Equity Compensation for Startups

Equity compensation for startups is the practice of paying early-stage, privately held company employees partly in ownership, through incentive stock options, non-qualified stock options, restricted stock, or restricted stock units. The underlying instruments are the same ones public companies use, and the tax mechanics of each belong to their own pages. What this page covers is what is different about equity at a startup: shares that cannot be sold, a value set by appraisal rather than a market, and a set of timing decisions and risks specific to a private company that may become very valuable, be acquired, or fail entirely.

Two features shape almost every startup-equity decision. The first is that the stock is illiquid: there is no public market, so an employee generally cannot sell shares until the company is acquired or goes public, and a grant that looks valuable on paper can produce no cash for years or ever. The second is that the price is set by appraisal. A private company obtains an independent "409A valuation," named for the tax code section that penalizes options priced below fair market value, and that appraised value fixes the strike price of options and the value used for tax. Because there is no stock ticker, the gap between the low strike price of an early grant and a later, higher valuation is where the potential reward lives, and also where the tax complexity begins.

The startup setting adds decisions that a public-company employee rarely faces. Early exercise, buying option shares before they vest while the price and any spread are still low, paired with an 83(b) election filed within 30 days, can start the clock on long-term capital gains and minimize the tax on the bargain element, at the cost of putting cash at risk in a company that may fail. Startups increasingly grant double-trigger restricted stock units, which vest only when two conditions are met, a time requirement and a liquidity event such as an acquisition or IPO, so that employees are not taxed on units they cannot yet sell. Choosing between incentive stock options and non-qualified options at a startup involves trade-offs unique to the setting, including the alternative minimum tax exposure that exercising incentive options can create on a paper spread with no cash to pay it. Above all sits concentration risk: an employee's salary, a large share of net worth, and future upside can all depend on the same private company, so the paper value and the real, diversified value of that equity can be very different things. One tax benefit specific to startups is worth naming without detailing here: stock in a qualifying early-stage company may later be eligible for the qualified small business stock exclusion, whose rules and holding periods are covered on their own page.

A startup grants equity on a vesting schedule, sets option strike prices from its latest 409A valuation, and the employee makes a series of choices, whether to early-exercise, whether to file an 83(b) election, when to exercise vested options, and how much concentration to accept, against a backdrop of no near-term ability to sell.

A hypothetical illustration of the illiquidity problem: Nadia is granted options on 10,000 shares at a $1.00 strike, set by the company's 409A valuation. Two years later a funding round values the shares at $11.00, so her vested options show a $10.00-per-share paper gain, about $100,000 on paper. She still cannot turn that into cash, because there is no market for the private shares, and if she exercises she must pay $10,000 to buy them and may owe tax on the $100,000 spread with money she does not have. If the company later fails, the shares can be worth nothing. The paper figure and the spendable figure are not the same, which is the central fact of startup equity.

Pros

• Offers a share of the upside if the company succeeds, potentially far beyond the cash pay given up.
• Early grants at a low strike price, held to a liquidity event, can produce large long-term capital gains.
• Aligns employees with the company's growth.

Cons

• Illiquid: the shares usually cannot be sold until an acquisition or IPO, which may never come.
• Exercising options can create a tax bill on a paper gain with no cash to pay it, and incentive options can trigger the alternative minimum tax.
• Value is set by appraisal, not a market, so it is uncertain and can fall.
• Concentration risk is severe when salary, net worth, and upside all depend on one unproven company.