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README

# The Open Guide to Equity Compensation

❇️ *This guide is now [published on Holloway](https://www.holloway.com/g/equity-compensation/about).
Read it there for search, booksmarks/highlights, expert commentary, and PDF/EPUB download.*

## Introduction

**Equity compensation** is the practice of granting partial ownership in a company in
exchange for work.
In its ideal form, equity compensation aligns the interests of individual employees with
the goals of the company they work for, which can yield dramatic results in team building,
innovation, and longevity of employment.
Each of these [contributes](#history-and-significance) to the creation of value—for a
company, for its users and customers, and for the individuals who work to make it a
success.

The [ways equity can be granted](#how-equity-is-granted) as compensation—including restricted
stock, stock options, and restricted stock units—are **notoriously complex**. Equity
compensation involves confounding terminology, legal obscurities, and many high-stakes
decisions for those who give and receive it.

If you talk to enough employees and hiring managers, you’ll hear stories of how they or
their colleagues met with the painful consequences of not learning enough up front.
Though many people learn the basic ideas from personal experience or from colleagues or
helpful friends who have been through it before, the intricacies of equity compensation
are best understood by tax attorneys, corporate lawyers, and other professionals.

Decisions related to [negotiating an offer](#offers-and-negotiations) and
[exercising stock options](#stock-option-scenarios), in particular, can have **major financial
consequences**. Because the value of employee equity is determined by the fate of the
company, an employee’s equity may be [illiquid](#what-is-private-stock-worth) for a long time
or ultimately [worth nothing](#growth-and-risk), while taxes and the costs of exercise, if
they apply, may not be recouped.
Even when a company is doing well, an employee may suffer
[catastrophic tax pitfalls](#tax-dangers) because they didn’t anticipate the tax consequences
of their decisions.

Understanding the technicalities of equity compensation does not guarantee that fortune
will smile upon you as warmly as it did [the early hires](#history-and-significance) of
Facebook. But a thorough overview can help you be informed when
[discussing with professionals](#seeking-professional-advice) for further assistance, make
better decisions for your personal situation, and avoid some [common](#tax-dangers) and
[costly](#the-amt-trap) mistakes.

### Why This Guide?

The first edition of this work, written by the same lead authors as the one you’re reading
now, received significant feedback and discussion
[on Hacker News](https://news.ycombinator.com/item?id=10880726),
[on GitHub](https://github.com/jlevy/og-equity-compensation), and from individual experts.
Now, Holloway is pleased to publish this new edition of the Guide.
We’ve expanded sections, added resources and visuals, and filled in gaps.

There is [a lot of information](#further-reading) about equity compensation spread across
blogs and articles that focus on specific components of the topic, such as vesting, types
of stock options, or equity levels.
We believe there is a need for a consolidated and shared resource, written by and for
people on different sides of compensation decisions, including employees, hiring managers,
founders, and students.
Anyone can feel overwhelmed by the complex details and high-stakes personal choices that
this topic involves.
This reference exists to answer the needs of beginners and the more experienced.

Holloway and our contributors are motivated by a single purpose:
To help readers understand important details and their contexts well enough to make better
decisions themselves.
The Guide aims to be **practical** (with concrete suggestions and pitfalls to avoid),
**thoughtful** (with context and multiple expert perspectives, including divergent opinion on
controversial topics), and **concise** (it is dense but contains only notable details—still,
it’s at least a three-hour read, with links to three hundred sources!).

The Guide does not purport to be either perfect or complete.
A reference like this is always in process.
That’s why we’re currently testing features to enable the Holloway community to suggest
improvements, contribute new sections, and call out anything that needs revision.
We welcome (and will gladly credit) [your help](#please-help).

We especially wish to [recognize](#credits) the dozens of people who have helped write,
review, edit, and improve it so far—and in the future—and hope you’ll check back often as
it improves.

### Scope

This Guide **currently covers**:

- Equity compensation in **C corporations** in the **United States**.
- Equity compensation for most employees, advisors, and independent contractors in private
companies, from startups through larger private corporations.
- Limited coverage of equity compensation in public companies.

Topics **not yet covered**:

- Equity compensation programs, such as [ESPPs](https://www.investopedia.com/terms/e/espp.asp)
in public companies.
(We’d like to [see this improve](#please-help) in the future.)
- Full details on executive equity compensation.
- Compensation outside the United States.
- Compensation in companies other than C corporations, including
[LLCs](https://en.wikipedia.org/wiki/Limited_liability_company) and
[S corporations](https://en.wikipedia.org/wiki/S_corporation), where equity compensation is
approached and practiced in very different ways.

For these situations, see [other resources](#when-to-turn-elsewhere) and get
[professional advice](#seeking-professional-advice).

### Who May Find This Useful

Our aim is to be as helpful to the beginner as to those with more experience.
Having talked with employees, CEOs, investors, and lawyers, we can assure you that no
matter how much you know about equity compensation, you will likely run into confusion at
some point.

If you’re an **employee** or a **candidate for a job**, some of these may apply to you:

- You’ve heard phrases like *stock*, *stock options*, *strike price*, *ISOs*, *RSUs*, *83(b)
election*, *409A valuation*, *AMT*, or *early exercise* and know they are probably
important but are mystified by what some of them really mean or whether they apply to your
situation.
- You’re considering a job offer but don’t know how to
[navigate or negotiate](#offers-and-negotiations) the equity component of the offer.
- You’re joining a startup for the first time and are overwhelmed by all the
[paperwork](#documents-and-agreements).
- You’re quitting, taking a leave of absence, or are being laid off or fired from a company
where you have stock or options and are thinking through the decisions and consequences.
- A company you work for is going through an acquisition, IPO, or shutdown.
- You have stock in a private company and [need cash](#stock-option-scenarios).

**Founders** or **hiring managers** who need to talk about equity compensation with employees
or potential hires will also find this Guide useful.
As many entrepreneurs and hiring managers will tell you, this topic isn’t easy on that
side of the table, either!
Negotiating with candidates and fielding questions from candidates and employees requires
understanding the same complex technicalities of equity compensation well.

That said, this topic is **not simple** and we ask that readers be willing to invest time to
get through a lot of confusing detail.
If you’re in a hurry, or you don’t care to learn the details, this Guide may not be for
you. [Seek advice](#seeking-professional-advice).

### A Note on Fairness

Much of what you read about equity compensation was written by a single person, from a
single vantage point.
The authors and editors of this Guide have navigated the territory of equity compensation
from the perspective of employees, hiring managers, founders, and lawyers.
We do believe that the knowledge here,
[combined with professional advice](#seeking-professional-advice), can make a significant
difference for **both employees and hiring managers**.

One of the difficulties for candidates negotiating equity compensation is that they may
have less information about what they are worth than the person hiring them.
Companies talk to many candidates and often have access to or pay for expensive
market-rate compensation data.
While some data on [typical equity levels](#typical-employee-equity-levels) have been
published online, much of it fails to represent the value of a candidate with their own
specific experience in a specific role.
However, even without exact data, candidates and hiring managers can develop better mental
frameworks to think about [offers and negotiations](#offers-and-negotiations).

On the other hand, challenges are not limited to those of employees.
Founders and hiring managers also often struggle with talking through the web of
technicalities with potential hires, and can make equally poor decisions when making
offers. Either over-compensating or under-compensating employees can have unfortunate
consequences.

In short, both companies and employees are routinely hurt by uninformed decisions and
costly mistakes when it comes to equity compensation.
A shared resource is helpful for both sides.

## Roadmap

### The Holloway Reader

The Holloway Reader you’re using now is designed to help you find and navigate the
material you need. **Use the search box.**
It will reveal definitions, section-by-section results, and content contained in **the
hundreds of resources we’ve linked to** throughout the Guide.
Think of it as a mini library of the best content on equity compensation.
We also provide mouseover (or short tap on mobile) for **definitions of terms**, related
section suggestions, and external links while you read.

### How This Guide Is Organized

This Guide contains a lot of material.
And it’s dense.
Some readers may wish to read front to back, but you can also **search or navigate directly**
to parts that are of interest to you, **referring back** to foundational topics as needed.

Equity compensation lies at the intersection of corporate law, taxation, and employee
compensation, and so requires some basic understanding of all three.
You might think compensation and taxation are separate topics, but they are so intertwined
it would be misleading to explain one without the other.
We cover material in logical order, so that if you do read the earlier sections first,
later sections on the interactions of tax and compensation will be clearer.

We start with [**Equity Compensation Basics**](#equity-compensation-basics): What compensation
and equity are, and why equity is used as compensation.

But before we get much further, we need to talk about what stock is, and how companies are
formed. [**Fundamentals of Stock Corporations**](#fundamentals-of-stock-corporations) covers how
companies organize their ownership, how stock is issued, public companies and private
companies, and IPOs and liquidity (which determine when equity is worth cash).

While not everyone reading this works at an early stage company, those who do can benefit
from understanding the role of equity in [**Startups and Growth**](#startups-and-growth). This is
good context for anyone involved in a private company that has taken on venture capital.

[**How Equity is Granted**](#how-equity-is-granted) is the core of this Guide.
We describe the forms in which equity is most commonly granted, including restricted stock
grants, stock options, and RSUs.

Now is where it gets messier—taxes:

- [**Tax Basics**](#tax-basics): A technical summary of how taxation works.
Many of the headaches of equity compensation involve how it is taxed, including ordinary
income tax, long-term capital gains tax, and the lesser-known but sometimes critical
alternative minimum tax.
- [**Taxes on Equity Compensation**](#taxes-on-equity-compensation): How much tax you owe is greatly
affected by the kind of equity you have (such as restricted stock awards, stock options,
or RSUs), when you choose to pay (including 83(b) elections), and when you choose to
exercise options.

After these technical concerns, we move on to how you can think about all this in
practice. These sections focus on scenarios common to employees and candidates, but are
also of likely interest to founders and hiring managers:

- [**Plans and Scenarios**](#plans-and-scenarios): Whether you have equity now or will in the
future, it is helpful to learn *how to think about* the value of equity and its tax
burden. We also cover whether you can [sell private stock](#can-you-sell-private-stock).
- [**Offers and Negotiations**](#offers-and-negotiations): Equity often comes up as you’re
negotiating or debating whether to accept a job offer.
Here we cover what to expect, what to ask, tips and pitfalls, and more.

