Stock Options (Startup)
What are startup stock options?
Stock options are a contractual right to purchase company shares at a predetermined strike price at a future date. For startups, options are granted from an employee option pool. The two most common types are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). IRS Section 422 governs ISO eligibility and tax treatment.
How do ISOs and NSOs differ for startup employees?
| Feature | ISO vs NSO |
|---|---|
| Who can receive | ISOs: employees only. NSOs: anyone including contractors and advisors |
| Tax at exercise | ISO: no ordinary income tax (AMT may apply). NSO: spread taxed as ordinary income |
| Tax at sale | ISO: long-term capital gains if holding periods met. NSO: further gain above exercise price is capital gain |
| $100K annual limit | ISOs are capped at $100K vesting per year at grant FMV. Excess automatically becomes NSO |
Under IRC Section 422, ISOs must be exercised within 90 days of leaving the company or they convert to NSOs and lose preferential tax treatment. Many early employees lose significant value simply by missing this window after departure.
What is the 83(b) election and why does early exercise matter?
Employees with early exercise rights (the ability to purchase unvested shares) can file an 83(b) election with the IRS within 30 days of exercise. This starts the capital gains holding period immediately and is taxed on the current spread (often near zero at pre-seed). Missing the 30-day window is irreversible.
How do ISOs and NSOs differ in tax treatment at exercise?
ISOs (Incentive Stock Options) are only available to employees and offer preferential tax treatment: no ordinary income tax at exercise (though the spread may trigger AMT), and long-term capital gains treatment on any gain if shares are held for at least 2 years from grant and 1 year from exercise. NSOs (Non-Qualified Stock Options) trigger ordinary income tax on the spread between strike price and fair market value at the time of exercise, regardless of when the shares are sold. For a typical employee exercising NSOs with a $0.10 strike and $5.00 FMV, the $4.90 spread is taxable income in the year of exercise even if the shares cannot be sold. ISOs are generally better for employees; NSOs are required for advisors and non-employee service providers.
What is early exercise and why does it matter for tax planning?
Early exercise allows employees to purchase unvested shares at the current low strike price before the fair market value increases, converting what would be ordinary income on exercise to long-term capital gain on the eventual sale. The purchased unvested shares are subject to a right of repurchase by the company (at the original purchase price) until they vest, so the employee takes no economic risk beyond the cash paid for the shares. To lock in the tax benefit, the employee must file an 83(b) election with the IRS within 30 days of the early exercise date. The election notifies the IRS that the employee is choosing to be taxed now (on the near-zero spread) rather than at vesting. Missing the 30-day window is irreversible. For employees at seed-stage companies where the 409A strike price is low, early exercise with a timely IRS 83(b) election is one of the most valuable tax planning actions available.
What do founders and employees get wrong with stock options?
The most common mistake for employees is not exercising ISOs before leaving the company. ISOs expire 90 days after termination of employment. An employee who vested 200,000 options over 4 years and resigns must exercise within 90 days or forfeit all vested options. In many cases the exercise price is significant (especially at later-stage companies), and employees who cannot afford to exercise lose their entire equity position on departure. Some companies have extended exercise windows to 5 or 10 years to address this; founders should consider this when designing option plan terms.
A second error is not modelling the AMT impact before exercising a large block of ISOs. For high-value ISO grants, the spread at exercise is an AMT preference item that can generate an AMT liability even when no shares have been sold. An employee exercising $2M worth of ISOs in a single year may owe $200,000 to $400,000 in AMT with no cash proceeds from a sale to fund the payment. Employees should model the AMT impact before exercising, especially in the year of an acquisition.
Third: founders often misunderstand the 409A valuation requirement before option grants. Every option grant must be priced at or above the 409A fair market value as of the grant date. Grants made before a 409A valuation is completed, or after a material event that renders the existing 409A stale, expose the company to IRS penalties and expose employees to immediate ordinary income tax on the full option value. A valid 409A must be in place before any grant is authorised.
How it works in practice
Case example: First engineering hire, Series A company
A SaaS startup hires its first senior engineer 8 months after founding. The offer includes 48,000 ISOs (0.4% of fully diluted shares) at a $0.10 strike price (409A FMV at time of grant), vesting over 4 years with a 1-year cliff.
At the 1-year cliff, 12,000 shares vest. The company has just closed Series A at a $12M post-money; the 409A has been refreshed to $0.80 per common share. The engineer exercises all 12,000 vested ISOs at $0.10, paying $1,200 and receiving shares currently worth $9,600. No ordinary income tax at exercise for ISOs, but $8,400 of spread is an AMT preference item.
Three years later at a $60M acquisition, the engineer's 48,000 shares (all vested) are worth $288,000 at $6/share. Strike price cost: $4,800. Long-term capital gain (held over 2 years): $283,200. If they had received NSOs instead, the $6/share gain above the $0.10 strike would have been taxed as ordinary income, a difference of roughly $60,000 in tax at the 37% federal rate.
Frequently asked questions
How much equity should a startup employee option be worth?
This depends on role, stage, and joining timing. Seed-stage engineering hires typically receive 0.1% to 0.5% of fully diluted shares. Series A engineering hires typically receive 0.05% to 0.2%. Post-Series B hires receive smaller percentages as the company valuation grows but also carries less risk.
Can I exercise my options before they vest?
Only if your option plan allows early exercise. Many standard option plans do not include this feature. Early exercise with an 83(b) election can significantly reduce the eventual tax bill if the company appreciates, but involves paying the strike price for unvested shares that could lapse if you leave.
What happens to my unvested options if the company is acquired?
The acquisition agreement governs this. Common outcomes: single-trigger acceleration (all unvested shares vest immediately on acquisition), double-trigger acceleration (unvested shares vest only if the employee is also terminated without cause), or substitution (acquirer replaces grants with equivalent equity in the acquiring company).
What is the $100K ISO limit and what happens when it is exceeded?
Under IRS rules, no more than $100K worth of options (measured at grant FMV) can vest in any single calendar year as ISOs. Anything above this automatically becomes NSOs, losing the preferential tax treatment. This typically affects senior hires with large grants at higher-valued companies.
What is the 90-day exercise window and why does it matter so much?
When an employee leaves a company, their vested ISOs must be exercised within 90 days or they expire and are cancelled. After 90 days, ISOs automatically convert to NSOs (losing the preferential tax treatment), and most plans then require exercise within a total of 5 to 10 years from grant. Many departing employees who leave after a multi-year tenure cannot afford to exercise their options (especially at later-stage companies with high strike prices) and lose their entire equity position on departure. Companies can and should consider extending this window to 5 or 10 years to prevent this outcome.
Related glossary terms
- Option Pool, the equity reserve from which all stock option grants are made
- Advisory Shares, equity grants to advisors, typically NSOs from the same option pool
- Vesting Cliff, the minimum tenure required before any options from a grant begin to vest
Explore related Fintera content
- Fractional CFO for Startups: The 2026 Playbook, how a fractional CFO sets up compliant option plans and 409A valuations before the first grant
- When to Hire a CFO: 9 Signs It's Time, when equity complexity warrants bringing in senior finance leadership
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