Two instruments dominate startup equity compensation: stock options and restricted stock. Options are the right to buy shares at a fixed price in the future. Restricted stock is actual shares subject to vesting — meaning the company can repurchase them if you leave before the vesting schedule is complete.
Each has different tax treatment, different risk profiles for employees, and different administrative requirements for the company. The choice matters both for founders designing a compensation plan and for employees evaluating an offer. Getting it wrong creates either an unnecessary tax bill for your team or a compliance problem that surfaces at exactly the wrong moment — during fundraising or due diligence before a sale.
Stock Options: How They Work
A stock option grants the employee the right — but not the obligation — to buy a fixed number of shares at a fixed price called the strike price or exercise price. The strike price is set at the current fair market value of the company's common stock at the time of grant, established by a 409A valuation. If the company grows and the stock becomes more valuable, the employee can exercise the option, buy shares at the original strike price, and keep the spread.
The key mechanic: options have value only if the company's stock price exceeds the strike price. If the company raises at a lower valuation later (a down round), options granted at a higher strike price may be "underwater" — worth nothing until the stock recovers.
ISOs vs. NSOs
There are two types of stock options, and the distinction is significant.
Incentive Stock Options (ISOs) are available only to employees — not consultants, not advisors, not directors who are not also employees. If the employee holds the shares for more than two years from the grant date and more than one year from the exercise date, the entire gain at sale is taxed at capital gains rates, not ordinary income rates. No tax at grant, no tax at exercise (for regular income tax purposes), capital gains at sale. The catch: ISOs trigger Alternative Minimum Tax at exercise, calculated on the spread between the strike price and the fair market value at the time of exercise. In a company growing rapidly, this AMT exposure can be substantial even if the employee has not yet sold any shares.
There is also a $100,000 annual limit on ISOs that can become exercisable in any calendar year (measured by fair market value at grant). Options exceeding that limit automatically convert to NSOs.
Non-Statutory Stock Options (NSOs) are available to everyone — employees, consultants, advisors, and board members. Tax treatment is simpler but less favorable: the employee pays ordinary income tax at exercise on the spread between the strike price and the fair market value at that time, regardless of whether they have sold any shares. No capital gains treatment on the spread, but also no AMT issue. Any subsequent appreciation from exercise price to sale price is capital gains.
Most startup option plans grant ISOs to employees up to the $100,000 annual limit, then NSOs for the remainder. Grants to non-employees are always NSOs.
The Exercise Problem
Here is the practical problem most employees don't think about until they're facing it: exercising options costs money. The strike price must be paid in cash. If an employee leaves a company after four years of vesting with options at a $0.10 strike price on one million shares, they need $100,000 cash to exercise — plus potential taxes — before they can own the shares.
The standard post-termination exercise window makes this worse: most option plans allow departing employees only 90 days to exercise their vested options before they expire. An employee who cannot raise the cash in 90 days loses options earned over years. Many startups have begun offering extended exercise windows of two to five years for employees in good standing at departure. This is a meaningful benefit worth asking about when evaluating an offer.
Early Exercise
Some option plans allow employees to exercise options before they vest ("early exercise"). The employee pays the strike price on all shares up front, even unvested ones. The company retains its repurchase right on unvested shares — so if the employee leaves, the company buys back the unvested portion at the original exercise price. The advantage: if the employee files an 83(b) election within 30 days of early exercise, they pay income tax on a very small spread (or zero spread if the strike price equals fair market value at grant, which it should), and all future appreciation is capital gains. This is particularly valuable for early employees whose strike price is very low.
Restricted Stock: How It Works
Restricted stock is actual shares — not a right to buy shares, but the shares themselves — issued to the recipient at the time of grant, subject to vesting. The company has the right to repurchase unvested shares at the original purchase price if the employee leaves. Once shares vest, the company's repurchase right lapses and the employee owns them outright.
Founders always receive restricted stock, not options. The reason is timing: restricted stock is issued when the company is first formed and the fair market value is essentially zero. Founders purchase their shares at a nominal price — often fractions of a cent per share — and file an 83(b) election (more on this below) to lock in that zero-value basis. All future appreciation is capital gains from that point forward.
Tax Treatment and the 83(b) Election
Without an 83(b) election, restricted stock is taxed as it vests. Each tranche of shares that vests is treated as ordinary income equal to the fair market value of those shares at the time of vesting, minus any amount paid. For early employees and founders, this creates a predictable tax situation: if you vest 25% of your shares in year one, you owe ordinary income tax on 25% of the company's fair market value at that point.
The 83(b) election allows you to opt out of this treatment by paying tax on the full grant — all shares, vested and unvested — at the time of grant. If the company is worth essentially nothing at grant, the tax is trivial. All subsequent appreciation, even on shares that haven't yet vested, is then taxed as capital gains at sale. The catch: you must file the election within 30 days of the grant. Miss the window and you cannot go back.
This is the same 83(b) election that applies to early exercise of options and to any equity grant where there is a vesting-based forfeiture risk. The 30-day deadline is absolute. Courts and the IRS have not recognized exceptions for late filings regardless of circumstances.
Comparison: Who Gets What
| Factor | Restricted Stock | Stock Options (ISO) | Stock Options (NSO) |
|---|---|---|---|
| Typical recipient | Founders, very early employees | Employees post-seed | Consultants, advisors, employees over ISO limit |
| Tax at grant | Taxable on spread (usually zero); 83(b) recommended | None | None |
| Tax at vesting/exercise | Ordinary income on spread (unless 83(b) filed) | No regular income tax; AMT on spread | Ordinary income on spread |
| Tax at sale | Capital gains on appreciation after basis | Capital gains (if ISO holding periods met) | Capital gains on post-exercise appreciation |
| 83(b) election | Yes, strongly recommended at grant | Yes, at early exercise | Yes, at early exercise |
| AMT risk | None | Yes, at exercise | None |
The 409A Valuation
Companies granting stock options must establish the fair market value of their common stock through a 409A valuation before setting the strike price. This is a third-party appraisal — not something the board sets informally. Setting strike prices below fair market value without a defensible 409A creates immediate tax problems for employees under Section 409A of the Internal Revenue Code, which imposes a 20% penalty tax plus interest on deferred compensation that fails its requirements.
A 409A valuation should be updated whenever there has been a material change in the company's financial condition — typically after each fundraising round. Options granted between a financing and a new 409A carry some regulatory risk if the company's valuation has changed significantly.
The Practical Bottom Line
Restricted stock for founders and very early employees when the company has no material value. File the 83(b) election within 30 days of every restricted stock grant and every early exercise — no exceptions. ISOs for employees after the company has an established fair market value, subject to the $100,000 annual limit. NSOs for everyone else and for amounts exceeding the ISO cap. Get a 409A valuation before your first option grants and update it after each financing round.
The equity compensation decisions you make in the first twelve months of a company set the tax baseline for everyone who builds the business with you. Getting them right is worth the time.