- How employee stock options work
- What are employee stock options?
- What are the different types of stock options?
- Incentive stock options (ISO)
- Non-qualified stock options (NSO)
- How do you get stock options?
- The stock option grant
- The strike price
- How do stock options vest?
- How to exercise your stock options
- A simple example
- Methods of exercise
- Why exercising is a big decision
- How are stock options taxed?
- What happens to your stock options if you leave the company?
- Are stock options worth it?
- Frequently asked questions about stock options
What are employee stock options?
Employee stock options (ESO) are a form of equity compensation that gives you the right, but not the obligation, to buy a specific number of company shares at a fixed price, called the strike price, within a set period of time.
Many startups, private companies, and corporations offer stock options as part of a compensation package. If the stock’s value increases over time, you can buy shares at the original, lower price and potentially profit from the difference. Option holders are never required to exercise. That's why they're called options.
For companies that can't compete on salary alone, stock options are a powerful tool for attracting and retaining employees. 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 types of stock options: incentive stock options (ISO) and non-qualified stock options (NSO). The key difference between these stock options is how they are taxed. ISOs may qualify for special tax treatment that affects how much money you might take home after selling your shares.
Incentive stock options (ISO) | Non-qualified stock options (NSO) | |
Tax at exercise | Generally no ordinary income tax, but may trigger alternative minimum tax (AMT) | Taxed as ordinary income on the difference between the current fair market value and your strike price |
Tax at sale | Can qualify for lower long-term capital gains tax rates if holding period requirements are met | Any additional gain is taxed as a long-term or short-term capital gain |
Typically granted to | Employees only | Employees, contractors, and advisors |
Some companies may also offer other types of equity, like restricted stock units (RSUs), which are different from stock options and have their own set of rules and tax implications.
→ 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 often results in lower taxes compared to other equity types.
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. You should also be aware of the ISO $100K limit, which caps the total value of ISOs that can become exercisable in any calendar year. One thing to watch for: You could owe the alternative minimum tax (AMT) if you exercise your options but don't sell your shares in the same year.
Non-qualified stock options (NSO)
With NSOs, you usually pay taxes both when you exercise and when you sell. When you exercise NSOs, 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. When PE-backed corporations issue equity grants to their employees, about 60% of those grants take the form of ISOs, while 29% are NSOs and 8% are RSUs.
How do you get stock options?
A company formally awards stock options through a stock option agreement. This legal document outlines the terms of your equity, and the stock option agreement must be approved by the company's board of directors.
In the past, this process often involved a mess of paper documents, emails, and manual tracking, which could lead to errors and confusion. Carta's equity management software moves this process online. Founders can issue grants and employees can accept them on one platform, keeping an accurate cap table record in a single place.
If your company needs to formalize its employee stock ownership plan (ESOP), templates for key documents including a form of option agreement, form of exercise agreement, and equity incentive plan are a helpful starting point, though you should always consult a legal advisor to tailor the plan to your company's specific circumstances.
The stock option grant
A stock option grant is the official document that details your equity award. Read it carefully, because it contains all the terms governing your options.
Key details in your grant include:
Option type: Specifies whether you are receiving ISOs or NSOs, which determines the tax rules that apply to your equity.
Number of shares: The total number of shares you have the right to purchase under the grant.
Strike price: The predetermined price you will pay per share when you decide to exercise your options.
Vesting schedule: The timeline over which you earn the right to exercise your options, usually tied to your continued employment.
Expiration date: The deadline by which you must exercise your options or lose them. In most cases, ISOs expire 10 years from the grant date.
Accepting an option grant is free and does not obligate you to ever purchase the shares. It secures your opportunity to do so in the future, locking in your strike price and starting your vesting schedule.
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 departure. If you don't exercise before that window closes, you lose the opportunity to purchase them.
If you didn't receive a stock option grant, ask your company. If you just joined in the last month or two, the board may not have approved your stock options yet. 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 Carta portfolio to view, accept, and print the actual agreement.
The strike price
The strike price, also known as the exercise price, is the pre-set price per share you 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 prevents 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, 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 periods to encourage you to stay and contribute to the company's growth over many years. 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 structure for equity grants is a four-year schedule with a one-year cliff. At least 95% of cliffs 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.
How to exercise your stock options
Exercising stock options means 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.
