Employee Equity Plans: A Founder's Playbook for Stock Options & Vesting

Equity is the fuel of the startup ecosystem. It aligns incentives, attracts top talent when cash is tight, and gives employees a tangible stake in the company's success. But for founders, designing an employee equity plan can feel like navigating a minefield of legal jargon, tax codes, and market conventions.

This guide provides a crisp, practical playbook for designing and communicating employee equity—what to grant, how it vests, and the key legal and tax guardrails you can’t ignore.

Disclaimer: This guide is U.S.-centric and for informational purposes only. It is not legal or tax advice. Always coordinate with your legal counsel and CPA to tailor a plan that fits your specific circumstances.

The Building Blocks 🧱​

Before diving into strategy, it's crucial to understand the fundamental components of any equity plan. These are the instruments and terms that form the basis of every grant you'll make.

Equity Instruments​

You have several tools at your disposal, each with different use cases and tax implications.

• Stock Options: These give an employee the right, but not the obligation, to purchase a set number of shares at a predetermined price (the "strike price").

  • Incentive Stock Options (ISOs): Available only to employees, ISOs offer potential tax advantages. If specific holding periods are met, the gains can be taxed at the lower long-term capital gains rate. However, they are subject to strict rules, including a $100,000 per-year limit on the value of stock that can first become exercisable and tight post-termination exercise windows.
  • Non-Qualified Options (NSOs): A more flexible tool, NSOs can be granted to employees, directors, advisors, and contractors. The downside is less favorable tax treatment; the "spread" between the Fair Market Value (FMV) at exercise and the strike price is taxed as ordinary income to the recipient upon exercise.

• Restricted Stock Units (RSUs): An RSU is a promise from the company to deliver shares at a future date, typically upon meeting certain vesting conditions. Unlike options, the employee doesn't pay to acquire the shares. RSUs are generally taxed as ordinary income when they vest and are delivered. Crucially, RSUs are not eligible for an 83(b) election.

• Restricted Stock Awards (RSAs): An RSA is a grant of actual shares of stock that are subject to a vesting schedule. If the employee leaves before they are fully vested, the company has the right to repurchase the unvested shares. RSAs are most common for founders and very early hires when the company's FMV is low or near zero.

Key Terms​

• Strike Price / Exercise Price: This is the fixed price per share an employee pays to purchase the stock when they exercise their options. For compliance and tax reasons, this price must be set at or above the company's FMV on the date the options are granted.

• 409A Valuation: This is an independent appraisal of your company's common stock to determine its FMV. Relying on a formal 409A valuation creates a safe harbor with the IRS, protecting the company from claims that it granted "discounted" options. This valuation is typically valid for 12 months, unless a material event (like a new financing round) occurs.

• 409A Compliance: Internal Revenue Code Section 409A governs non-qualified deferred compensation. Granting options with a strike price below the FMV at the time of grant is a major violation. The penalties are severe, including immediate income inclusion for the employee on all vested awards and an additional 20% federal tax, plus potential state penalties.

• Rule 701: This is an SEC exemption that allows private companies to issue securities as compensation to their service providers without the need for a full public registration. However, if your company issues more than $10 million in securities under Rule 701 within a 12-month period, you are required to provide enhanced financial and risk disclosures to all recipients.

Vesting, Cliffs, and Acceleration 🗓️​

Vesting ensures that employees earn their equity over a period of continued service, aligning their long-term interests with the company's.

Default, Clean-and-Simple Vesting​

The undisputed industry standard for employee grants is 4-year vesting with a 1-year cliff. Here’s how it works:

• The 1-Year Cliff: An employee must stay with the company for one full year to receive their first portion of equity (typically 25% of the total grant). If they leave before the one-year mark, they get nothing.
• Monthly Vesting Thereafter: After the cliff, the remaining 75% of the grant vests in equal monthly installments over the next three years.

This structure is simple, predictable, and well-understood by employees, founders, and VCs alike.

Acceleration on Change of Control​

Acceleration clauses dictate what happens to unvested equity if the company is acquired.

• Single-Trigger Acceleration: Vesting automatically accelerates upon a single event: the change of control (acquisition) itself. This is less common for broad-based plans because it can reduce the incentive for key employees to stay on with the acquiring company.
• Double-Trigger Acceleration: Vesting accelerates only if two distinct events occur: (1) a change of control and (2) a qualifying termination of the employee's employment (e.g., termination without cause or resignation for "good reason") within a certain period after the deal closes. This is the preferred structure for investors and acquirers as it helps retain key talent, while still offering protection to the employee.

Picking the Right Vehicle at Each Stage 🚀​

The best equity instrument often depends on your company's stage and valuation.

Pre-seed/Seed Stage​

• Default to options. Use ISOs for employees to offer potential tax advantages and NSOs for non-employees like advisors and contractors. The low strike price at this stage makes options an attractive and powerful incentive.
• Use RSAs for founders and perhaps the first handful of hires when the FMV is negligible. This allows them to file an 83(b) election and start the clock on long-term capital gains treatment.
• Consider early exercise (allowing employees to exercise options before they vest) only if you have the operational bandwidth to educate employees on the 83(b) election and track the company's repurchase rights meticulously.

Growth/Pre-IPO Stage​

• As your valuation climbs, the strike price on new option grants can become prohibitively high. At this point, consider switching to RSUs for senior or specialized roles. Since employees don't pay to acquire RSU shares, they hold value even if the company's stock price doesn't increase dramatically.
• For private companies, it's critical to use double-trigger RSUs. This structure ties vesting to both a time-based schedule and a future liquidity event (like an IPO or acquisition). This aligns the employee's tax burden with their ability to sell shares and cover the tax bill, avoiding a scenario where employees owe significant taxes on illiquid stock.

