How stock options work

What are stock options?

Stock options are a form of equity compensation that gives an employee the right, but not the obligation, to buy a specific number of shares of company stock at a set price in the future. Stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called the strike price.

Many startups, private companies, and corporations offer stock options as part of a compensation package so employees can share in the company’s success. If the value of the stock increases over time, employees can buy the shares at the original, lower price and potentially profit from the difference. However, option holders are never required to exercise—that’s why they’re called options.

For young companies that can’t compete on salary alone, stock options are a powerful tool for attracting and retaining key employees. Employee tenure data reflects the effectiveness of this strategy, which shows that voluntary departure timelines are often consistent with typical four-year vesting schedules, indicating that employees are incentivized to stay until their grants are fully vested. This approach aligns everyone’s interests by giving employees a chance to share in the company’s success through employee equity. When the company does well, everyone with equity has the potential to benefit.

In this lesson of Startup Essentials by Carta, we answer one of the most common questions we hear from founders and employees of startups: What are stock options, and how do they work?

What are the different types of stock options?

Companies primarily offer two main types of stock options: incentive stock options (ISO) and non-qualified stock options (NSO). The main difference between these kinds of stock options is how they are taxed, as ISOs could qualify for special tax treatment. This distinction is important because it affects how much money you might take home after selling your shares.

Some companies may also offer other types of equity, like restricted stock units (RSU), which are different from stock options and have their own set of rules and tax implications. It’s helpful to understand the differences between RSUs and stock options so you can make informed financial decisions.

→ Learn more about the differences between RSUs and stock options

Incentive stock options (ISO)

ISOs are a special type of stock option that can receive favorable tax treatment from the IRS. This is a significant benefit for employees who receive them, as it can lead to lower taxes compared to other types of equity.

The main advantage is that if you meet specific holding period requirements, you may only pay long-term capital gains tax when you sell your shares. This rate is typically lower than ordinary income tax. To qualify, you must hold the stock for at least one year after you exercise and two years after your grant date, and be aware of other regulations like the ISO $100K limit. However, you could have to pay the alternative minimum tax (AMT) as a result of exercising your options if you don’t sell your shares in the same year you exercise them.

Non-qualified stock options (NSO)

With NSOs, you usually have to pay taxes both when you exercise and sell. The tax event for NSO is more immediate and straightforward than for ISO. When you exercise NSO, the difference between the fair market value (FMV) of the stock and your strike price is taxed as ordinary income in that year.

While both NSOs and ISOs are used for employee compensation, recent data on executive equity grants shows that ISOs are actually the more common form of stock option for executives at private companies. In 2024, more than 50% of initial equity grants issued to executives at both private equity- and venture capital-backed corporations were ISOs, while just over 25% of grants were NSOs.

How do you get stock options?

A company formally awards stock options to an employee through a stock option agreement. This is a legal document that outlines the terms of your equity, and the stock option and agreement must be approved by the company’s board of directors. It’s the official record of your right to purchase company stock in the future.

In the past, this process was often a mess of paper documents, emails, and manual tracking, which could lead to errors and confusion. Today, equity management software like Carta moves the entire workflow online. This allows founders to issue grants and employees to accept them on one platform—creating a single, accurate record on the company’s cap table and giving you easy access to your equity information.

The stock option grant

A stock option grant is the official document that details your equity award. It’s important to read and understand this document, as it contains all the key information about your options and your rights as an option holder.

Key details in your grant include:

• Option type: This specifies whether you are receiving ISO or NSO, which determines the tax rules that apply to your equity.

• Number of shares: This is the total number of shares you have the right to purchase under the grant.

• Strike price: This is the predetermined price you will pay per share when you decide to exercise your options.

• Vesting schedule: This is the timeline over which you earn the right to exercise your options, usually tied to your continued employment.

Accepting an option grant is free and does not obligate you to ever purchase the shares. It simply secures your opportunity to do so in the future, locking in your strike price and starting your vesting schedule.

Your stock option grant should also specify its expiration date. In general, ISOs expire 10 years from the date you’re granted them. However, your option grant can also expire after you leave the company—you may only have a short window of time to exercise your stock options (buy the shares) after you leave. If you don’t exercise your stock options before then, you’ll lose the opportunity to purchase them.

Ask your company if you didn’t receive a stock option grant. If you just joined in the last month or two, it’s possible that the board has not yet approved your stock options, in which case you should receive the grant shortly after the next board meeting.

If your company uses Carta to issue stock options, you won’t receive a paper version of your stock option grant. Instead, simply log into your portfolio to view, accept, and print the actual agreement.

The strike price

The strike price, also known as the exercise price, is the fixed price per share you’ll pay to purchase the stock. For private companies, IRS rules require the strike price to be equal to or greater than the stock’s FMV on the date of the grant. This is to prevent companies from issuing options at a discount, which could have negative tax consequences.

To determine this FMV, companies must get a 409A valuation, which is an independent appraisal of the company’s common stock. The 409A valuation for common stock is typically lower than the price investors pay for preferred stock in a financing round. This is because preferred stock comes with extra rights and protections that common stock doesn’t have. Using a professional, audit-ready 409A valuation service like Carta’s helps companies set a compliant strike price and avoid costly tax penalties for their employees.

How do stock options vest?

Vesting is the process of earning your options over a period of time. Companies use vesting to encourage you to stay with them and contribute to the company’s success over many years.Think of it as how a company rewards you for your continued contribution to its growth. You don’t receive all your options at once. Instead, you earn them according to a predetermined schedule outlined in your grant agreement.

