs carry statutory conditions, and an option that fails any of them is simply an NSO. The plan must be shareholder approved. The strike price must be at least fair market value at grant. The term cannot exceed ten years. The option is not transferable except by will or the laws of descent and distribution, so the holder cannot sell or give it away during their lifetime.

Two further rules turn on the individual holder. Somebody owning more than ten percent of the combined voting power can only receive an ISO priced at 110 percent of fair market value with a term of five years or less. And the aggregate value of stock for which ISOs first become exercisable in a calendar year cannot exceed $100,000 per person, with the excess treated as nonqualified.

The last row explains why the ninety day window exists. The first row explains why most small company cap tables end up carrying both types at once.

Tax at Grant, Exercise and Sale

Nothing is taxed at grant for either option type, provided the strike price is at least fair market value. The difference between the two shows up at exercise, and again at sale.

Take the nonqualified option first, because it behaves like payroll. When somebody exercises, the spread between what they paid and what the stock is worth that day is compensation. It goes through payroll like any other wages: income tax withholding, Social Security and Medicare, and federal unemployment tax.

The spread also appears on the W-2, with the same amount shown separately in box 12 under code V, per the IRS Instructions for Forms W-2 and W-3. You take a corporate deduction for it. From that point the shares have a tax basis equal to their value at exercise, so any further rise or fall is capital gain or loss.

The incentive stock option is quieter at exercise and noisier later. There is no ordinary income and no withholding when it is exercised, which the IRS confirms in its guidance on stock options. If the holder then sells the shares more than two years after the grant date and more than one year after exercise, the entire gain is long term capital gain, and you get no deduction at all.

Selling sooner is a disqualifying disposition: the spread becomes ordinary compensation income for the holder, and you get a deduction for the same amount. The catch for you is easy to miss. Your corporate deduction from ISOs is contingent on employees breaking their own holding periods, which is not something to plan around and not a reason to grant.

Withholding on an NSO exercise follows the ordinary supplemental wage rules, exactly as it does for a bonus. The problem is not the rate but the mechanics: a large exercise can produce a withholding obligation bigger than the paycheck it sits in, and payroll has to be told before it happens.

The Alternative Minimum Tax

Exercising an incentive stock option and holding the shares adds the spread to alternative minimum taxable income, which can produce a tax bill on a paper gain in a company whose stock cannot be sold.

This is the part of ISO treatment nobody explains at the offer stage and everybody discovers in April. The favorable tax treatment is real, but it is bought with an exposure that arrives before any money does. Somebody exercises an option on shares worth far more than they paid, receives nothing in cash, and may owe alternative minimum tax on the difference.

You are not their tax adviser and should not act like one. What you can do is make sure nobody exercises in ignorance. A plain paragraph in the grant agreement and a reminder at the point of exercise cost nothing, and they prevent somebody discovering a five figure bill and tracing it back to a benefit you gave them.

It is also an argument for being deliberate about who receives ISOs. The treatment is better in theory. Whether it is better in practice depends on whether the person can carry the exposure, and for junior employees the honest answer is frequently no.

The Window After Somebody Leaves

The default post-termination exercise window is ninety days, and the reason is statutory rather than customary: an incentive stock option must be exercised within three months of employment ending or it stops being an incentive stock option.

The statutory condition is that the holder has to have been an employee of the company, its parent or its subsidiary at all times from the grant date until the day three months before exercise. That period extends to one year where the employee is permanently and totally disabled. Ninety days is simply the drafting convention that sits inside three months.

The human consequence is severe and mostly unintended. Somebody works for you for four years, vests their entire grant, leaves, and then has three months to produce the strike price for every share plus whatever tax follows. For a grant of any size at a company that has grown, that is a sum most employees cannot raise.

When the leaver cannot raise it, the grant they earned expires unexercised and the shares go back into the pool. The equity you thought you were paying them turned out to be conditional on their savings.

Extending the window is defensible and it is not free. Leavers stay on the cap table for years, which complicates every financing and every shareholder signature. You inherit a withholding problem, because a nonqualified exercise by a former employee is still wages. And you lose the recycling of forfeited options back into the pool.

What matters most is deciding once, writing it into the plan, and applying it to everybody. Deciding case by case, under pressure, for the departing employee who is upset, is how a company ends up with four different windows on one cap table.

The Option Pool and Dilution

The option pool is a block of shares reserved under the plan for future grants, and it dilutes existing shareholders the moment it is authorized on a fully diluted basis, not when options are actually granted from it.

That timing is the part founders get wrong. A fully diluted count treats every reserved share as already issued. Here is the arithmetic on a company with two founders and eight million shares between them.

Two conclusions follow. First, creating or enlarging the pool is the dilutive act, and granting from an existing pool changes nothing about your ownership percentage on a fully diluted basis.

Second, the pool top-up is a negotiating point in every priced round. Investors normally require it to happen before their money goes in, which means the dilution falls on existing shareholders rather than being shared with the incoming investor.

Size the pool from a hiring plan rather than a percentage you read somewhere. A pool built from real roles survives an investor conversation. A pool built from a rule of thumb tends to be either too small to hire with or larger than you needed to give up.

