📌 Educational Resource Disclaimer
This glossary provides general explanations of common equity terms. These definitions and examples are for educational purposes only and do not constitute legal, financial, or tax advice.
Equity structures vary significantly between companies, and your specific situation may have unique terms and conditions. For guidance on how these concepts apply to your individual situation, please consult with a qualified legal, financial, or tax professional.
ESOP (Employee Stock Ownership Plan)
In the startup context, this usually refers to an employee stock option pool — shares reserved for granting options to employees. (Note: “ESOP” has a different meaning for public companies.)
How it works:
Board approves equity incentive plan
Reserves a pool of shares (typically 10-20% of fully diluted cap table)
Grants options to employees from this pool
Pool is “topped up” during funding rounds
Example:
Pre-Series A: Create 15% option pool (1,500,000 shares)
Grant options to first 10 employees
Series A: Investors require 20% post-money pool
Need to increase pool by issuing more shares (dilutes founders)
Why it matters: Option pools dilute founders but are necessary for hiring. Investors often require specific pool sizes as a condition of investment.
Equity Incentive Plan (Stock Option Plan)
The formal legal document approved by the board that establishes the rules for granting equity to employees, advisors, and consultants.
What it includes:
Total shares reserved for the plan
Types of awards available (ISOs, NSOs, RSUs, RSAs)
Vesting rules and acceleration provisions
Exercise periods and expiration terms
Amendment procedures
Administration details
Example plan structure:
2022 Equity Incentive Plan
├── Share Reserve: 2,000,000 shares
├── Award Types: ISOs, NSOs, RSAs, RSUs
├── Standard Vesting: 4 years, 1-year cliff
├── Exercise Window: 90 days post-termination (ISOs)
└── Administration: Board of Directors
Why it matters: You must have an approved plan before granting any equity. The plan sets the rules for all grants and must comply with securities laws.
ISO (Incentive Stock Option)
A type of stock option with favorable tax treatment, but only available to employees (not contractors or advisors) and subject to specific rules.
Key rules:
Can only grant to employees
Must have $100K annual vesting limit (based on grant value)
Must exercise within 90 days of leaving company (typically)
Strike price must be at or above fair market value at grant
Tax advantages (if holding requirements are met):
No tax at exercise (but watch AMT)
Gains taxed as long-term capital gains (lower rate)
Holding requirements: Hold shares for 1 year after exercise AND 2 years after grant date
Example:
Receive ISO grant at $1.00/share FMV
Exercise after vesting: No immediate tax
Hold shares 2+ years
Sell at $10/share: Pay long-term capital gains on $9 gain (typically ~20% federal)
Disqualifying disposition: If sold before meeting holding requirements, treated like NSOs (ordinary income on spread).
Why it matters: ISOs can save significant taxes but require careful planning around AMT and holding periods.
NSO (Non-Qualified Stock Option)
Stock options without the tax advantages of ISOs. Can be granted to anyone (employees, contractors, advisors, board members).
Tax treatment:
At exercise: Pay ordinary income tax on spread (FMV - strike price)
At sale: Pay capital gains tax on further appreciation
Example:
Grant at $1.00/share (FMV)
Exercise when FMV is $5.00/share
Ordinary income tax on $4.00 spread (could be ~40% federal + state)
Tax bill: ~$1.60 per share, even though they weren’t sold
Later sell at $10/share
Capital gains on additional $5.00 appreciation
Why it matters: NSOs create immediate tax liability at exercise, which can be painful if the stock isn’t liquid. Many employees can’t afford to exercise even after vesting.
Phantom Stock
A form of deferred compensation that mirrors the value of actual company stock without granting real equity ownership. Employees receive units that track the company's stock value, and when the units vest or upon a triggering event (typically an exit), they receive cash payments equal to the appreciation.
Key characteristics:
No actual shares issued
No ownership rights or voting power
Does not appear on the cap table
Settled in cash, not stock
Avoids dilution of existing shareholders
Tax treatment:
No tax at grant
Ordinary income tax when units are settled
Company gets tax deduction for payments
Example:
Employee receives 10,000 phantom stock units
Grant date value: $5/share (total notional value $50,000)
Three years later at vesting: $15/share
Employee receives: $150,000 cash payment (10,000 units × $15)
Company deducts $150,000 as compensation expense
Why it matters: Phantom stock provides equity-like incentives without diluting shareholders or requiring actual share issuance. Common in situations where issuing real equity is complicated (foreign subsidiaries, LLCs, companies nearing IPO).
RSA (Restricted Stock Award)
Actual shares granted to you upfront, subject to vesting and repurchase rights. Unlike options, you own the shares immediately (subject to company repurchase rights until they vest). RSAs are issues under an ESOP/Equity Plan.