Finally, we offer some additional resources:

- [**Documents and Agreements**](#documents-and-agreements): A bit more detail on the actual legal
paperwork you’re likely to see as you negotiate and after you’ve accepted an offer.
- [**Further Reading**](#further-reading): A curated list of what else you can read on the subject,
including many papers, books, and articles that have informed this Guide.

🚧 What about a Getting Help section outlining when to go to whom for professional help?

### When to Turn Elsewhere

**CEOs**, **CFOs**, **COOs**, or anyone who runs a company or team of significant size should be
sure to talk to an equity compensation consultant or a specialist at a law firm to learn
about equity compensation plans.

**Founders** looking for an introduction to the legalities of running a company may wish to
check out [*Legal Concepts for Founders*](https://handbook.clerky.com/), from Clerky, in
addition to talking to a lawyer.
Founders should also lean on their investors for advice, as they may have additional
experience.

**Executive compensation** at large or public companies is an even more nuanced topic, on
both sides of the table.
Hire an experienced lawyer or compensation consultant.
There are extensive legal [resources](https://www.compensationstandards.com/home/) available
on executive compensation.

### Seeking Professional Advice

This Guide does not replace professional advice.

Please read the full [disclaimer](#disclaimer) and seek professional advice from a lawyer,
tax professional, or other compensation expert before making significant decisions.

Does that make reading through these details a waste of time?
Not at all. Important decisions rarely should or can be blindly delegated.
This Guide *complements but does not replace* the advice you get from professionals.
Working with the support of a professional can help you make better decisions when you
have an understanding of the topic yourself and know what questions to ask.

## Equity Compensation Basics

### History and Significance

Companies ranging from two-person startups to the
[Fortune 500](http://fortune.com/fortune500/) have found that granting partial ownership in a
company is among the best methods to attract and retain exceptional talent.
In the United States, partial ownership through [stock options](#stock-options) has been a
key part of pay for executives and other employees since the 1950s.[^corpgovlaw.6vw7qt]
As recently as 2014, **7.2%** of all private sector employees (**8.5 million** people) and
**13.1%** of *all* employees of companies with stock held stock options, according to the
National Center for Employee Ownership.[^nceoorgass.x6588n]
Many believe employee ownership has
[💰fostered innovations](https://www.wsj.com/articles/reviving-the-flagging-spirit-of-silicon-valley-1428706671)
in technology, especially in Silicon Valley, from the
[early days](http://www.hp.com/hpinfo/abouthp/histnfacts/publications/measure/pdf/1976_07.pdf)
of Hewlett-Packard to recent examples like Facebook.
Stock options helped the first 3,000 employees of Facebook enjoy roughly **$23 billion** at
the time the company went public.[^ftcomconte.x613np]

🌪 Some controversy surrounds the use of equity compensation for high-paid executives.
Public companies offer executives equity compensation in no small part because of a tax
loophole. In 1993, President Bill Clinton attempted to limit executive pay with a new
section[^treasurygo.tbpcyx] of the Internal Revenue Code.
Unfortunately, the legislation backfired;
a loophole made performance-based pay—including stock options—fully tax deductible,
thereby creating a dramatic incentive to pay executives through stock options.[^epiorgpubl.cq5o0o]
From 1970–79, the average compensation for a CEO of one of the 50 largest firms in the
United States was **$1.2M**, of which **11.2%** was from stock options.
By 2000–05, the same numbers had risen to **$9.2M** and **37%**, respectively.[^nberorgpap.wtsymr]

### Growth and Risk

Generally, equity compensation is closely linked to the **growth** of a company.
Cash-poor startups persuade early employees to take pay cuts and join their team by
offering meaningful [ownerships stakes](#typical-employee-equity-levels), catering to hopes
that the company will one day grow large enough to [go public](#ipos) or
[be sold](#sales-and-liquidity) for an ample sum.
More mature but still fast-growing companies find offering compensation linked to
ownership is more attractive than high cash compensation to many candidates.

With the hope for growth, however, also comes **risk**. Large, fast-growing companies often
hit hard times.
And [startups](#startups-and-growth) routinely fail or yield no returns for investors or
workers. According to [a report](http://fortune.com/2017/06/27/startup-advice-data-failure/)
by Cambridge Associates and Fortune Magazine, between 1990 and 2010, **about 60%** of
venture capital-backed companies returned less than the original investment, leaving
employees with the painful realization that their startup was not, in fact, the next
Google. Of the remaining **40%**, just a select few go on to make a many of their employees
wealthy, as has been the case with iconic high-growth companies, like Starbucks,[^investoped.aaps6n] UPS,[^moneycnnco.80o8bh]
Amazon,[^techcrunch.9ucopn] Google,[^dealbookny.es6h1j] or Facebook.[^enwikipedi.q7bc95]

### Compensation and Equity

🄳 **Compensation** is any remuneration to a person (including employees, contractors,
advisors, founders, and board members) for services performed or rendered to a company.
Compensation comes in the forms of cash pay (salary and any bonuses) and any non-cash pay,
including [benefits](https://en.wikipedia.org/wiki/Employee_benefits#United_States) like
health insurance, family-related protections, perks, and retirement plans.

Company strategies for compensation are
[far from simple](http://firstround.com/review/counterintuitive-comp-tips-for-the-unwary-and-uninitiated/).
Beth Scheer, head of talent at the venture fund Homebrew, offers a
[thoughtful overview](https://quip.com/HEB3Ah9dYD6o) of compensation in startups.

Another term you may encounter is
[*total rewards*](https://www.worldatwork.org/total-rewards-model/), which refers to a model of
attracting and retaining employees using a combination of salary and incentive
compensation (like equity), benefits, recognition for contribution or commitment (like
awards and bonuses), training programs, and initiatives to improve the work environment.

🄳 In the context of compensation and investment, **equity** broadly refers to any kind of
ownership in a company that can be held by individuals (like employees or board members)
and by other businesses (like venture capital firms).
One common kind of equity is stock, but equity can take other forms, such as stock options
or warrants, that give ownership rights.
Commonly, equity also comes with certain conditions, such as vesting or repurchase rights.
Note the term *equity* also has
[several other](https://www.investopedia.com/terms/e/equity.asp) technical meanings in
accounting and real estate.

🄳 [**Equity compensation**](http://www.investopedia.com/terms/e/equity-compensation.asp) is the
practice of granting equity in exchange for work.

In this Guide we focus on equity compensation in stock corporations, the kind of company
where ownership is represented by stock.
(We describe stock in more detail in [the next section](#fundamentals-of-stock-corporations).)
Equity compensation in the form of a direct grant of stock with no strings attached is
very rare. Instead, employees are given stock with additional restrictions placed on it,
or are given contractual rights that later can lead to owning stock.
These forms of equity compensation include restricted stock, stock options, and restricted
stock units, each of which we’ll [describe in detail](#how-equity-is-granted).

### The Goals of Equity Compensation

The purpose of equity compensation is threefold:

- **Attract and retain talent.**
When a company already has or can be predicted to have significant financial success,
talented people are [incentivized](https://avc.com/2010/10/employee-equity-options/) to work
for the company by the prospect of their equity being
[worth a lot](https://www.entrepreneur.com/article/253438) of money in the future.
The actual probability of life-changing lucre may be low (or at least, lower than you may
think if your entire knowledge of startups is watching “[The Social Network](https://en.wikipedia.org/wiki/The_Social_Network)”).
But even a small chance at winning big can be worth the risk to many people, and to some
the risk itself can be exciting.
- **Align incentives.**
Even companies that can afford to pay lots of cash may prefer to give employees equity,
so that employees work to increase the *future* value of the company.
In this way, equity aligns individuals’ incentives with the interests of the company.
At its best, this philosophy fosters an environment of teamwork and a “rising tides lift
all boats” mentality.
It also encourages everyone involved to think
[long-term](https://www.cebglobal.com/blogs/equity-compensation-will-stop-short-termism-and-boost-growth/),
which is key for company success.
As we’ll [discuss later](#offers-and-negotiations), the amount of equity you’re offered
usually reflects both your contribution to the company and your commitment to the company
in the future.
- **Reduce cash spending.**
By giving equity, a company can often pay less in cash compensation to employees now,
with the hope of rewarding them later, and put that money toward other investments or
operating expenses.
This can be essential in the early stages of a company or at other times where there may
not be enough revenue to pay large salaries.
Equity compensation can also help recruit senior employees or executives who would
otherwise command especially high salaries.

🚧 Mention or link to lockup periods etc.

## Fundamentals of Stock Corporations

In this section, we describe the basics of how stock and shares are used.

Those familiar with stock, stock corporations, public companies, and private companies can
[jump ahead](#how-equity-is-granted) to how those companies grant equity.

### Kinds of Companies

🄳 A **company** is a legal entity formed under corporate law for the purpose of conducting
trade. In the United States, specific rules and regulations govern several kinds of
[business entities](https://en.wikipedia.org/wiki/Types_of_business_entity#United_States).
Federal and state law have significant implications on liability and taxation for each
kind of company.
Notable types of companies include sole proprietorships, partnerships, limited liability
companies (LLCs), S corporations, and C corporations.

🄳 A **corporation** is a company that is legally recognized as a single entity.
The corporation itself, and not its owners, is obligated to repay debts and accountable
under contracts and legal actions (that is, is a “[legal person](https://en.wikipedia.org/wiki/Legal_person)”).
Most commonly, the term *corporation* is used to refer to a
**[stock corporation (or joint-stock company)](https://en.wikipedia.org/wiki/Joint-stock_company)**,
which is a corporation where ownership is managed using stock. **Non-stock corporations**
that do not issue stock exist as well, the most common being
[nonprofit organizations](https://en.wikipedia.org/wiki/Nonprofit_organization). (A few
[less common](https://en.wikipedia.org/wiki/Non-stock_corporation) for-profit non-stock
corporations also exist.)

In practice, people often use the word *company* to mean *corporation*.

