Stock Option

A stock option is the contract granting the right to purchase common stock at a fixed strike price for a defined period. It is used as the primary equity-compensation mechanic at venture-backed startups, vesting over time (typically 4 years with a 1-year cliff) before becoming exercisable. It is the standard structure for employee equity in C-corp startups, distinct from outright stock grants because the employee must pay to convert the option into actual shares.

The mechanic of a stock option:

• Grant: the company issues the option with a defined number of shares, strike price (set by 409A valuation at grant date), vesting schedule, and expiration (typically 10 years).
• Vesting: the option vests over the vesting schedule (typically 4 years, 1-year cliff, monthly thereafter); only vested options can be exercised.
• Exercise: after vesting, the employee can pay the strike price to convert the vested option into shares. Pre-tax cost: number of vested shares times strike price.
• Post-exercise: the employee now owns common stock (not options) and can hold for capital gains treatment, sell in a secondary if permitted, or wait for an exit.
• Expiration: if not exercised within the term (typically 10 years from grant) or within the post-termination exercise window after leaving (typically 90 days), the option expires worthless.

The tax structure: incentive stock options (ISOs) are tax-advantaged for employees (no ordinary income tax on exercise, potential AMT, long-term capital gains on sale if held long enough) but are limited to $100,000 of FMV vesting per year per employee. Non-qualified stock options (NSOs) have less favorable tax treatment (ordinary income on the bargain element at exercise, capital gains on subsequent appreciation) but no annual cap and can be granted to contractors and consultants. The dilution math: when an employee exercises a vested option, the company issues new shares, slightly diluting all existing holders. The option pool is sized at the funding round to anticipate this dilution (typically 10-20% of post-money capitalization).

What founders get wrong: Treating option grants as if they're stock grants. Options require active management by the holder (exercise decisions, tax planning, AMT awareness, PTEW deadlines) and many employees lose vested equity because they don't understand the mechanics. The right discipline: include education in onboarding (1-hour session covering grant, vesting, exercise, taxes), provide exit-window flexibility where possible (extended PTEW from 90 days to multiple years for tenured employees), and make sure departing employees get clear PTEW reminders. Companies that handle this well retain employee goodwill and convert more equity into actual employee wealth.

Related: Common Stock · Option Pool · Vesting · Option Strike Price · 83(b) Election

FAQ

What is a stock option?
A contract granting the holder the right (but not the obligation) to purchase a share of common stock at a fixed price (the strike price) for a defined period (typically 10 years from grant). Used as the primary equity-compensation mechanic at venture-backed startups.

What's the difference between ISOs and NSOs?
Incentive stock options (ISOs) are tax-advantaged for employees (no ordinary income on exercise, potential AMT, long-term capital gains if held long enough) but capped at $100,000 of FMV vesting per year. Non-qualified stock options (NSOs) have less favorable tax treatment (ordinary income on the bargain element at exercise) but no annual cap and can be granted to contractors.

What happens to my options if I leave the company?
You typically have a post-termination exercise window (PTEW), usually 90 days from termination, to exercise vested options. Unexercised vested options expire after the PTEW; unvested options are forfeited. Some companies extend the PTEW (to multiple years) for tenured employees as a benefit; ask before accepting an offer if this matters to you.