A practical guide to employee stock options (and which types your startup should issue)

If you want to attract top talent to your startup, it’s important to think beyond salary when creating total compensation packages. Employees are likely also looking for benefits or equity — often in the form of stock options. 

Although equity plays a central role in early-stage hiring, it’s often misunderstood. When used well, it helps you attract talent without spending too much cash. If used poorly, it can confuse your team and cost you more ownership than you expected.

To make smart decisions, you’ll need a clear understanding of how employee stock options work. This guide breaks down: 

• The basics of employee stock options
• Key terms every founder should know
• What strike price actually means
• How options compare to restricted stock units (RSUs)
• Types of equity for startup employees
• Stock option pros and cons
• How to choose the right structure for your stage
• Practical employee equity considerations 

If you’re an early founder, you might be wondering, “What is an employee stock option, and how does it work?” So, let's start with the basics: An employee stock option gives someone the right, but not the obligation, to buy company shares at a fixed price in the future.

The company sets the rules for when those shares can be purchased. If the company’s value exceeds the fixed price, the employee may be able to buy shares at a price below their current market value. If the company’s value stays stagnant, the option might not increase in value at all.

To fully understand stock options, you’ll first need to understand the language around them. If you can’t answer the question, “What is strike price in employee stock options?,” here’s a quick glossary to get you started:

• Strike price: This is the amount an employee must pay to purchase each share.
• Vesting schedule: This determines when employees earn the right to buy shares. A vesting schedule is usually spread out over several years.
• Cliff: This is the minimum period of time an employee must work before their options vest.
• Exercise: When an employee buys vested shares at the strike price, this is called exercising. To exercise vested shares, the employee is usually required to pay cash to the company.
• Expiration: This is the deadline to exercise vested options. For incentive stock options (ISOs), employees have a limited window after leaving the company to maintain ISO tax treatment.
• Dilution: When new shares are issued, other shareholders’ ownership percentages are reduced.
• 409A valuation: When you’re issuing options, 409A valuation determines the fair market value of your common shares for tax purposes.
• Capitalization (cap) table: The cap table lists who owns shares in your company and how much each person owns.

Now that you understand the key terms, let’s take a closer look at one that matters most: strike price. This is what determines whether your options actually have value for employees. Since this is the price the employee must pay to buy the shares, their financial gain depends on the gap between that price and the company’s future value.

So, how are strike prices set? For private companies, stock options are generally granted at or above the fair market value of common shares. This is required by Section 409A of the Internal Revenue Code. The market value is determined through a 409A valuation, which is an independent appraisal of what your common shares are worth at a specific point in time.

For example, if your most recent 409A values common shares at $2 each, you’ll typically grant new options with a $2 strike price. If you grant options below fair market value, you risk significant tax penalties.

Since the strike price follows your company’s valuation, timing is important. Early hires usually get options when valuations are lower, so they have a better chance of financial gain if the company grows. As you raise capital and your valuation goes up, future hires will get options with higher strike prices.

Stock options aren’t the only way to grant equity. Another common alternative is restricted stock units (RSUs).

RSUs work differently from stock options. When RSUs vest, the company automatically delivers shares, without employees paying the strike price. The IRS treats the value of those shares as ordinary income at vesting. 

Timing, taxes, and risk are the main differences to consider when comparing employee stock options vs. RSUs. With options, employees choose whether to exercise, and when. With RSUs, shares are automatically transferred  when they vest. 

Early-stage startups typically use stock options. Later-stage private and public companies more often use RSUs, especially when share values are more established and liquidity is closer.

Beyond choosing between options and RSUs, founders also need to understand the specific types of equity they can offer.

Startups typically use one of four types of equity compensation. Each one changes who can receive equity, when taxes apply, and how much administration is required.

Here’s a breakdown of each type of equity for startup employees:

• Incentive stock options (ISOs): Companies can grant ISOs to employees. If employees meet certain holding requirements, they may qualify for capital gains tax treatment, instead of paying ordinary income tax on the profit.
• Non-qualified stock options (NSOs): Companies can grant NSOs to employees, contractors, and advisors. When someone exercises NSOs, they generally pay ordinary income tax on the difference between the strike price and the share value.
• Restricted stock units (RSUs): Companies automatically issue shares when RSUs vest. The IRS treats the value of those shares as ordinary income at that time. 
• Restricted stock: Companies issue restricted stock shares upfront, subject to vesting. Founders and very-early hires often receive restricted stock when the company’s valuation is still low.

The right choice depends on your company’s stage, who you’re granting equity to, and how much complexity you’re prepared to manage.

For founders, stock options help conserve cash. You can offer competitive compensation without increasing salary expenses. Vesting schedules also encourage employees to stay with the company over time. 

However, each option granted increases the total number of shares outstanding, which reduces each existing shareholder's ownership percentage. As you hire more employees, your cap table becomes more complex and requires ongoing management. 

For employees, stock options can create substantial financial gain if the company’s value increases. But exercising requires paying the strike price, and employees may wait years before they can sell their shares. If the company never grows beyond the strike price, there’s no financial return. 

Stock options reward employees if the company succeeds, but they also mean employees take on the risk if it doesn’t.

To put all of this in context, it helps to understand how startup equity compares to public company equity.

At the earliest stages, most startups grant ISOs to employees. ISOs limit eligibility to employees, and may qualify for capital gains tax treatment, if holding requirements are met.

As you hire contractors or advisors, you’ll likely use NSOs. Federal tax rules restrict ISOs to employees, so NSOs cover everyone else.

As your company grows and valuations increase, the strike price on new option grants will also rise. Later hires may receive options with less room for financial gain than earlier employees. 

At later stages, especially when an acquisition or initial public offering (IPO) becomes more likely, some companies introduce RSUs. With RSUs, employees don’t have to pay the strike price. Employees pay taxes at vesting based on the shares' value at that time.

When you’re ready to choose a type of equity for your employees, your company’s stage, hiring plan, cash position, and willingness to dilute ownership should guide your decision.

Before you issue any equity, make sure your legal, financial, and communication basics are in place. Small mistakes here can create tax exposure, cap table complications, or confusion that’s difficult to fix later.

Take these steps before granting equity to your employees:

1. Confirm that your 409A valuation is current. Granting options at a price below fair market value can create tax consequences.
2. Plan your option pool in advance. Every grant affects your capitalization table and reduces existing ownership percentages.
3. Document grants clearly, so employees understand vesting, expiration deadlines, tax treatment, and the timeframes for when they can sell shares.

Employee equity shapes who will benefit from your company’s future value. The structure you choose affects taxes, dilution, and hiring flexibility. 

As your team grows, equity decisions intersect with payroll, cash flow, and financial planning. Learn how Mercury supports the financial operations behind equity decisions. 

This article is for informational purposes only and does not constitute legal, tax, investment, or financial advice. Founders should consult their own legal and financial advisors before making capital or financing decisions.