🄳 **Incorporation** is the
[legal process](https://en.wikipedia.org/wiki/Incorporation_(business)) of forming (or
**incorporating**) a new corporation, such as a business or nonprofit.
Corporations can be created in any country.
In the United States, incorporation is handled by state law, and involves filing
[articles of incorporation](https://en.wikipedia.org/wiki/Articles_of_incorporation) and a
variety of other [required information](https://handbook.clerky.com/formation/process) with
the Secretary of State.
(Note that the formation of companies that are not corporations, such as partnerships or
LLCs, is not the same as incorporation.)

🄳 A [**C corporation (or C corp)**](https://en.wikipedia.org/wiki/C_corporation) is a type of
stock corporation in the United States with certain federal
[tax treatment](https://ct.wolterskluwer.com/resource-center/articles/what-c-corporation). It
is the most prevalent kind of corporation.[^investoped.m9wdqp]
Most large, well-known American companies are C corporations.
C corporations differ from
[S corporations](https://www.incorporate.com/starting-a-business/s-corporation) and other
business entities in several ways, including how income is taxed and who may own stock.
C corporations have no limit on the number of shareholders allowed to own part of the
company. They also allow other corporations, as well as partnerships, trusts, and other
businesses, to own stock.

C corps are overwhelmingly popular for early-stage
[private companies](#public-and-private-companies) looking to sell part of their business in
exchange for investment from individuals and organizations like venture capital firms
(which are often partnerships), and for established public companies selling large numbers
of stock to individuals and other companies on the
[public exchange](https://en.wikipedia.org/wiki/Stock_exchange).

In practice, for a few reasons, these companies are usually formed in Delaware, so
legalities of all this are defined in Delaware law.[^quoracomwh.wsnr2b][^nytimescom.67ksyb]
You can think of Delaware law as the primary “language” of U.S. corporate law.
Incorporating a company in Delaware has evolved into a national standard for high-growth
companies, regardless of where they are physically located.

🔸 This Guide focuses specifically on C corporations and [does not cover](#scope) how equity
compensation works in LLCs, S corporations, partnerships, or sole proprietorships.
Both equity and compensation are handled in significantly different ways in each of these
kinds of businesses.

Loosely, one way to think about companies is that they are simply a set of
[contracts](https://www.law.cornell.edu/wex/contract), negotiated over time between the people
who own and operate the company, and which are enforced by the government, that aligns the
interests of everyone involved in creating things customers are willing to pay for.
Key to these contracts is a way to precisely track ownership of the company;
issuing stock is how companies often choose to do this.

🚧 Mention how court cases are settled?

### Stock and Shares

🄳 [**Stock**](https://en.wikipedia.org/wiki/Stock) is a legal invention that represents
ownership in a company. [**Shares**](https://en.wikipedia.org/wiki/Share_(finance)) are portions
of stock that allow a company to grant ownership to a variety of people or other companies
in flexible ways.
Each **shareholder (or stockholder)**, as these owners are called, holds a specific number
of shares. Founders, investors, employees, board members, contractors, advisors, and other
companies, like law firms, can all be shareholders.

🄳 Stock ownership is often formalized on **stock certificates**, which are fancy pieces of
paper that prove who owns the stock.

Sometimes you have stock but don’t have the physical certificate, as it may be held for
you at a law office.

Some companies now manage their ownership through online services called *ownership
management platforms*, such as [Carta](https://carta.com/). If the company you work for uses
an ownership management platform, you will be able to view your stock certificates and
stock values online.

Younger companies may also choose to keep their stock *uncertificated*, which means your
sole evidence of ownership is your contracts with the company, and your spot on the
company’s cap table, without having a separate certificate for it.

🄳 [**Outstanding shares**](http://www.investopedia.com/terms/o/outstandingshares.asp) refer to
the total number of shares held by all shareholders.
This number starts at an essentially arbitrary value (such as 10 million) when the company
is created, and thereafter will increase as new shares are added (issued) and granted to
people in exchange for money or services.

Outstanding shares may increase or decrease for other reasons too, such as
[stock splits and share buybacks](http://www.investorguide.com/article/11713/splits-and-buybacks-explained/),
which we won’t get into here.

Later, we discuss several [subtleties](#counting-shares) in how shares are counted.

🚧 What is a good overview on stock splits and share buyback.
Key resources?

🄳 Any shareholder has a **percentage ownership** in the company, determined by dividing the
number of shares they own by the number of outstanding shares.
Although stock paperwork will always list numbers of shares, if share value is uncertain,
percentage ownership is often a more meaningful number, particularly if you know or can
estimate a likely valuation of the company.
Even if the number of shares a person has is fixed, their percentage ownership will change
over time as the outstanding shares change.
Typically, this number is presented in percent or
[**basis points**](https://www.investopedia.com/terms/b/basispoint.asp) (hundredths of a percent).

### Public and Private Companies

🄳 [**Public companies**](https://en.wikipedia.org/wiki/Public_company) are corporations in which
any member of the public can own stock.
People can buy and sell the stock for cash on public
[stock exchanges](https://www.investopedia.com/terms/e/exchange.asp). The value of a company’s
shares is the value displayed in the stock market reports, so shareholders know how much
their stock is worth.

🄳 Most smaller companies, including all startups, are
[**private companies**](https://en.wikipedia.org/wiki/Privately_held_company) with owners who
control how those companies operate.
Unlike a public company, where anyone is able to buy and sell stock, owners of a private
company control who is able to buy and sell stock.
There may be few or no transactions, or they may not be publicly known.

🚧 What are public exchanges and how is stock bought and sold in practice?
Mention accredited investors?

### Governance

🄳 A corporation has a **board of directors**, a
[group of people](https://en.wikipedia.org/wiki/Board_of_directors) whose legal obligation is
to oversee the company and ensure it serves the best interests of the shareholders.
Public companies are legally obligated to have a board of directors, while private
companies often elect to have one.
The board typically consists of **inside directors**, such as the CEO, one or two founders,
or executives employed by the company, and **outside directors**, who are not involved in
the day-to-day workings of the company.
These **board members** are elected individuals who have legal, corporate governance rights
and duties when it comes to voting on key company decisions.
A board member is said to have a **board seat** at the company.

Boards of directors range from 3 to 31 members, with an average size of 9.[^investoped.fn52lq] Boards are
almost always an odd number in order to avoid tie votes.
It’s worth noting that the state of California requires public companies to have at least
one woman on their boards.[^nytimescom.gec7iw]

Key decisions of the board are made formally in *board meetings* or in writing (called
*written consent*).[^dlapiperac.wb4617] Many decisions around granting equity to employees are approved by the
board of directors.

🚧 This section could be expanded, and also include more legal links.

### IPOs

🄳 A private company becomes a public company in a process called an
[**initial public offering (IPO)**](https://en.wikipedia.org/wiki/Initial_public_offering).
Historically, only private companies with a strong track record of years of growth have
considered themselves ready to take this significant step.
The IPO has [pros and cons](https://www.investopedia.com/university/ipo/ipo.asp) that include
exchanging a host of high regulatory costs for the benefits of significant capital.
After a company “IPOs” or “**goes public**," investors and the general public can buy stock,
and existing shareholders can sell their stock far more easily than when the company was
private.

Companies take years to IPO after being formed.
The median time between a company’s founding and its IPO has been increasing.
According to a Harvard report, companies that went public in **2016** took **7.7 years** to do
so, compared to **3.1 years** for companies that went public in **1996**.[^corpgovlaw.vbw82s]

🚧 What are the restrictions and regulations on selling stock that affect employees at
IPO? What is a lockup period?

### Sales and Liquidity

❗️ With private companies, it can be very [hard to know](#what-is-private-stock-worth) the
value of equity.
Because the value of private company stock is not determined by regular trades on public
markets, shareholders can only make educated guesses about the likely future value, at a
time when they will be able to sell stock.

After all, private company stock is simply a legal agreement that entitles you to
something of highly uncertain value, and could well be worthless in the future, or highly
valuable, depending on the fate of the company.

☝️ We’ll discuss the notion of a company officially assigning a
[fair market value](#409a-valuations) later, but even if a company gives you a value for your
stock for tax and accounting purposes, it doesn’t mean you can expect to sell it for that
value!

🄳 An [**acquisition**](https://www.investopedia.com/terms/a/acquisition.asp) is the purchase of
more than 50% of the shares of one company (the acquired company) by another company (the
purchaser). This is also called a **sale** of the acquired company.
In an acquisition, the acquired company cedes control to the purchaser.

🄳 The ability to buy and sell stock is called **liquidity**. In startups and many private
companies, it is often hard to sell stock until the company is sold or goes public, so
there is little or no liquidity for shareholders until those events occur.
Thus, sales and IPOs are called both **exits** and **liquidity events**. Sales, dissolutions,
and bankruptcy are all called **liquidations**.

Often people wish they could sell stock in a private company, because they would prefer
having the cash.
This is only possible occasionally.
We get into the details [later](#can-you-sell-private-stock), in our section on selling
private stock.

🄳 A [**dividend**](http://www.investopedia.com/terms/d/dividend.asp) is a distribution of a
company’s profit to shareholders, authorized by the board of directors.
Established public companies and some private companies pay dividends, but this is rare
among startups and companies focused on rapid growth, since they often wish to re-invest
their profits into expanding the business, rather than paying that money back to
shareholders. Amazon, for example, has
[never paid](https://www.fool.com/investing/2017/12/28/will-amazon-start-paying-a-dividend-in-2018.aspx)
dividends.

## Startups and Growth

If you’re considering working for a startup, what we cover next on how these early-stage
companies raise money and grow is helpful in understanding what your equity may be worth.

If you’re only concerned with large and established companies, you can skip ahead to
[how equity is granted](#how-equity-is-granted).

### Startups

🄳 A [**startup**](https://en.wikipedia.org/wiki/Startup_company) is an emerging company,
typically a private company, that aspires to grow quickly in size, revenue, and influence.
Once a company is established in the market and successful for a while, it usually stops
being called a startup.

☝️ Unlike the terminology around corporations, which has legal significance, the term
*startup* is informal, and not everyone uses it consistently.

