ISOs are a type of stock option that qualifies for special tax treatment. Unlike other types of options, you usually don’t have to pay taxes when you exercise (buy) ISOs. Plus, you may be able to pay a lower tax rate if you meet certain requirements. Here’s what you need to know.
When a company gives you equity as part of your compensation package, they’re offering you partial ownership of the company. However, your stock usually has to vest first, meaning you typically need to work for the company for a period of time if you want to become an owner.
Vesting is the process of earning an asset, like stock options or employer-matched contributions to your 401(k) over time. Companies often use vesting to encourage you to stay longer at the company and/or perform well so you can earn the award.
Stock vesting explained
With stock options, like ISOs or NSOs, you aren’t getting actual shares of stock—yet. Instead, you’re getting the right to exercise (buy) a set number of shares at a fixed price later on. You usually have to earn your options over time—a process called vesting. And you can only exercise vested stock options (unless your company allows early exercising).
If your company gives you RSUs, on the other hand, they’re giving you stock in the future. You may have to stay at the company for a certain amount of time, and sometimes you or the company must hit a stated milestone in order for these shares to vest. But unlike stock options, you don’t need to purchase them—you just need to wait for them to vest.
Your vesting schedule, which shows when you’ll earn your options or shares, should be detailed in your option grant (e.g. 1,000 options over four years).
There are three common types of vesting schedules: time-based, milestone-based, and a hybrid of time-based and milestone-based.
Time-based vesting and one-year cliffs
With time-based stock vesting, you earn options or shares over time.
Most time-based vesting schedules have a vesting cliff. A cliff is when the first portion of your option grant vests. After the cliff, you usually gradually vest the remaining options each month or quarter.
Many companies offer option grants with a one-year cliff. This means you must stay at the company for at least a year if you want to exercise any options. Any unvested options get put back into the option pool when you leave (and after the post-termination exercise period has elapsed).
Under a standard four-year time-based vesting schedule with a one-year cliff, 1/4 of your shares vest after one year. After the cliff, 1/36 of the remaining granted shares (or 1/48 of the original grant) vest each month until the four-year vesting period is over. After four years, you are fully vested.
Keep in mind that each option grant has its own vesting schedule—vesting isn’t based on your overall tenure at the company. If you got one grant in 2020 with a four-year vesting schedule and another grant from the same company in 2022 with a four-year vesting schedule, you wouldn’t vest all of the options in both grants until 2026.
With milestone vesting, you get your options or shares after completing a specific project or when you and/or the company reach a business goal (e.g. the company hits a certain valuation). This type of vesting isn’t as common as time-based vesting.
Hybrid vesting is a combination of time-based and milestone vesting. With hybrid vesting, you have to both work at the company for a certain amount of time and hit one or more milestones to receive your options or shares.
Stock vesting example
Meetly, Inc. hired Sadie on November 1st, 2017. As part of her compensation package, Meetly gave Sadie an option grant with the following details:
- Grant date: 11/1/2017
- Options granted: 192
- Vesting schedule: Monthly for four years with a one-year cliff
One year after Sadie’s hire date, on November 1st, 2018, she reaches her cliff and 1/4 of her shares (48 shares) vest. She can now exercise those 48 shares (though she’s not obligated to).
Over the next three years, an additional four shares vest every month. By November 1st, 2021, Sadie is completely vested and can exercise all 192 of the shares in her option grant if she chooses.
If she leaves the company before November 1st, 2021, Sadie will surrender all unvested shares, which will be returned to the company’s option pool.
For a more thorough explanation of strike prices, option pools, and other equity concepts that affect startup founders and employees, see our full equity guide.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”). This communication is for informational purposes only, and contains general information only. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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