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. Very little is written for the person on the other side of the table, who has to decide whether to grant anything at all, how much, on what terms, and who then has to administer the result for the next decade.

That asymmetry 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, choosing between two option types with different tax treatment and different eligible recipients, and quietly deciding, through one clause about post-termination exercise, whether the grant will ever be worth anything.

This is the employer view of all of that: what a grant is, how vesting and the cliff work, why the strike price needs a valuation before you can name it, ISOs against NSOs, 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, which is the document that states how many shares can ever be issued under it and who is eligible. For incentive stock options 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, under 26 U.S.C. 422. Then you obtain a valuation. Then the board approves each grant. Then the grant agreement is signed and the cap table is updated.

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 catches small companies out. 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 is doing a specific job and it is worth naming it honestly. It is there so that 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. That is a real protection for a small company where every point of ownership matters.

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 judgement 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. Acceleration 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 mechanism is worth understanding rather than accepting on trust. A stock option is exempt from the deferred compensation regime of section 409A only where the exercise price is never less than fair market value on the date of grant, the option is over service recipient stock, and the option contains no additional feature for deferring compensation. Those conditions 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 which 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 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.

That single sentence resolves 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 failing 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. Somebody owning more than ten percent of the combined voting power can only receive an ISO priced at one hundred and ten 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 two rows together explain 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: income tax withholding, Social Security and Medicare, federal unemployment tax, and it appears on the W-2, with the same amount shown separately in box 12 under code V. You take a corporate deduction for it. From that point the shares have a basis equal to their value at exercise, and any further movement 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. If they sell sooner, that is a disqualifying disposition: the spread becomes ordinary compensation income for them and you get a deduction for the same amount.

The consequence 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 pay cheque 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 favourable 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 costs nothing and prevents 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 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. The grant they earned expires unexercised, the shares go back into the pool, and 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 authorised on a fully diluted basis, not when options are actually granted from it.

That timing is the part founders get wrong, so here is the arithmetic on a company with two founders and eight million shares between them.

Two conclusions follow. 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. And the pool top-up is a negotiating point in every priced round, because 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 written compensation philosophy stating how equity is banded by level is worth more than any individual grant decision.

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.

Form 3921 catches people out. 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.

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.

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.

Frequently Asked Questions