Startups are not the same as small businesses.
Small businesses, like a coffee shop or plumbing business, typically intend to grow slowly
and organically, while relying much less on investment capital and equity compensation.
Distinguished startup investor
[Paul Graham](https://en.wikipedia.org/wiki/Paul_Graham_(programmer)) has
[emphasized](http://www.paulgraham.com/growth.html) that it’s best to think of a startup as
any [early stage](#stages-of-a-startup) company intending to grow quickly.

∑ C corporations dominate the startup ecosystem.
LLCs tend to be better suited for slower-growth companies that intend to distribute
profits instead of re-investing them for growth.
Because of this, and for complex reasons related to how their capital is raised, venture
capitalists significantly prefer to invest in C corporations.

🚧 What are good stats on how many people work in startups vs.
established companies?

### Fundraising, Growth, and Dilution

Many large and successful companies began as startups.
In general, startups rely on investors to help fund rapid growth.

🄳 **Fundraising** is the process of seeking capital to build or scale a business.
Selling shares in a business to investors is one form of fundraising, as are loans and
[initial coin offerings](https://en.wikipedia.org/wiki/Initial_coin_offering). **Financing**
refers both to fundraising from outside sources and to bringing in revenue from selling a
product or service.

🄳 **Venture capital** is a form of financing for early-stage companies that individual
investors or investment firms provide in exchange for partial ownership, or equity, in a
company. These investors are called **venture capitalists (or VCs)**. Venture capitalists
invest in companies they perceive to be capable of growing quickly and commanding
significant market share.
“Venture” refers to the risky nature of investing in early-stage businesses—typically
startups—with unproven business models.

A startup goes through several [stages of growth](#stages-of-a-startup) as it raises capital
based on the hope and expectation that the company will grow and make more money in the
future.

🄳 Companies add (or “issue”) shares during fundraising, which can be exchanged for cash
from investors.
As the number of outstanding shares goes up, the percentage ownership of each shareholder
goes down. This is called [**dilution**](http://www.investopedia.com/terms/d/dilution.asp).

☝️ Dilution doesn’t necessarily mean that you’re losing anything as a shareholder.
As a company issues stock and raises money, the smaller percentage of the company you *do*
have could be worth more.
The size of your slice gets relatively smaller, but, if the company is growing, the size
of the cake gets bigger.
For example, a typical startup might have three rounds of funding, with each round of
funding issuing 20% more shares.
At the end of the three rounds, there are more outstanding shares—roughly 73% more in this
case, since 120%×120%×120% is 173%—and each shareholder owns proportionally less of the
company.

🄳 The [**valuation**](https://en.wikipedia.org/wiki/Valuation_(finance)) of the company is the
present value investors believe the company has.
If the company is doing well, growing revenue or showing indications of future revenue
(like a growing number of users or traction in a promising market), the company’s
valuation will usually be on the rise.
That is, the [price](https://en.wikipedia.org/wiki/Share_price) for an investor to buy one
share of the company would be increasing.

❗️ Of course, things do not always go well, and the valuation of a company does not always
go up. It can happen that a company fails entirely and all ownership stakes become
worthless, or that the valuation is lower than expected and
[certain kinds](#classes-of-stock) of shares become worthless while other kinds have some
value. When investors and leadership in a company expect the company to do better than it
actually does, it can have a lot of disappointing consequences for shareholders.

### Dilution Illustrations

These visualizations illustrate how ownership of a venture-backed company evolves as
funding is raised.
One scenario imagines changes to ownership in a well-performing startup, and the other is
loosely based on a careful analysis of Zipcar,[^reactionwh.uw835n] a ride-sharing company that experienced
substantial dilution before eventually going public and being
[acquired](#sales-and-liquidity). These diagrams simplify complexities such as the ones
discussed in that analysis, but they give a sense of how ownership can be diluted.

```hlwy-infographics
{
"name": "CaptableDilution",
"data": {
"hypothetical": {
"label": "Hypothetical",
"stages": [
{
"label": "Founding",
"postValuation": 1000,
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 4000000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 3000000
},
{
"type": "founder3",
"label": "Founder #3",
"shares": 3000000
}
]
},
{
"label": "Series A",
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 4000000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 3000000
},
{
"type": "founder3",
"label": "Founder #3",
"shares": 3000000
},
{
"type": "options",
"label": "Options Pool",
"shares": 1500000
},
{
"type": "investment",
"label": "Seed",
"preValuation": 8000000,
"raised": 2000000
},
{
"type": "investment",
"label": "Series A",
"preValuation": 8000000,
"raised": 5000000
}
]
},
{
"label": "Series C",
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 4000000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 3000000
},
{
"type": "founder3",
"label": "Founder #3",
"shares": 3000000
},
{
"type": "options",
"label": "Options Pool",
"shares": 1500000
},
{
"type": "investment",
"label": "Seed",
"preValuation": 8000000,
"raised": 2000000
},
{
"type": "investment",
"label": "Series A",
"preValuation": 8000000,
"raised": 5000000
},
{
"type": "investment",
"label": "Series B",
"preValuation": 20000000,
"raised": 10000000
},
{
"type": "investment",
"label": "Series C",
"preValuation": 40000000,
"raised": 20000000
}
]
}
]
},
"zipcar": {
"label": "Approx. Zipcar",
"stages": [
{
"label": "Founding",
"postValuation": 1000,
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 570000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 570000
}
]
},
{
"label": "Series A",
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 570000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 570000
},
{
"type": "options",
"label": "Options Pool",
"shares": 378000
},
{
"type": "investment",
"label": "Series A",
"preValuation": 5800000,
"raised": 1400000
}
]
},
{
"label": "Series B",
"captable": [
{
"type": "founder1",
"label": "Founder #1",
"shares": 570000
},
{
"type": "founder2",
"label": "Founder #2",
"shares": 570000
},
{
"type": "options",
"label": "Options Pool",
"shares": 378000
},
{
"type": "investment",
"label": "Series A",
"preValuation": 5800000,
"raised": 1400000
},
{
"type": "investment",
"label": "Series A",
"preValuation": 2200000,
"raised": 4700000
}
]
}
]
}
}
}
```

### Stages of a Startup

Understanding the value of stock and equity in a startup requires a grasp of the stages of
growth a startup goes through.
These stages are largely reflected in how much funding has been raised—how much ownership,
in the form of shares, has been sold for capital.

Very roughly,
[typical stages](http://blog.eladgil.com/2011/03/how-funding-rounds-differ-seed-series.html)
are:

- [**Bootstrapped**](https://www.investopedia.com/terms/b/bootstrapping.asp) (little funding or
self-funded): Founders are figuring out what to build, or they’re starting to build with
their own time and resources.
- [**Series Seed**](https://www.investopedia.com/terms/s/seedcapital.asp) (roughly $250K to $2
million in funding): Figuring out the product and market.
The low end of this spectrum is now often called **pre-seed**.
- [**Series A**](https://www.investopedia.com/terms/s/seriesa.asp) ($2 to $15 million): Scaling the
product and making the business model work.
- [**Series B**](https://www.investopedia.com/terms/s/series-b-financing.asp) (tens of millions):
Scaling the business.
- **Series C, D, E, et cetera** (tens to hundreds of millions): Continued scaling of the
business.

Keep in mind that these numbers are more typical for startups located in California.
The amount raised at various stages is typically smaller for companies located outside of
Silicon Valley, where what would be called a seed round may be called a Series A in, say,
Houston, Denver, or Columbus, where there are fewer companies competing for investment
from fewer venture firms, and costs associated with growth (including providing livable
salaries) are lower.[^nytimescom.bcfuyu][^chicagotri.fq0msp]

🔸 Most startups don’t get far.
According to an analysis of
[angel investments](https://www.investopedia.com/terms/a/angelinvestor.asp), by Susa Ventures
general partner [Leo Polovets](http://codingvc.com), **more than half** of investments fail;
**one in 3** are small successes (1X to 5X returns); **one in 8** are big successes (5X to
30X); and **one in 20** are huge successes (30X+).[^codingvcco.bcspni]

🚧 What are some stats beyond angel investments?

🔸 Each stage reflects the reduction of risk and increased dilution.
For this reason, the amount of equity team members get is higher in the earlier stages
(starting with founders) and increasingly lower as a company matures.
(See the picture above.)

### The Option Pool

🄳 At some point early on, generally before the first employees are hired, a number of
shares will be reserved for an employee
**[option pool](http://www.investopedia.com/terms/o/option-pool.asp) (or employee pool)**. The
option pool is part of a legal structure called an equity incentive plan.
A typical size for the option pool is 20% of the stock of the company, but, especially for
earlier stage companies, the option pool can be 10%, 15%, or other sizes.

Once the pool is established, the company’s board of directors grants stock from the pool
to employees as they join the company.

∑ Well-advised companies will reserve in the option pool only what they
[expect to use](http://siliconhillslawyer.com/2014/05/01/option-pool-not-ocean-startups/) over
the next 12 months or so;
otherwise, given how equity grants are usually promised, they may be over-granting equity.
The whole pool may never be fully used, but companies should still try not to reserve more
than they plan to use.
The size of the pool is determined by
[complex factors](http://venturehacks.com/articles/option-pool-shuffle) between founders and
investors. It’s worth employees (and
[founders](https://www.cooleygo.com/negotiating-option-pool/)) understanding that a small pool
can be a good thing in that it reflects the company preserving ownership in negotiations
with investors.
The size of the pool may be increased later.

### Counting Shares

There are some key subtleties you’re likely to come across in the way
[outstanding shares](#stock-and-shares) are counted:

🄳 Private companies always have what are referred to as **authorized but unissued** shares,
referring to shares that are authorized in legal paperwork but have not actually been
issued. Until they are issued, the
[unissued stock](https://www.investopedia.com/terms/u/unissuedstock.asp) these shares
represent doesn’t mean anything to the company or to shareholders:
no one owns it.

☝️ For example, a corporation might have 100 million *authorized* shares, but will only
have *issued* 10 million shares.
In this example, the corporation would have 90 million *authorized but unissued* shares.
When you are trying to determine what percentage a number of shares represents, you do
*not* make reference to the authorized but unissued shares.

☝️ You actually want to know the total issued shares, but even this number can be
confusing, as it can be computed
[more than one way](http://www.mattbartus.com/option-grants-fully-diluted-or-issued-and-outstanding/).
Typically, people count shares in two ways: *issued and outstanding* and *fully diluted*.

