If you work for a startup or tech company, equity compensation might be a significant part of your pay. Stock options can make you wealthy—or worthless—depending on how the company performs and how you manage them.
Types of Equity Compensation
Stock Options (ISOs and NSOs)
The right to BUY company stock at a set price (the "strike price" or "exercise price") in the future.
Restricted Stock Units (RSUs)
Actual shares of stock that vest over time. No purchase required.
Employee Stock Purchase Plans (ESPP)
Ability to buy company stock at a discount (usually 15%) through payroll deductions.
We will focus on options and RSUs since they are most common in compensation packages.
Stock Options: The Basics
When you receive stock options, you get:
- Number of shares — How many you can buy
- Strike price — The price you pay per share
- Vesting schedule — When you earn the right to exercise
- Expiration date — When options become worthless if not exercised
Pro Tip
Options have value only if the current stock price is ABOVE your strike price. If your strike price is $10 and the stock is trading at $8, your options are "underwater" and worthless to exercise.
Vesting Schedules
Most options vest over 4 years with a 1-year cliff:
- Year 1: 25% vest (after the "cliff")
- Years 2-4: Remaining 75% vest monthly or quarterly
If you leave before the cliff, you get nothing.
ISOs vs. NSOs
Incentive Stock Options (ISOs)
- Available only to employees
- Favorable tax treatment if you follow the rules
- No ordinary income tax at exercise (but AMT may apply)
- Gains taxed as long-term capital gains if you hold 2 years from grant and 1 year from exercise
Non-Qualified Stock Options (NSOs)
- Available to employees, contractors, advisors
- Taxed as ordinary income at exercise
- The "spread" (current price minus strike price) is taxable income
You have ISOs with a $5 strike price. The stock is now $25. If you exercise and hold properly, your $20/share gain is taxed at long-term capital gains rates (0-20%). With NSOs, that same $20 would be taxed as ordinary income (up to 37%).
The ISO Trap: Alternative Minimum Tax (AMT)
ISOs sound great, but there is a catch: the spread at exercise is a "preference item" for AMT.
Example:
- Exercise 10,000 ISOs at $5 strike
- Stock price at exercise: $50
- Spread: $45 x 10,000 = $450,000
- This $450,000 counts toward AMT calculation
Many people have been hit with massive AMT bills from exercising ISOs—sometimes owing taxes on gains they never realized because the stock later crashed.
Avoid This
Never exercise large amounts of ISOs without understanding your AMT exposure. Work with a tax professional before exercising.
RSUs: Simpler but Still Tricky
RSUs are more straightforward—you receive actual shares when they vest. No exercise decision required.
Tax treatment:
- Value at vesting is taxed as ordinary income
- Future gains are taxed as capital gains
- Your employer withholds taxes (often by selling some shares)
RSU Planning
Since RSUs are taxed at vesting, you cannot defer the tax. But you can:
- Sell immediately for
- Hold for potential future gains (risking concentration)
- Plan around high and low income years
Key Decisions with Stock Options
When to Exercise
Early exercise (before vesting): Some plans allow this. Starts the clock on long-term capital gains sooner. Risk: you could forfeit if you leave.
At vesting: Common approach. Options are earned, so no forfeiture risk.
Before expiration: Must exercise or lose them. Options typically expire 10 years from grant or 90 days after leaving the company.
Exercise and Hold vs. Exercise and Sell
Exercise and hold:
- Potential for more gains if stock rises
- Risk of stock falling
- With ISOs, qualifies for favorable tax treatment
Exercise and sell (same-day sale):
- Locks in gains immediately
- No additional capital at risk
- Taxed as ordinary income (for ISOs, loses favorable treatment)
The Concentration Problem
Many employees have too much wealth tied to their employer:
- Salary depends on the company
- Stock options depend on the company
- If the company fails, you lose both
Do This
Diversify as you vest. A common rule: do not hold more than 10-20% of your in any single stock, including your employer.
ESPP: Often Free Money
If your company offers an ESPP with a 15% discount:
- Contribute the maximum allowed
- Sell immediately after purchase
- Pocket the ~15% guaranteed return
This is one of the safest "free money" opportunities in personal finance.
Tax Strategies for Equity Compensation
For ISOs
- Calculate AMT exposure before exercising
- Consider exercising in January (gives you a year to sell if needed)
- Hold for qualifying disposition if possible
- Do not let options expire worthless
For RSUs
- Plan for the tax hit at vesting
- Consider selling for diversification
- Coordinate with other income for management
For All Equity
- Understand your company's stock performance
- Do not let emotional attachment cloud judgment
- Treat equity as part of total compensation, not a lottery ticket
When You Leave the Company
Options:
- Usually must exercise within 90 days of departure
- Unvested options are forfeited
- Need cash to exercise (strike price x shares)
RSUs:
- Unvested RSUs are typically forfeited
- Vested RSUs are yours
An employee leaves a startup with 50,000 vested options at a $2 strike price. The stock is valued at $10. To exercise, they need $100,000 cash (plus potentially $400,000 in taxes on the gain). Many people cannot afford to exercise and lose their options.
The Bottom Line
Quick Win
If you have equity compensation, create a spreadsheet tracking: grant dates, vesting schedules, strike prices, current values, and expiration dates. Review quarterly and before any job change. Understanding your equity prevents costly mistakes.
Equity compensation can be transformative wealth—or a confusing mess that leads to bad decisions. Take time to understand what you have and make informed choices.