How they work:
Company grants shares, you pay par value (usually nominal)
Shares vest over time (typically 4 years)
If you leave before vesting, company can repurchase unvested shares
You can file an 83(b) election to pay taxes upfront
Example:
Grant: 50,000 RSAs at $0.001 par value
You pay: $50 (50,000 × $0.001)
File 83(b) election within 30 days
Pay tax on FMV at grant (say $0.01/share = $500)
All future appreciation taxed as capital gains
Why RSAs for founders: Founders typically receive RSAs because
Getting in early when FMV is very low
83(b) election minimizes taxes
Want to own shares (not just options)
Subject to reverse vesting (company repurchases if you leave)
Why it matters: RSAs with 83(b) elections can be extremely tax-efficient if the company succeeds. The earlier you file the 83(b), the better.
RSU (Restricted Stock Unit)
A promise to give you shares in the future when they vest. Unlike options, you don’t pay anything and don’t need to exercise, shares are automatically delivered when they vest.
How they work:
Company grants RSUs
RSUs vest over time (typically 4 years)
When RSUs vest, you automatically receive shares
You pay ordinary income tax on the value of vested shares
Example:
Grant: 10,000 RSUs
Year 1: 2,500 RSUs vest
FMV at vesting: $5.00/share
You receive: 2,500 shares (usually net of taxes withheld)
Tax: Ordinary income on $12,500 (2,500 × $5.00)
Company typically withholds shares to cover taxes
RSUs vs. Options:
Feature | RSUs | Stock Options |
Purchase required | No | Yes (exercise) |
Upfront cost | No | Yes (strike price) |
Tax at vesting | Yes (ordinary income) | No (unless NSO early exercise) |
Common in | Public companies, late-stage startups | Early-stage startups |
Why it matters: RSUs are simpler than options (no exercise decision) but create immediate tax liability when they vest. More common at public companies where shares are liquid and are also used by private companies as they approach IPO due to the fact the cost of exercising options may be prohibitive as a company’s value increases.
Stock Appreciation Rights (SARs)
A compensation instrument that gives employees the right to receive payment equal to the appreciation in the company's stock value over a specified period, without requiring them to purchase shares. Similar to phantom stock but structured more like options with an exercise decision.
Key characteristics:
Grant price established at issuance (like an option strike price)
Employee decides when to exercise (within a window)
Settlement in cash, stock, or combination
No purchase required
Appreciation-only benefit
How they work:
Employee granted SARs with base price
SARs vest over time
Employee exercises when ready
Receives value of (current price - base price) × number of SARs
Example:
Grant: 5,000 SARs at $10 base price
Vesting: 4 years
After 4 years: Stock worth $30/share
Employee exercises: Receives $100,000 ((30 - 10) × 5,000)
Can be paid in cash, shares worth $100,000, or mix
Phantom Stock vs. SARs:
Feature | Phantom Stock | SARs |
Exercise decision | No (automatic at vest/trigger) | Yes (employee chooses when) |
Base value | Tracks full share value | Only appreciation above base |
Flexibility | Less (settles at predetermined event) | More (exercise timing) |
Why it matters: SARs provide option-like upside without requiring employees to pay exercise costs or take on risk. More common in mature private companies or public companies where regular options might create tax complications.
Stock Options
The right (but not obligation) to purchase shares at a predetermined price (the strike price) within a specific time period. Options are the most common form of employee equity compensation in the US.
How they work:
Company grants an employee options with a strike price
Options vest over time (typically 4 years)
Once vested, the employee can exercise (purchase) the shares
The employee pays the strike price multiplied by the number of shares
They now own actual shares
Example:
You receive a grant: 10,000 options at $1.00 strike price
After 2 years: 5,000 options vest
You exercise 5,000 options: Pay $5,000 (5,000 × $1.00)
You now own 5,000 shares of common stock
If company later sells for $10/share: Your shares worth $50,000
Why it matters: Options give employees upside without immediate cost or tax implications. However, they must be exercised (costing money) before becoming actual shares.
Options vs. Warrants
While both give holders the right to buy shares at a fixed price, they differ in who receives them and why:
Feature | Stock Options (ISO/NSO) | Warrants |
Typical Recipients | Employees, advisors, contractors | Investors, lenders, banks |
Context | Compensation for services | Financing deals, debt agreements |
Issued Under | Equity Incentive Plan | Separate warrant agreements |
Common Examples | Employee receives 50,000 ISOs | Venture debt lender receives warrants as loan sweetener |
Key Takeaway: If it was granted to an employee/advisor for their work, it's probably an option. If it was issued to an investor/lender as part of a deal, it's probably a warrant.
Strike Price (Exercise Price)
The price per share you must pay to exercise your stock options. For ISOs, this must be at least the fair market value on the grant date (determined by 409A valuation).
Example:
Options granted: $1.00 strike price
Vested options: 10,000
To exercise: Pay $10,000 (10,000 × $1.00)
Company later valued at $5/share
Your spread: $4.00 per share
Why it matters: Lower strike prices mean cheaper exercise costs and more upside potential. Strike price is locked in at grant date.