🄳 **Issued and outstanding** refers to the number of shares actually issued by a company to
shareholders, and does not include shares that others may have an option to purchase.

🄳 **Fully diluted** refers to all of the shares that a company has issued, all of the
shares that have been set aside in a stock incentive plan, and all of the shares that
could be issued if all convertible securities (such as outstanding warrants) were
exercised.

A key difference between fully diluted shares and shares issued and outstanding is that
the total of fully diluted shares will include all the shares in the employee option pool
that are reserved but *not yet issued to* employees.

🔹 If you’re trying to figure out the likely percentage a number of shares will be worth
in the future, it’s best to know the number of shares that are fully diluted.

∑ Even the fully diluted number may not take into account outstanding convertible
securities (like convertible notes) that are *waiting* to be converted into stock at a
future milestone.
For a more complete understanding, in addition to asking about the fully-diluted
capitalization you can ask about any convertible securities outstanding that are not
included in that number.

☝️ The terminology mentioned here isn’t universally applied.
It’s worth discussing these terms with your company to be sure you’re on the same page.

🄳 A **capitalization table (cap table)** is a
[table](https://www.investopedia.com/terms/c/capitalization-table.asp) (often a spreadsheet or
other official record) that records the ownership stakes, including number and class of
shares, of all shareholders in the company.
It is updated as stock is granted to new shareholders.[^cooleygoco.p5v68j]

🚧 Better discuss future sources of dilution.
Define convertible securities and convertible notes and “[fully diluted](https://www.lawinsider.com/dictionary/fully-diluted-basis)”
more. Do people say “fully diluted” but not include convertible securities?

### Classes of Stock

🄳 Investors often ask for rights to be paid back first in exchange for their investment.
The way these different rights are handled is by creating different
[**classes of stock**](https://www.upcounsel.com/classes-of-stock). (These are also sometimes
called [**classes of shares**](https://www.investopedia.com/terms/c/class.asp), though that term
has another meaning in the context of mutual funds.)

🄳 Two important classes of stock are
[**common stock**](https://en.wikipedia.org/wiki/Common_stock) and
[**preferred stock**](https://en.wikipedia.org/wiki/Preferred_stock). In general, preferred stock
has “[rights, preferences, and privileges](https://www.americanbar.org/groups/business_law/publications/blt/2014/01/04_bigler/)”
that common stock does not have.
Typically, investors get preferred stock, and founders and employees get common stock (or
stock options).

The exact number of classes of stock and the differences between them can vary company to
company, and, in a startup, these can vary at [each round](#stages-of-a-startup) of funding.

☝️ Another term you’re likely to hear is
[*founders’ stock*](http://www.alleywatch.com/2013/08/what-is-founders-stock-legally/), which is
(usually) common stock allocated at a company’s formation, but otherwise doesn’t have any
different rights from other common stock.[^lsvpwordpr.dgym96]

Although preferred stock rights are too complex to cover fully, we can give a few key
details:

🄳 Preferred stock usually has a
[**liquidation preference (or preference)**](http://www.investopedia.com/terms/l/liquidation-preference.asp),
meaning the preferred stock owners will be paid before the common stock owners when a
[liquidity event](#sales-and-liquidity) occurs, such as if the company is sold or goes public.

🄳 A company is in
[**liquidation overhang**](https://equityzen.com/blog/startup-valuations-and-liquidation-preference-overhang/)
when the value of the company doesn’t reach the dollar amount investors put into it.
Because of liquidation preference, those holding preferred stock (investors) will have to
be paid before those holding common stock (employees).
If investors have put millions of dollars into a company and it’s sold, employees’ equity
won’t be worth anything if the company is in liquidation overhang and the sale doesn’t
exceed that amount.[^avccom2010.zxzhsl]

☝️ The complexities of the liquidation preference are
[infamous](https://venturebeat.com/2010/08/16/beware-the-trappings-of-liquidation-preference/).
It’s worth understanding that investors and entrepreneurs negotiate a lot of the details
around preferences, including:

- The *multiple*, a number designating how many times the investor must be paid back before
common shareholders receive proceeds.
(Often the multiple is 1X, but it can be 2X or higher.)

- Whether preferred stock is
[*participating*](https://en.wikipedia.org/wiki/Participating_preferred_stock), meaning
investors get their money back and also participate in proceeds from common stock.

- Whether there is a *cap*, which limits the payout if it is participating.

- ∑
[🔑This primer](https://medium.com/@CharlesYu/the-ultimate-guide-to-liquidation-preferences-478dda9f9332)
by Charles Yu gives a concise overview.
Founders and companies are affected significantly and in subtle ways by these
considerations.
For example, as lawyer José Ancer points out, common and preferred stockholders are
typically quite different and their incentives
[sometimes](http://siliconhillslawyer.com/2017/10/13/common-stock-v-preferred-stock/)
[diverge](http://siliconhillslawyer.com/2018/02/07/board-works-common-stock/).

- 🚧 What are good resources to mention that describe conversion of preferred stock to
common stock?

🔹 For the **purposes of an employee who holds common stock**, the most important thing to
understand about preferences is that they’re not likely to matter if a company does well
in the long term.
In that case, every stockholder has valuable stock they can eventually sell.
But if a company fails or [exits](#sales-and-liquidity) for less than investors had hoped,
the preferred stockholders are generally first in line to be paid back.
Depending on how favorable the terms are for the investor, if the company exits at a low
or modest valuation, it’s likely that common shareholders will receive little—or nothing
at all.

## How Equity Is Granted

In this section we’ll lay out how equity is granted in practice, including the
differences, benefits, and drawbacks of common types of equity compensation, including
restricted stock awards, stock options, and restricted stock units (RSUs).
We’ll go over a few less common types as well.
While the [intent](#the-goals-of-equity-compensation) of each kind of equity grant is
similar, they differ in many ways, particularly around how they are
[taxed](#taxes-on-equity-compensation).

Except in rare cases where it may be negotiable, the type of equity you get is up to the
company you work for.
In general, larger companies grant RSUs, and startups grant stock options, and
occasionally executives and very early employees get restricted stock awards.

🚧 Add section on when equity is granted, including plus-ups.

### Restricted Stock Awards

At face value, the most direct approach to equity compensation would be for the company to
award stock to an employee in exchange for work.
In practice, it turns out a company will only want to do this with restrictions on how and
when the stock is fully owned.

Even so, this is actually one of the least common ways to get equity.
We mention it first because it is the simplest form of equity compensation, useful for
comparison as things get more complex.

🄳 A **restricted stock award** is when a company grants someone stock as a form of
compensation. The stock awarded has additional conditions on it, including a vesting
schedule, so is called **restricted stock**. Restricted stock awards may also be called
simply **stock awards** or **stock grants**.

∑ What *restricted* means here is actually
[complex](https://github.com/jlevy/og-equity-compensation/issues/24). It refers to the fact
that the stock (i) has certain restrictions on it (like transfer restrictions) required
for private company stock, and (ii) will be subject to repurchase at cost pursuant to a
vesting schedule.
The repurchase right lapses over the service-based vesting period, which is what is meant
in this case by the stock “vesting.”

☝️ Restricted stock awards are
[not the same](https://www.fool.com/knowledge-center/the-difference-between-a-restricted-stock-unit-res.aspx)
thing as restricted stock units.

Typically, stock awards are limited to executives or very early hires, since once the
value of the shares increases, the tax burden of receiving them (without paying the
company for their value) can be too great for most people.
Usually, instead of restricted stock, an employee will get stock options.

### Stock Options

🄳 [**Stock options**](https://en.wikipedia.org/wiki/Employee_stock_option) are contracts that
allow individuals to buy a specified number of shares in the company they work for at a
fixed price. Stock options are the most common way early-stage companies grant equity.

🄳 A person who has received a stock option grant is not a shareholder until they
**exercise** their option, which means purchasing some or all of their shares at the strike
price. Prior to exercising, an option holder does not have voting rights.

🄳 The **strike price (or exercise price)** is the fixed price per share at which stock can
be purchased, as set in a stock option agreement.
The strike price is generally set lower (often much lower) than what people expect will be
the *future* value of the stock, which means selling the stock down the road could be
profitable.

☝️ *Stock options* is a confusing term.
In investment, an *option* is a right (but not an obligation) to buy something at a
certain price within a certain time frame.
You’ll often see stock options discussed in the context of
[investment](https://www.investopedia.com/terms/s/stockoption.asp). What investors in
financial markets call *stock options* are indeed options on stock, but they are not
*compensatory* stock options awarded for services.
In this Guide, and most likely in any conversation you have with an employer, anyone who
says “stock options” will be referring to compensatory stock options.

☝️ Stock options are not the same as stock;
they are only the *right to buy stock* at a certain price and under a set of conditions
specified in an employee’s stock option agreement.
We’ll get into these conditions next.

∑ Although everyone typically refers to “stock options” in the plural, when you receive a
stock option grant, you are receiving *an option* to purchase a given number of shares.
So technically, it’s incorrect to say someone “has 10,000 stock options.”

It’s best to understand the financial and [tax implications](#taxes-on-isos-and-nsos) before
deciding [when to exercise](#stock-option-scenarios) options.
In order for the option to be tax-free to receive, the strike price must be the fair
market value of the stock on the date the option is granted.

∑ Those familiar with
[stock trading](https://www.investopedia.com/university/stocks/stocks3.asp) (or those with
economics degrees) will tell you about the
[**Black-Scholes model**](https://www.investopedia.com/university/options-pricing/black-scholes-model.asp),
a general mathematical model for determining the value of options.
While theoretically sound, this does not have as much practical application in the context
of employee stock options.

🚧 Any real-world examples or statistics of how low strike price has led to big payoffs?
Also we could mention and relate this to the term *employee stock options (or ESOs)* and
dispel any confusion between ESOs and ESPPs.

### Vesting and Cliffs

🄳 **Vesting** is the process of gaining full legal rights to something.
In the context of compensation, founders, executives, and employees typically gain rights
to their grant of equity incrementally over time, subject to restrictions.
People may refer to their shares or stock options vesting, or may say that a person is
vesting or has fully vested.

