Employee stock options

An employee stock option (ESO) is the right to purchase a fixed number of company shares at a fixed price (the “strike” or “grant price”) after a vesting period. The employee benefits only if the stock price rises above the strike, in which case they can exercise (buy shares) at the fixed strike and capture the difference. Options are the oldest form of equity compensation and remain common in startups, though RSUs have become more popular in large public companies.

How stock options work

An employee is granted 10,000 stock options with a strike price of $1 (the grant-date fair market value). Over 4 years, the options vest (typically 2,500 per year with a 1-year cliff). Once vested, the employee can exercise (buy shares) at any time before the options expire (usually 10 years after grant).

Scenario 1: Stock appreciates to $10.

• The employee exercises 2,500 vested options, paying $2,500 ($1 strike × 2,500 options).
• They receive 2,500 shares worth $25,000 at current market price.
• Gain: $25,000 - $2,500 = $22,500.

Scenario 2: Stock stays at $1 or declines.

• The options are worthless; the employee simply does not exercise.
• No cost, no benefit.

This is the key appeal of options: unlimited upside, zero downside. However, the tradeoff is zero guaranteed value. A grant of $10,000 worth of RSUs is worth roughly $10,000; a grant of options worth $10,000 at grant is worth zero if the stock does not appreciate.

Types of options: ISOs vs. NQSOs

Incentive Stock Options (ISOs):

• Qualify for preferential tax treatment if held long enough (2+ years from grant, 1+ year from exercise).
• Long-term capital gains on exercise gain (15–20% top rate).
• Limited to $100,000 per employee per year.
• Only available to employees (not contractors).

Non-Qualified Stock Options (NQSOs):

• Exercise gain taxed as ordinary income at the time of exercise.
• No limit on grant size.
• Available to employees, contractors, and consultants.
• Common in mature companies.

The tax difference is substantial. An employee exercising $100,000 worth of NQSO gains (options granted at $1, exercised at $11) owes ordinary income tax on $100,000 (~40%, or $40,000). The same scenario with ISOs, held for the long-term holding periods, would result in $15,000 of capital gains tax.

Strike price and underwater options

The strike price is typically set at the grant-date fair market value. For public companies, this is the closing stock price on the grant date. For private companies, it is the FMV established by the board (often set by a third-party valuation).

If the stock price declines below the strike price, the options are “underwater” — exercising would be a loss. For example, options granted at $10 when the stock later drops to $5 are worthless. Many companies refresh option grants or issue new ones to re-incentivize employees.

Exercise and vesting

Vesting is independent of exercise. An option vests over time (you earn the right to exercise it). Exercise is a separate action (you pay the strike and receive shares). You cannot exercise an option until it is vested, but you can exercise any time after vesting until expiration.

Most options expire 10 years after grant, though some have shorter terms. Private companies often shorten the exercise window (e.g., 90 days post-departure) to encourage early exercise and lock in long-term capital gains.

Cashless exercise

Most employees do not have the cash to exercise all their options when they vest. A common solution is a “cashless exercise” — the employee contacts a broker, instructs them to exercise and immediately sell enough shares to cover the exercise cost and any taxes, and nets out the gain.

For example:

• 10,000 options at $1 strike, current stock price $10.
• Cashless exercise: Broker sells 1,000 shares to cover $1,000 exercise cost, netting $9,000 to the employee.

Options in startups versus public companies

Startups heavily rely on options because they have limited cash and want to compensate employees in equity upside. Options are attractive to employees who believe in the company’s growth.

Public companies have shifted toward RSUs because the strike price needs to be set at FMV, and for a public company, the stock often appreciates after vesting, making options more valuable than RSUs. RSUs give a guaranteed value regardless of stock price appreciation.

Tax complexities

The taxation of options is intricate and varies by option type, holding periods, and exercise method. An employee who exercises ISOs must hold the shares for the long-term holding period to avoid disqualification (which triggers ordinary income tax). A careless employee who sells too early can lose the favorable tax treatment. Conversely, NQSOs are taxed at ordinary rates immediately upon exercise, and the employee can sell immediately with capital gains treatment on any future appreciation.

Options and dilution

Options represent a claim on future shares. A company that grants 1 million options to employees but has only 10 million shares outstanding is diluted by 10% fully diluted. When options are exercised, the company receives the strike price in cash (a benefit) but issues new shares (a dilution). The net effect depends on whether the strike price is less than the current stock price.