Taxes You Must Design Around (And Explain Clearly) 💸​

Tax compliance is non-negotiable. Designing your plan around these key tax rules will save you and your employees from major headaches.

• 83(b) Election (for RSAs & Early-Exercised Options): An 83(b) election allows a recipient of stock that is subject to vesting (i.e., RSAs or early-exercised options) to pay taxes on the value of that stock upfront, at the time of grant. This is advantageous when the value is low. The filing window is an ironclad 30 days from the stock transfer date. If missed, the employee will be taxed on the value of the shares as they vest, which could be a much higher amount. Note: An 83(b) election does not apply to standard options or RSUs.

• ISOs: To receive favorable ISO tax treatment, the employee generally must exercise the option within 3 months of their termination date (or 1 year in the case of disability). While a company can extend this window, any exercise after the 3-month mark causes the option to be treated as an NSO for tax purposes. Additionally, be mindful of the $100,000 limit: only the first $100,000 worth of stock (valued at grant) that becomes exercisable for an employee in a given calendar year can qualify as an ISO. Any excess is automatically treated as an NSO.

• 409A: The surest way for options to avoid the harsh penalties of Section 409A is to ensure the strike price is at least the FMV on the grant date. This is why maintaining a 409A safe-harbor valuation is critical. Be wary of modifications; extending the post-termination exercise period while an option is "in-the-money" (FMV > strike price) can be deemed a modification, potentially triggering 409A issues. A 409A failure can cause immediate income inclusion of all vested awards plus a 20% additional federal tax.

• RSUs: RSUs are generally taxed as ordinary income at vesting and delivery. As mentioned, double-trigger RSUs are the go-to for private companies to defer this taxable event until a liquidity event occurs.

• Securities Compliance (Rule 701): Diligently track the value of equity granted under Rule 701. If you cross the $10 million threshold in a rolling 12-month period, you must provide specific financial statements and risk disclosures to all award recipients.

Option Plan Mechanics That Just Work ⚙️​

Standardizing your plan's core mechanics creates fairness and administrative simplicity.

Plan and Approvals​

Your Equity Incentive Plan is the formal legal document governing all grants. It must be approved by the Board of Directors and typically by stockholders as well. The Grant Date for any specific award is the date the board formally approves it, and the strike price is set based on the 409A valuation in effect on that day.

Terms to Standardize​

• Term: Options should expire no later than 10 years from the grant date. For ISOs granted to 10%+ shareholders, the term is limited to 5 years.
• Post-Termination Exercise Period (PTEP): A 90-day window is standard and aligns with the rules for preserving ISO tax status. Longer windows are possible, but remember that (a) exercises after 90 days are taxed as NSOs, and (b) extending the window while options are in-the-money carries 409A modification risk.
• Exercise Methods: Offer multiple ways to exercise, such as a cash payment or a net exercise, where the company withholds shares to cover the exercise price and potentially taxes.

Early Exercise (Optional)​

• Pros: Allowing employees to exercise options before they vest starts the clock earlier for long-term capital gains and Qualified Small Business Stock (QSBS) treatment. It also enables them to file an 83(b) election when the tax impact is minimal.
• Cons: It adds administrative complexity. You must educate employees on the 83(b) process, track the company's right to repurchase unvested shares, and clearly communicate that the company does not file the 83(b) election on their behalf.

A Founder/Board Checklist ✅​

Use this checklist to ensure your equity plan is built on a solid foundation.

• Decide on Instruments:
  • Early Stage: Default to ISOs/NSOs. Use RSAs for founders.
  • Late Stage: Consider adding double-trigger RSUs for key hires.
• Set Vesting Policy:
  • Make 4 years, 1-year cliff, monthly thereafter your company-wide default.
• Codify Change-of-Control:
  • Use double-trigger acceleration for executives. Avoid broad single-trigger grants.
• Implement Operational Guardrails:
  • Maintain a current 409A valuation and document the FMV for every grant.
  • Track your Rule 701 issuance totals monthly.
  • Include clear 83(b) instructions and highlight the 30-day deadline in every RSA or early-exercise grant packet.
  • Standardize your post-termination exercise policy in your plan documents.

Common Pitfalls (And How to Avoid Them) ⚠️​

• Discounted Options: This can trigger a 409A disaster. Avoid it by always tying the strike price to a current 409A valuation and documenting it.
• Casual Exercise Window Extensions: This can be a 409A modification. Avoid it by getting sign-off from legal counsel before implementing any broad extensions.
• Missed 83(b) Filings: This can create a massive, unexpected tax bill for your employee. Avoid it by over-communicating the 30-day deadline and providing clear instructions.
• Confusing RSUs and 83(b): RSUs are not eligible for an 83(b) election. Avoid it by educating managers and candidates on the distinction.
• Ignoring Rule 701: Crossing the $10M threshold without the required disclosures can lead to regulatory trouble. Avoid it by tracking your issuance totals diligently.

Final Note​

Equity is more than just compensation—it’s a statement about your company culture. It signals ownership, trust, and shared ambition. By keeping your documents clean, your rules predictable, and your communication continuous, you can build a plan that works for everyone from new grads to C-level executives—without surprising your board, your auditor, or the IRS.