🄳 In the majority of cases, vesting occurs incrementally over time, according to a
**vesting schedule**. A person vests only while they work for the company.
If the person quits or is terminated immediately, they get no equity, and if they stay for
years, they’ll get most or all of it.

Awards of stock, stock options, and RSUs are almost always subject to a vesting schedule.

🄳 Vesting schedules can have a **cliff** designating a length of time that a person must
work before they vest at all.

For example, if your equity award had a one-year cliff and you only worked for the company
for 11 months, you would not get anything, since you haven’t vested in any part of your
award. Similarly, if the company is sold within a year of your arrival, depending on what
your paperwork says, you may receive nothing on the sale of the company.

A very common vesting schedule is vesting over **4 years**, with a **1 year** cliff.
This means you get 0% vesting for the first 12 months, 25% vesting at the 12th month, and
1/48th (2.08%) more vesting each month until the 48th month.
If you leave just before a year is up, you get nothing, but if you leave after 3 years,
you get 75%.

🄳 In some cases, vesting may be triggered by specific events outside of the vesting
schedule, according to contractual terms called **accelerated vesting (or acceleration)**.
Two kinds of accelerated vesting that are commonly negotiated are if the company is sold
or undergoes a merger (**single trigger**) or if it’s sold and the person is fired (**double
trigger**).

🌪 Cliffs are an important topic.
When they work well, cliffs are an effective and reasonably fair system to both employees
and companies.
But they can be abused and their complexity can lead to misunderstandings:

- The intention of a cliff is to make sure new hires are committed to staying with the
company for a significant period of time.
However, the flip side of vesting with cliffs is that if an employee is leaving—quits or
is laid off or fired—just short of their cliff, they may walk away with no stock ownership
at all, sometimes through no fault of their own, as in the event of a family emergency or
illness. In situations where companies fire or lay off employees just before a cliff, it
can easily lead to hard feelings and even lawsuits (especially if the company is doing
well enough that the stock is worth a lot of money).[^inccombusi.oldydy][^bloombergc.a48epn]
- 🔹 As a manager or founder, if an employee is performing poorly or may have to be laid
off, it’s both thoughtful and wise to let them know what’s going on well before their
cliff.
- ∑ Founders often have vesting on their stock themselves.
As entrepreneur Dan Shapiro explains, this is often for
[good reason](http://www.danshapiro.com/blog/2012/04/vesting-is-a-hack/).
- 🔹 As an employee, if you’re leaving or considering leaving a company before your vesting
cliff is met, consider waiting.
Or, if your value to the company is high enough, you might
[negotiate](https://www.businessinsider.com/everything-you-need-to-know-about-cliff-vesting-2011-5)
to get some of your stock “[vested up](https://www.foley.com/when-should-vesting-of-equity-grants-accelerate-06-19-2014/)”
early. Your manager may well agree that is is fair for someone who has added a lot of
value to the company to own stock even if they leave earlier than expected, especially for
something like a family emergency.
These kinds of vesting accelerations are entirely discretionary, however, unless you
negotiated for special acceleration in an employment agreement.
Such special acceleration rights are typically reserved for executives who negotiate their
employment offers heavily.
- 🚧 How does taking time off, for example a leave of absence, affect the vesting schedule?
- Acceleration when a company is sold (called
[*change of control*](http://stockoptioncounsel.com/blog/change-of-control-terms-for-startup-stock-options-restricted-stock-and-rsus/2018/6/4)
terms) is common for founders and not so common for employees.
It’s worth understanding acceleration and triggers in case they show up in your option
agreement, but these may not be something you can negotiate unless you are going to be in
a key role.
- Companies may impose additional restrictions on stock that is vested.
For example, your shares are very likely subject to a right of first refusal, which means
that you can’t sell the stock without offering it first to the company.
And it can happen that companies reserve the right to
[repurchase](https://www.forbes.com/sites/dianahembree/2018/01/10/startup-employee-alert-can-your-company-take-back-your-vested-stock-options/#75fb48ee6e49)
vested shares in certain events.

🚧 Can we give any examples here?

### How Options Expire

🄳 The **exercise window (or exercise period)** is the period during which a person can buy
shares at the strike price.
Options are only exercisable for a fixed period of time, until they expire, typically
seven to ten years as long as the person is working for the company.
But this window is not always open.

❗ **Expiration after termination.**
Options can expire after you quit working for the company.
Often, the expiration is **90 days** after termination of service, making the options
effectively worthless if you cannot exercise before that point.
As we’ll get into later, you need to understand the costs, [taxes](#taxes-on-isos-and-nsos),
and tax [liabilities](#the-amt-trap) of exercise and to plan ahead.
In fact, you can find out when you are granted the options, or better yet, before you sign
an offer letter.

🔹 **Longer exercise windows.**
Recently (since around 2015) a few companies are finding ways to keep the exercise window
open for years after leaving a company, promoting this practice as fairer to employees.
Companies with
[extended exercise windows](https://github.com/holman/extended-exercise-windows) include
Amplitude,[^amplitudec.fvea8b] Clef,[^githubcomc.ygtolb] Coinbase,[^mediumcomb.nqs9mo] Pinterest,[^fortunecom.nnfd6o] and Quora.[^quoracomwh.4dxi02]
However, the 90-day exercise window remains the norm.

🌪 **The exercise window debate.**
Whether to have extended exercise windows has been debated at significant length.
Some believe extended exercise windows are
[the future](https://triplebyte.com/blog/extending-stock-option-exercise-window-guide#.12rv7ovrv),
arguing that a shorter window makes a company’s success a
[punishment](http://stockoptioncounsel.com/blog/nc7go8ivzxb1el5rhv6nltrjan0n2t/2017/3/6) to
early employees.

Key considerations include:

- Everyone agrees that employees holding stock options with an expiring window often have to
make a painful choice if they wish to leave:
Pay for a substantial tax bill (perhaps five to seven figures) on top of the cost to
exercise (possibly looking for [secondary liquidity or a loan](#can-you-sell-private-stock))
or walk away from the options.
- Many familiar with this situation have spoken out
[forcefully](https://zachholman.com/posts/fuck-your-90-day-exercise-window/) against shorter
exercise windows, arguing that an employee can help grow the value of a company
substantially—often having taken a lower salary in exchange for equity—but end up with
[no ownership](https://triplebyte.com/blog/fixing-the-inequity-of-startup-equity) because
they’re unable or unwilling to stay for the several years [typically needed](#ipos) before an
IPO or sale.
- On the other side, a few companies and investors
[stand by](https://a16z.com/2016/06/23/options-timing/) the existing system, arguing that it
is better to incentivize people not to leave a company, or that long windows effectively
transfer wealth from employees who commit long-term to those who leave.
- Some focused on the legalities also argue that it’s a legal requirement of ISOs to have a
90-day exercise window.
While this is technically true, it’s not the
[whole story](https://news.ycombinator.com/item?id=9254299). It is possible for companies to
extend the exercise window by changing the nature of the options (converting them from
ISOs to NSOs) and [many companies](https://github.com/holman/extended-exercise-windows) now
choose to do just that.
- Another path is to
[split the difference](http://stockoptioncounsel.com/blog/early-expiration-of-startup-stock-options-part-2-the-full-10-year-term-solution/2017/3/28)
and give extended windows only to longer-term employees.
- Taken together, it’s evident many employees have not been clear on the nuances of this
when joining companies, and some have
[🔑suffered](https://medium.com/@ben_mathes/90-days-and-my-six-figure-mistake-a495f4a188e2)
because of it.
With the risks of short exercise windows for employees becoming more widely known, longer
exercise windows are gradually becoming more prevalent.
As an employee or a founder, it is fairer and wiser to understand and negotiate these
things up front, and avoid unfortunate surprises.

☝️ Options granted to advisors typically vest over a shorter period than employee grants,
often one to two years.
Advisor grants also typically have a longer exercise window post termination of service,
and will usually have single trigger acceleration on an acquisition, because no one
expects advisors to stay on with a company once it’s acquired.
Typical terms for advisors, including equity levels, are available in the
[📥Founder/Advisor Standard Template (FAST)](https://fi.co/contents/fast#), from the Founder
Institute.

### Kinds of Stock Options

🄳 Compensatory stock options come in two flavors, **incentive stock options (ISOs)** and
**non-qualifying stock options (NQOs, or NQSOs)**. Confusingly, lawyers and the IRS use
[several names](https://www.irs.gov/taxtopics/tc427) for these two kinds of stock options,
including **statutory stock options** and **non-statutory stock options (or NSOs)**,
respectively.

In this Guide, we refer to ISOs and NSOs.

- Companies generally decide to give ISOs or NSOs depending on the legal advice they get.
It’s rarely up to the employee which they will receive, so it’s best to know about both.
There are pros and cons of each from both the recipient’s and the company’s perspective.
- ISOs are common for employees because they have the possibility of being more favorable
from a tax point of view than NSOs.
- 🔸 ISOs can only be granted to employees (not independent contractors or directors who are
not also employees).
- But ISOs have a number of limitations and conditions and can also create difficult
[tax consequences](#taxes-on-isos-and-nsos).

### Early Exercise

🄳 Sometimes, to help reduce the tax burden on stock options, a company will make it
possible for option holders to **early exercise (or forward exercise)** their options, which
means they can exercise even before they vest.
The option holder becomes a stockholder sooner, after which the vesting applies to actual
stock rather than options.
This will have [tax implications](#83b-elections).

🔸 However, the company has the right to repurchase the *unvested* shares, at the price
paid or at the fair market value of the shares (whichever is lower), if a person quits
working for the company.
The company will typically repurchase the unvested shares should the person leave the
company before the stock they’ve purchased vests.

### Restricted Stock Units

While stock options are the most common form of equity compensation in smaller private
companies, RSUs have become the most common type of equity award for public and large
private companies.
Facebook pioneered the use of RSUs as a private company to allow it to avoid having to
register as a public company earlier.

🚧 Why? More links on history of RSUs and Facebook story?