A time-based vesting schedule typically includes a one-year "cliff" before you earn any equity. For corporations, the most common recipe for equity grants is a four-year schedule with a one-year cliff. In fact, when a cliff is part of the grant, the vast majority of cliffs—at least 95%—happen at the one-year mark.

This structure encourages long-term commitment from employees, and many companies also use equity refresh grants to further incentivize tenured employees.

Stock option plan document templates

While you should always consult with a legal advisor to tailor your stock option plan to your company's circumstances, our free templates are a great place to start. We’ve included templates for three essential documents every stock option plan should have:

1. Form of option agreement

2. Form of exercise agreement

3. Equity incentive plan

How to exercise your stock options

Exercising stock options is the act of purchasing the shares you have vested at your fixed strike price. Once you exercise, you transition from being an option holder to a shareholder in the company, with all the rights that come with ownership.

There are a few common methods for purchasing stock options, from a cashless exercise to the possibility of an early exercise for some grants, each with its own financial considerations:

• Cash exercise: You pay for the shares and any associated taxes out of your own pocket. This is the most straightforward method if you have the funds available and are ready to make the investment.

• Cashless exercise: Typically offered in connection with a company liquidity event such as a tender offer. You sell a set number of shares, with the company receiving the exercise cost, and you keep the proceeds from the sale minus the exercise cost.

How are stock options taxed?

For many employees, understanding how stock options are taxed is a common source of confusion and anxiety. This isn’t just an assumption; a survey from Carta shows that 55% of employees find making equity decisions stressful, and 63% don’t know how to reduce the tax liability related to their equity.

With NSO, you are typically taxed when you exercise, and the spread between your strike price and the current FMV is included as W-2 income to you as the employee. With ISO, the tax event is generally deferred until you sell the shares.

This complexity is why many founders choose to provide their teams with expert guidance to help answer common employee stock option tax questions. By using Carta’s Equity Advisory, founders can give their employees access to licensed tax professionals who can offer personalized guidance, taking the burden off of founders and HR teams.

Exercising incentive stock options can be a great way to build wealth, but it can also trigger the AMT, a separate tax calculation that can lead to a surprisingly large bill. To avoid any surprises, you should estimate your potential AMT liability before you exercise.

Download our free AMT calculator to model your tax scenario and make a more informed financial decision.

Free AMT calculator

Carta’s free AMT Calculator helps you estimate your potential tax bill.

Download the calculator

What happens to your stock options if you leave the company?

When you leave your job, your options typically stop vesting immediately. You will only be able to exercise the options that have already vested as of your termination date. It’s important to understand what happens to vested stock when you leave, as you will only be able to exercise the options that have already vested as of your termination date. Any unvested options are returned to the company’s option pool.

You’ll have a limited window of time to exercise your vested options, known as the post-termination exercise period (PTEP). If you don’t exercise within this window, you forfeit the right to purchase those shares forever. While the traditional PTEP was often short, many modern startups are offering longer, more employee-friendly exercise windows.

Don’t forget about this window of eligibility. Your company isn’t obligated to remind you when you leave—they usually only tell you in your option grant when you first join.

Knowing what stock options are and how they work can help you make more informed decisions about when to sign your option grant, when to exercise your options, and what to do when you leave your company.

Are stock options risky?

Yes, there is risk involved with stock options. If the company’s stock price never goes above your strike price (“in the money”), your options will have no monetary value. This risk, known as having "underwater" options, is more common than many people realize, especially when market conditions shift. For example, after a period of high growth, the market saw a significant change. In Q1 2023, 45% of Series D companies saw their 409A valuation decline—up from less than 5% in Q1 2021—illustrating how quickly option grants can go underwater when valuations reset.

However, you can also see this risk as a feature, not a bug. This structure is what aligns the incentives of employees with founders and investors. It creates a shared goal of building a valuable and successful company, so that everyone who contributed to that success has a chance to share in the rewards.

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Frequently asked questions about stock options

What’s the difference between stock options and shares?

Stock options are the right to buy shares in the future at a set price, while shares, like common stock or restricted stock, represent direct ownership in the company today. Holding options is not the same as holding stock. You must exercise your options to become a shareholder.

Can stock options expire?

Yes, all stock options have an expiration date, which is typically 10 years from the grant date. If you don’t exercise your options before they expire, they become worthless and you lose the opportunity to purchase them.

What happens to my options if the company is acquired or goes public?

If the company is acquired or goes public, your options may vest early, be converted to options in the new company, be cashed out, or be canceled depending on the terms of your option agreement and the details of the deal. You may also have an opportunity to exercise vested options and potentially sell the resulting shares.

What is a stock option pool, and how does it affect my ownership?

A stock option pool is a reserved amount of company shares set aside for employees and future hires. It dilutes all shareholders, including you, meaning your percentage ownership of the company may decrease when the pool is created or increased.

Will my stock options be diluted if the company raises more money?

Yes, when the company raises more money and issues new shares to investors, your stock options will be diluted, reducing your percentage ownership in the company.

How do I find out the current value of my stock options?

You can estimate the current value of your options by subtracting your strike price from the company’s latest FMV per share, then multiplying by the number of options you have.

Can I sell my vested shares before an IPO or exit event?

Usually, you cannot sell your vested shares before an IPO or exit event due to company restrictions, but some companies allow limited secondary sales with approval. Always check your company’s policies.

What is the difference between employee stock options and an employee stock purchase plan?

Employee stock options give you the right to buy company shares at a set price in the future, usually as part of your compensation. An employee stock purchase plan (ESPP) allows you to buy shares, often at a discount, through payroll deductions during specific offering periods.