Equity is also the component of total compensation that is easiest to over-weight, because it is the one that never shows up in the bank balance. A grant that costs nothing this month can cost a great deal of ownership over the four years it takes to vest.

A written compensation philosophy stating how equity is banded by level is worth more than any individual grant decision. It gives every offer the same starting point, and it stops the most persistent negotiator setting the precedent for everybody hired afterward.

How much equity to grant each hire

Size an individual grant backwards from total compensation rather than forwards from a percentage. Decide what the role pays at market in cash, work out how far below that you are actually offering, and grant equity meant to cover the gap across the four year vest. That is arithmetic a candidate can check, which ends the argument faster than a benchmark does.

Converting the gap into a share count needs one price, and the defensible one for startup equity is your current 409A common valuation rather than the preferred price your investors paid. Divide the four year shortfall by that per share figure and round to a legible number. The preferred price makes any grant look larger and sets up a conversation you will lose at the next round.

Two habits stop the bands drifting once you have them. Write down the range for each level before you make an offer rather than after it, and give refresh grants a rule of their own, typically a smaller annual grant on its own four year schedule, so the person hired in year one does not quietly fall behind the person hired in year three.

What the Administration Costs

The grant takes an afternoon. The administration is permanent, and it is the part nobody budgets for.

Here is the recurring work, in the order it tends to arrive.

Those eight items reduce to three registers, and the file below is those three: what was granted and on what valuation, whose exercise window is running, and which exercises still need payroll or a Form 3921.

Form 3921 trips people up. It is filed by the corporation for each transfer of stock on the exercise of an incentive stock option under section 422(b), and the details sit on the IRS page for Form 3921. It is per exercise rather than per employee, and it falls due alongside everything else in payroll.

The electronic filing threshold trips up the same people. Once you file ten or more information returns in aggregate across all types, counting W-2s and 1099s alongside any Form 3921, the whole set has to go electronically rather than on paper.

None of this is difficult. All of it is continuous, and it does not stop when hiring does. That is the honest argument for granting equity to fewer people in larger amounts, because the administrative cost per grant is the same whether it is for five thousand shares or fifty thousand.

The Other Forms of Equity Compensation

An option is one instrument among several. Equity compensation also covers restricted stock, restricted stock units, employee stock purchase plans and the cash settled alternatives used by companies whose shares nobody can buy. Which one fits depends on two questions: can the stock be priced, and can it eventually be sold.

What an employee stock purchase plan is

An employee stock purchase plan, or ESPP, lets employees buy company stock through payroll deductions at a discount. The statutory version in section 423 of the Internal Revenue Code can price shares at 85 percent of fair market value, and the discount itself is not taxed on the purchase.

The conditions are tight. Shareholders approve the plan within twelve months before or after adoption. It has to be open to substantially all employees rather than a chosen few, with narrow exclusions for short service, part time and seasonal staff. Nobody holding 5 percent or more of the company may take part.

Two ceilings then apply. Each participant can accrue no more than $25,000 of stock value a year, measured when the option is granted rather than when it is bought. Offering periods run to 27 months, or to five years where the price is fixed as a percentage of value at exercise.

For a private small business this is usually theory rather than a plan. A discount means nothing without a market price to discount, and a purchase means nothing without a way to sell afterward.

Companies that do run one take on a filing duty. They file Form 3922 for each transfer of legal title to shares bought under the plan where the purchase price was below the shares' value on the grant date, or was not fixed on that date.

The instrument that deserves more attention from small employers is the last row of the table. Where a business is profitable, closely held and not for sale, phantom stock or an appreciation right pays the same economics in cash, taxed as wages, without putting anybody on the cap table.

Where Founders Get This Wrong

Six patterns, and the first two account for most of the damage.

Promising equity in an interview and papering it later is first. The grant date, and therefore the strike price, is set by board approval. A candidate told a number in March who is granted in July at a higher valuation has been given something different from what they accepted, and that is a conversation you will lose.

Setting a strike price without a valuation is second. It is the most expensive shortcut available in this area, and the penalties fall on the employee rather than on you, which makes it worse rather than better.

Expressing grants as percentages is third. Percentages move every time you issue a share. A grant agreement carries a share count, and a percentage mentioned in an offer conversation becomes a grievance the moment the next round closes.

Treating equity as free is fourth. It is the most expensive currency you have and the invoice simply arrives later. Granting generously because it does not touch this month's cash is how founders end up owning far less of their company than they meant to.

Ignoring the exercise window is fifth. A ninety day window quietly converts a four year grant into something that only benefits employees with savings. That may be the trade you want. It should not be one you make by accident because it was in the template.

And granting equity in a business that will never be sold is sixth. An option with no plausible liquidity event is a piece of paper, and a cash bonus or profit share does the same job honestly. Equity is not automatically part of a good small business benefits package.

If you are still deciding whether to offer equity at all, test your situation against the two lists below. The pros are the circumstances where equity earns its cost, and the cons are the ones where it wastes it.

If your situation passes that test, do the work in order. Adopt the plan with the post-termination window already written into it, and size the pool from your hiring plan. Get the valuation, then have the board approve each grant. Set up the reporting before the first exercise, not after it. And have a tax adviser and a lawyer review the plan before the first grant goes out.

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