An offer letter promises 48,000 stock options. That number says little on its own. What the options are worth to the employee depends on three other terms in the grant: the strike price, the vesting schedule and the window to exercise after leaving. This guide covers employee stock options vesting and the two terms around it, with worked numbers, using US rules. Tax treatment in other countries differs.
The figures below are illustrations, not data about any real company, and this is not tax advice.
What an option is
A stock option is a right to buy a set number of company shares at a fixed price, the strike or exercise price, for a limited time. The employee pays nothing to receive it. Value appears only if the shares become worth more than the strike price, and only for the options the employee has earned and can still exercise.
The IRS sorts employee options into two groups in its Topic 427 on stock options. Incentive stock options (ISOs) and options under an employee stock purchase plan are statutory options. Everything else is a nonstatutory option, often called an NSO or NQSO. The grant notice states which type a grant is.
The strike price
For an ISO, the price is set by law. Section 422 of the US tax code (26 U.S.C. § 422) requires that “the option price is not less than the fair market value of the stock at the time such option is granted.” An employee who owns more than 10% of the company’s voting power can still get ISOs, but only at a price of at least 110% of fair market value and with a term of no more than five years.
The strike price stays fixed while the share value moves. If the strike is $1.00 and the shares are later worth $4.00, each exercised option has a $3.00 spread. If the shares are worth $0.80, the option is underwater and nobody would pay $1.00 to exercise it.
How vesting works
Vesting decides when an option becomes the employee’s to exercise. Options that have not vested are usually lost when the employee leaves.
One widely used schedule appears in form option agreements that companies have filed with the SEC, such as this grant notice: “25% of the total number of Shares subject to such Option … shall vest on the one year anniversary of the Vesting Commencement Date, and 1/48th of the total number of Shares … shall vest on each monthly anniversary … thereafter,” as long as the employee keeps working for the company. The first year is the cliff: nothing vests until the 12-month mark, then a quarter arrives at once. The grant is fully vested after four years.
Schedules are set by each company’s plan and grant, so the grant notice is the document to read. Some vest monthly from the start, some use longer or uneven schedules, and some speed up vesting if the company is sold.
Worked numbers: leaving after 30 months
Take a grant of 48,000 options at a $1.00 strike on the schedule above. The employee leaves after 30 months, when the company values its shares at $4.00.
| Options | Calculation | |
|---|---|---|
| Vested at the one-year cliff | 12,000 | 25% of 48,000 |
| Vested in months 13 to 30 | 18,000 | 18 × 1,000 (1/48 each month) |
| Vested when leaving | 30,000 | |
| Forfeited, unvested | 18,000 | |
| Cost to exercise all vested options | $30,000 | 30,000 × $1.00 |
| Spread at a $4.00 share value | $90,000 | 30,000 × ($4.00 − $1.00) |
The $90,000 is not cash. The shares of a private company usually cannot be sold freely, so the employee would pay $30,000, and possibly tax, for stock that may not be sellable for years and may fall in value. A later round with a high liquidation preference can also leave less for common stock in a sale than the headline valuation suggests.
The exercise window after leaving
The same SEC-filed form gives a departing employee three months to exercise vested options, or twelve months after death or disability. Options left unexercised after that expire. The grant’s overall term is a separate limit: an ISO cannot be exercisable more than ten years after it was granted, under section 422.
The three months matches a tax rule. To keep ISO treatment, the employee must have been employed by the company from the grant until three months before the exercise (one year for a disabled employee). Some companies extend the post-departure window to several years. That gives employees more time to decide, but under the statute an ISO exercised more than three months after employment ends no longer gets ISO tax treatment.
When tax applies
According to IRS Topic 427:
- Nonstatutory options: for most private-company options there is no tax at grant. At exercise, the employee includes in income the fair market value of the shares minus the price paid. In the example above, that is the $90,000 spread, owed without any sale to pay for it.
- Incentive stock options: generally no regular income tax at grant or exercise, but the exercise can trigger the alternative minimum tax. The employer should send Form 3921 after an ISO exercise.
- At sale: the gain is generally a capital gain. For ISO shares, that holds only if the employee keeps them at least two years from the grant and one year from the exercise, as section 422 sets out. A sale sooner turns part of the gain into ordinary income.
There is also a cap. If more than $100,000 of stock, valued at the grant date, becomes exercisable for the first time in one calendar year under ISOs, section 422 treats the excess as nonstatutory options. A large grant can therefore be part ISO and part NSO.
What to check in a grant
- Is it an ISO or an NSO grant, and is part of it over the $100,000 limit?
- What is the strike price, and what fair market value was it set from?
- When is the vesting commencement date, and is there a cliff?
- What happens to vesting if the company is sold or the employee is let go?
- How long is the exercise window after leaving, and does a longer window change ISO status?
- How many shares exist in total? A percentage tells more than an option count, and the dilution calculator shows how later rounds shrink it.
Early investors handle the same problem with pro rata rights, which let them buy into later rounds to keep their percentage.