🄳
[**Restricted stock units (RSUs)**](http://www.investopedia.com/terms/r/restricted-stock-unit.asp)
refer to an agreement by a company to issue an employee shares of stock or the cash value
of shares of stock on a future date.
Each unit represents one share of stock or the cash value of one share of stock that the
employee will receive in the future.
(They’re called *units* since they are neither stock nor stock options, but another thing
altogether that is contractually linked to the value of stock.)

🄳 The date on which an employee receives the shares or cash payment for RSUs is known as
the **settlement date**.

- 🔸 RSUs may vest according to a vesting schedule.
The settlement date may be the time-based vesting date or a later date based on, for
instance, the date of a company’s IPO.
- RSUs are difficult in a startup or early stage company because when the RSUs vest, the
value of the shares might be significant, and taxes will be owed on the receipt of the
shares.[^thestartup.tn6iyt] This is not a bad result when the company has sufficient capital to help the
employee make the tax payments, or the company is a public company that has put in place a
program for selling shares to pay the taxes.
But for cash-strapped private startups, neither of these are possibilities.
This is the reason most startups use stock options rather than RSUs or stock awards.
- RSUs are often considered less preferable to grantees since they remove control over when
you owe tax. Options, if granted with an exercise price equal to the fair market value of
the stock, are not taxed until exercise, an event under the control of the optionee.
If an employee is awarded an RSU or restricted stock award which vests over time, they
will be taxed on the vesting schedule;
they have been put on “autopilot” with respect to the timing of the tax event.
If the shares are worth a lot on the date of vesting, the tax burden can be significant.
- ☝️ You don’t want to confuse *restricted stock units* with *restricted stock*, which
typically refers to restricted stock awards.

### Less Common Types of Equity

While most employee equity compensation takes the form of stock, stock options, or RSUs, a
complete tour of equity compensation must mention a few less common forms.

🄳 **Phantom equity** is a type of compensation award that references equity, but does not
entitle the recipient to actual ownership in a company.
These awards come under a variety of different monikers, but the key to understanding them
is knowing that they are really just cash bonus plans, where the cash amounts are
determined by reference to a company’s stock.
Phantom equity can have significant value, but may be perceived as less valuable by
workers because of the contractual nature of the promises.
Phantom equity plans can be set up as purely discretionary bonus plans, which is less
attractive than owning a piece of something.

Two examples of phantom equity are phantom stock and stock appreciation rights:

🄳 A
[**phantom stock**](http://www.investopedia.com/articles/stocks/12/introduction-phantom-stock.asp)
award is a type of phantom equity that entitles the recipient to a payment equal to the
value of a share of the company’s stock, upon the occurrence of certain events.

🄳
[**Stock appreciation rights (SARs)**](https://www.nceo.org/articles/phantom-stock-appreciation-rights-sars)
are a type of phantom equity that gives the recipient the right to receive a payment
calculated by reference to the appreciation in the equity of the company.

🚧 Elaboration needed on what events typically trigger phantom stock.
More data on how rare these are?
And what is appreciation?

🄳 [**Warrants**](https://en.wikipedia.org/wiki/Warrant_%28finance%29) are another kind of option
to purchase stock, generally used in investment transactions (for example, in a
convertible note offering, investors may also get a warrant, or a law firm may ask for one
in exchange for vendor financing).
They differ from stock options in that they are more abbreviated and stand-alone legal
documents, not granted pursuant to a single legal agreement (typically called a “[plan](#documents-and-agreements)”)
for all employees.

Employees and advisors may not encounter warrants, but it’s worth knowing they exist.

## Tax Basics

The awarding of equity compensation can give rise to multiple types of taxes for the
recipient, including federal and state income taxes and employment taxes.
There’s a lot that you have to be aware of. [Skip ahead](#taxes-on-equity-compensation) to
understand how taxes on equity work, but if you have time, this section gives a technical
summary of tax fundamentals, just in case you never really figured out all the numbers on
your pay stub.

You don’t need to know every detail, and can rely on software and professionals to
determine the tax you owe, but we do suggest understanding the different kinds of taxes,
how large they can be, and how each is “triggered” by different events.

Given the complexity, most taxpayers aren’t aware of exactly how their tax is calculated.
It does take up thousands of pages[^slatecomar.qqwwen] of the federal tax code and involves the intricate
diversity of state tax law as well.[^gpogovfdsy.clz3vr]

☝️ If you’re already familiar with tax terminology, this section may not have any major
surprises. But for those who are not used to it, watch out:
Many terms sound like regular English, but they’re not. *Ordinary income*, *long-term* and
*short-term*, *election*, *qualified small business*, and other phrases have very specific
meanings we’ll do our best to spell out.

### Kinds of Income

🄳 **Income** is the money an individual makes.
For tax purposes, there are two main types of income, which are taxed differently.
[**Ordinary income**](https://www.investopedia.com/terms/o/ordinaryincome.asp) includes wages,
salary, bonuses and interest made on investments.
[**Capital gains**](https://www.investopedia.com/terms/c/capital_gains_tax.asp) are the profits an
individual makes from selling assets, including stock.

One key difference between ordinary income and capital gains is that when capital gains
taxes are calculated, consideration is given not just to the sale price of the asset but
to the total gain or loss the investment incurred, each outcome having significantly
different tax consequences.

🄳 Capital gains are classified as long-term or short-term. **Long-term capital gains** are
the profits an individual makes from selling assets, such as stock, a business, a house,
or land, that were held for more than a year. **Short-term capital gains** are profits from
the sale of assets held for less than a year.

Although this topic is not without
[💰controversy](https://www.wsj.com/articles/how-should-capital-gains-be-taxed-1425271052),
the general idea is, if you are selling something you’ve owned for a long time, you can be
taxed a lower rate.

All these rates have evolved over time based on economic and political factors,[^taxpolicyc.sjye20] so you
can be confident they will change again in the future.

📰 In 2017, Congress passed the
[Tax Cuts and Jobs Act](https://en.wikipedia.org/wiki/Tax_Cuts_and_Jobs_Act_of_2017) (TCJA),
which made
[many changes](https://heritageinvestment.com/wp-content/uploads/2018/01/TCJA-HIG-Old-vs.-New-Comparison.pdf)
to tax rates for the **2018** tax year.
Long-term capital gains taxes did
[not change](https://www.marketwatch.com/story/your-simple-guide-to-the-new-capital-gains-tax-rates-2018-04-16)
significantly.

🚧 Can we clarify the term *investment income* too?

### Federal Taxes

🄳 **Income tax** is the money paid by individuals to federal, state, and, in some cases,
local governments, and includes taxation of ordinary income and capital gains.
Generally, U.S. citizens, residents, and some
[foreigners](https://www.irs.gov/individuals/international-taxpayers/nra-withholding) must
[file](https://www.irs.gov/pub/irs-pdf/p17.pdf) and pay federal income tax.

🔹 In general, federal tax applies to many
[kinds of income](https://www.irs.gov/taxtopics/tc400.html). If you’re an employee at a
startup, you need to consider four kinds of federal tax, each of which is computed
differently.

☝️ When it comes to equity compensation, it’s possible that you’ll have to worry about
*all of these*, depending on your situation.
That’s why we have a lot to cover here:

🄳 **Ordinary income tax** is the tax on wages or salary income, and short-term investment
income. The term **short-term capital gains tax** may be applied to taxes on assets sold
less than a year from purchase, but profits from these sales are taxed as ordinary income.
For a lot of people who make most of their money by working, ordinary income tax is the
biggest chunk of tax they pay.

🄳 **Employment taxes** are an additional kind of federal tax beyond ordinary income tax,
and consist of Social Security and
[Medicare taxes](https://www.irs.gov/businesses/small-businesses-self-employed/questions-and-answers-for-the-additional-medicare-tax)
that are withheld from a person’s paycheck.
Employment taxes are also referred to as
[**payroll taxes**](https://en.wikipedia.org/wiki/Payroll_tax) as they often show up on employee
pay stubs. The Social Security wage withholding rate in 2018 is 6.2% up to the FICA wage
base. The Medicare component is 1.45%, and it does not phase out above the FICA wage base.

- 🚧 Review and add more links on SS and Medicare taxes.

🄳 **Long-term capital gains tax** is a tax on the sale of assets held longer than a year.
Long-term capital gains tax is often lower than ordinary income tax.
Many investors hold assets for longer than a year in order to qualify for the lesser tax
burden of long-term capital gains.

🄳 **Alternative minimum tax (AMT)** is a
[supplemental income tax](https://en.wikipedia.org/wiki/Alternative_minimum_tax) that applies
to certain individuals in some situations.
This type of tax does not come up for many taxpayers, but higher income earners and people
in special situations may have to pay large AMT bills.
AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid
no income tax in 1966.[^taxpolicyc.mgorf1] It is not the same as ordinary income tax or employment tax, and
is calculated according to its
[own rules](https://www.nerdwallet.com/blog/taxes/alternative-minimum-tax-amt/).

🚧 What is the history and motivation of AMT?

❗ AMT is relevant to you if you’re reading this.
It’s important to understand because exercising ISOs can trigger AMT. In some cases a *lot*
of AMT, *even when you haven’t sold the stock* and have no money to pay.
We discuss this [later](#the-amt-trap).

#### Figure: Bracke Rates, Income, and Taxes

```hlwy-infographics
{
"name": "TaxRates",
"data": {
"rates": [
{
"rate": 0.1,
"single": 0,
"married": 0,
"hoh": 0
},
{
"rate": 0.12,
"single": 9525,
"married": 19050,
"hoh": 13600
},
{
"rate": 0.22,
"single": 38700,
"married": 77400,
"hoh": 51800
},
{
"rate": 0.24,
"single": 82500,
"married": 165000,
"hoh": 82500
},
{
"rate": 0.32,
"single": 157500,
"married": 315000,
"hoh": 157500
},
{
"rate": 0.35,
"single": 200000,
"married": 400000,
"hoh": 200000
},
{
"rate": 0.37,
"single": 500000,
"married": 600000,
"hoh": 500000
}
],
"deductions": {
"single": 0,
"married": 0,
"hoh": 0
}
}
}
```

```hlwy-infographics
{
"name": "TaxRates",
"data": {
"rates": [
{
"rate": 0,
"single": 0,
"married": 0,
"hoh": 0
},
{
"rate": 0.15,
"single": 38600,
"married": 77200,
"hoh": 51700
},
{
"rate": 0.2,
"single": 425801,
"married": 479001,
"hoh": 452401
}
],
"deductions": {
"single": 0,
"married": 0,
"hoh": 0
}
}
}
```

🄴 *Source: IRS and the
[Tax Foundation](https://files.taxfoundation.org/20180207142513/TaxFoundation-FF567-Updated.pdf)*

A bit on how all this fits together:

- Ordinary income tax applies in the situations you’re probably already familiar with, where
you pay taxes on [salaries or wages](https://www.irs.gov/taxtopics/tc401.html). Tax rates are
based on [filing status](https://www.irs.gov/newsroom/choosing-the-correct-filing-status) (if
you are single, married, or support a family), and on which
[**income bracket**](https://taxfoundation.org/2018-tax-brackets) you fall under.
- **Income brackets.**
For ordinary income, as of the **2018** tax year, there are income brackets at **10%**, **12%**,
**22%**, **24%**, **32%**, **35%**, and **37%**
[marginal tax rates](http://www.investopedia.com/terms/m/marginaltaxrate.asp)—see
[Notice 1036](https://www.irs.gov/pub/irs-pdf/n1036.pdf) or a Tax Foundation
[summary](https://files.taxfoundation.org/20180207142513/TaxFoundation-FF567-Updated.pdf). Be
sure you understand how these brackets work, and what bracket you’re likely to be in.
- ☝️ There is a popular misconception that if you move to a higher bracket, you’ll make less
money.[^todayyougo.tyjmz8] What actually happens is when you cross certain thresholds, each additional
(marginal) dollar you make is taxed at a slightly higher rate, equal to the bracket you’re
in. After you earn more than your deduction, on which you pay no tax, your post-tax income
looks like the diagram above.
(More discussion on such misconceptions are in
[this Reddit thread](https://www.reddit.com/r/personalfinance/comments/2wkbgz/graphing_one_misconception_about_tax_brackets/).)
- Investment gains, such as buying and selling a stock, are similarly taxed at “ordinary”
rates, unless they are [**long-term**](https://www.irs.gov/taxtopics/tc409.html), which means you
held the asset for more than a year.
- You also pay a number of other federal taxes (see a
[📥2018 summary for all states](https://www.adp.com/tools-and-resources/compliance-connection/state-taxes/2018-fast-wage-and-tax-facts.aspx)),
notably:
- **6.2%** for Social Security on your first $118,500
- **1.45%** for Medicare
- **0.9%**
[Additional Medicare Tax](https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax)
on income over $200,000 (single) or $250,000 (married filing jointly)
- **3.8%**
[Net Investment Income Tax](https://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs)
(NII) (enacted as part of the Affordable Care Act,[^taxpolicyc.w7dds7] also called “Obamacare”) on
investment income if you make over $200,000 (single) or $250,000 (married filing jointly).[^investoped.s08hcp]
- Ordinary federal income tax, Social Security, and Medicare taxes are withheld from your
paycheck by your employer and are called
[**employment taxes**](https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Understanding-Employment-Taxes).
- 🔹 Long-term capital gains are taxed at a lower rate than ordinary income tax: **0%**, **15%**,
or **20%**.[^foolcomtax.ox10ej] This covers cases where you get dividends or sell stock after holding it a
year. If you are in the middle brackets (more than about $37K and less than $413K of
ordinary income), your long-term capital gains rate is 15%. You can find more detail on
tax brackets at the [Tax Foundation](https://taxfoundation.org/2018-tax-brackets/).
- [AMT](http://fairmark.com/general-taxation/alternative-minimum-tax/alternative-minimum-tax-101/)
is a [complex part](https://www.irs.gov/taxtopics/tc556.html) of the federal tax code most
taxpayers don’t worry about.
But it comes into play when [exercising ISOs](#the-amt-trap). Most people do not pay AMT
unless it is “triggered” by specific
[situations](https://www.marketwatch.com/story/meet-the-new-friendlier-alternative-minimum-tax-2018-02-26),
typically high income (more than $500K) or high deductions.
Whether you pay AMT also depends on the state in which you file, since your state taxes
can significantly affect your deductions.
If you are affected, AMT tax rates are usually at **26%** or **28%** marginal tax rate, but
effectively **35%** for some ranges, meaning it is higher than ordinary income tax for some
incomes and lower for others.[^foolcomtax.3ka4p1]
AMT rules are so complicated you often need professional tax help if they might apply to
you. The IRS’s
[AMT Assistant](https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Alternative-Minimum-Tax-(AMT)-Assistant-for-Individuals)
might also help.
- 🔹 [Section 1202](https://www.investopedia.com/terms/s/section-1202.asp) of the Internal
Revenue Code provides a special tax break for qualified small business stock held for more
than five years.[^blogwealth.3vcf24]
Currently, this tax break is a 100% exclusion from income for up to $10M in gain.
There are also special rules that enable you to rollover gain on qualified small business
stock you have held for less than five years.
Stock received on the exercise of options can qualify for the Section 1202 stock benefit.
- 🚧 Fill in details on QSBS. Move this elsewhere?
Good readings on this?

### State Taxes

State tax rates and rules
[vary significantly](https://taxfoundation.org/state-individual-income-tax-rates-brackets-2018/).
Since federal rates are much higher than state rates, you usually think of federal tax
planning first.
But you should also know a bit about tax rates in your state.

State long-term capital gains rates range widely.
California has the highest, at **13.3%**; several states have none.[^foolcomper.bw6uel]

🔹 For this reason, some people even
[consider moving](https://www.forbes.com/sites/robertwood/2016/05/17/can-you-avoid-california-taxes-by-moving/#316bd9471694)
to another state if they are likely to have a windfall gain, like selling a lot of stock
after an IPO.

🚧 How do you determine to what state you owe taxes?
Any good resources on this?

## Taxes on Equity Compensation

Equity and taxes interact in complicated ways, and the tax consequences for an employee
receiving restricted stock, stock options, or RSUs are dramatically different.
This section will cover these messy details and help you make decisions that reduce the
tax burden of your equity compensation.

### 83(b) Elections

This section covers one of the most important and complex decisions you may need to make
regarding stock awards and stock options:
paying taxes early with an 83(b) election.

- Generally, restricted stock is taxed as ordinary income
[*when it vests*](http://www.investopedia.com/articles/tax/09/restricted-stock-tax.asp?performancelayout=true).
- If the stock is in a startup with low value, this may not result in high tax.
If it’s been years since the stock was first granted and the company is now worth a lot,
the taxes owed could be quite significant.

🄳 The Internal Revenue Code, in
[Section 83(b)](https://www.law.cornell.edu/uscode/text/26/83), offers taxpayers receiving
equity in exchange for work the option to pay taxes on their options before they vest.
If qualified, a person can tell the IRS they prefer this alternative in a process called
an
[**83(b) election**](http://acceleratedvesting.com/what-is-an-83b-election-and-when-do-i-make-it-part-1-with-graphic/).
Paying taxes early with an 83(b) election can potentially reduce taxes significantly.
If the shares go up in value, the taxes owed at vesting might be far greater than the
taxes owed at the time of receipt.

- ☝️ Why is it called an *election*? Because you are *electing* (choosing) to pay taxes
early in exchange for this treatment by the IRS. Does the IRS secretly enjoy making simple
concepts sound confusing?
We’re not sure.
- An 83(b) election isn’t guaranteed to reduce your taxes, however.
For example, the value of the stock may not increase.
And if you leave the company before you vest, you *don’t* get back the taxes you’ve
already paid.
- ❗ You must file the 83(b) election yourself with the IRS
[**within 30 days**](https://www.irs.gov/irb/2012-28_IRB/ar12.html) of the grant or exercise, or
the opportunity is irrevocably lost.
- ☝️ Note an 83(b) election is made on receipt of actual shares of stock.
Technically, it cannot be made on the receipt of a stock *option* itself:
You first must exercise that option, then file the election.
- If you receive an early exercisable stock option (when you don’t have to wait for the the
stock to vest), you can make an 83(b) election upon receipt of the exercised shares.
- Section 83(b) elections do not apply to vested shares;
the election only applies to stock that is not yet vested.
Thus, if you receive options that are *not* early exercisable (meaning you have to wait
until they vest to exercise), an 83(b) election would not apply.
- 🔹 Founders and very early employees will almost always want to do an 83(b) election upon
the receipt of unvested shares, since the stock value is probably low.
If the value is really low, and the taxes owed are not that great, you can make the
election without having to pay much tax and start your capital gains holding period on the
shares.
- 🚧 Clarify here which types of equity compensation the 83b can apply to.

📰 With the passage of the
[Tax Cuts and Jobs Act](https://en.wikipedia.org/wiki/Tax_Cuts_and_Jobs_Act_of_2017) (TCJA) in
2017, Congress approved a
[**new Section 83(i)**](https://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/wsgralert-section-83i.htm)
that is intended to allow deferral of tax until RSU and stock option holders can sell
shares to pay the tax bill.
Whether companies will choose or be able to make this available to employees is
[not clear](http://stockoptioncounsel.com/blog/tax-deferred-option-exercises-under-the-new-section-83i-tax-cuts-and-jobs-act-of-2017)
yet.

### 409A Valuations

When a person’s stock vests, or they exercise an option, the IRS determines the tax that
person owes. But if no one is buying and selling stock, as is the case in most startups,
then the value of the stock—and thus any tax owed on it—is not obvious.

🄳 The **fair market value (FMV)** of any good or property refers to a price upon which the
buyer and seller have agreed, when both parties are willing, knowledgeable, and not under
direct pressure to carry out the exchange.
The fair market value of a company’s stock refers to the price at which a company will
issue stock to its employees, and is used by the IRS to calculate how much tax an employee
owes on any equity compensation they receive.
The FMV of a company’s stock is determined by the company’s most recent 409A valuation.

🄳 A
[**409A valuation**](http://www.fenwick.com/FenwickDocuments/409_Valuations_Stock_Options.pdf) is
an assessment private companies are required by the IRS to conduct regarding the value of
any equity the company issues or offers to employees.
A company wants the 409A to be low, so that employees make more off options, but n

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