A simple example
Say you receive 1,000 options with a strike price of $2 per share. Over time, the company grows and the stock's FMV rises to $10 per share. If you exercise all 1,000 options, you pay $2,000 (1,000 x $2) to acquire shares currently worth $10,000 (1,000 x $10). The $8,000 difference is your potential gain, though the actual value depends on your ability to sell the shares, which at a private company typically requires a liquidity event.
Methods of exercise
There are a few common methods for purchasing stock options, each with its own financial considerations:
Cash exercise: You pay for the shares and any associated taxes out of your own pocket. Use this method when you have the funds available.
Cashless exercise: Typically offered in connection with a company liquidity event such as a tender offer. You sell a set number of shares, the company receives the exercise cost, and you keep the proceeds minus the cost.
Why exercising is a big decision
Exercising is rarely simple, especially for employees at private companies where shares are not yet liquid. In Q4 2024, employees at startups on Carta exercised just 32.2% of all equity grants that were both fully vested and in the money.
"Exercising options is expensive. If you're a person who's not wealthy, which is most of us, you are going into your savings and having to make a serious decision about where you're investing your extra capital."
— Heather Doshay, Partner, SignalFire (Source)
The cost of exercising, the tax implications, and the uncertainty about a future exit all factor into this decision. It may make sense to exercise early, wait for a liquidity event, or consult a tax professional before committing.
→ Learn more about an early exercise of stock options
How are stock options taxed?
With NSOs, you are typically taxed when you exercise. The spread between your strike price and the current FMV is included as W-2 income. With ISOs, the tax event is generally deferred until you sell the shares.
Stock options taxes may be a common source of confusion and anxiety for employees. Many founders give their teams access to licensed tax professionals for personalized guidance. Carta's Equity Advisory handles individual employee questions at scale, so that burden doesn't fall on founders and HR teams.
Exercising incentive stock options can help build wealth, but it can also trigger the AMT, a separate tax calculation that can lead to a surprisingly large bill. Estimate your potential AMT liability before you exercise to avoid surprises.
Download the free AMT calculator to model your tax scenario and make a more informed financial decision.
What happens to your stock options if you leave the company?
When you leave your job, your options stop vesting immediately. 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. Many modern startups now offer longer exercise windows than the traditional, short PTEP.
Your company isn't obligated to remind you about this deadline. In most cases, it’s mentioned once in your option grant when you first join.
Are stock options worth it?
Stock options carry real risk, but they can also create meaningful financial upside.
The upside: If the company's stock price rises above your strike price, your options become "in the money." You can exercise at the lower strike price and potentially profit from the difference. For employees at companies that eventually go public or get acquired, stock options can represent a significant portion of total compensation.
The risk: If the company's stock price never exceeds your strike price, your options will have no monetary value. This is more common than many people realize, especially when market conditions shift. For example, during the 2022–2023 market reset, 45% of Series D companies saw their 409A decline in Q1 2023—up from less than 5% just two years earlier.
You can also see this risk as a feature, not a bug. When everyone holds equity, employees, founders, and investors share the same goal: building something valuable. If it works, everyone who contributed gets a chance to share in the outcome.
The honest answer comes down to three questions: How much do you believe in the company's trajectory? Can you afford to exercise? Do you understand the tax implications? If you're unsure, talking to a licensed tax professional before any exercise decision is worth the time.
Request a demo to see how Carta can help you manage employee equity from grant to exercise.
Frequently asked questions about stock options
How do employee stock options work?
A company grants you stock options as part of your compensation. Each grant specifies a number of shares, a strike price, and a vesting schedule. As your options vest over time, you earn the right to buy shares at the strike price. If the company's stock value rises above that price, you can exercise your options to buy shares at the lower price and potentially profit from the difference. You typically need a liquidity event, like an IPO or acquisition, to sell shares at a private company.
What's the difference between stock options and shares?
Stock options give you the right to buy shares in the future at a set price. Shares, like common stock or restricted stock, represent direct ownership in the company today. You must exercise your options to become a shareholder.
Can stock options expire?
Yes. All stock options have an expiration date, typically 10 years from the grant date. If you don't exercise before they expire, the options become worthless.
What happens to my options if the company is acquired or goes public?
It depends on the terms of your option agreement and the deal itself. Your options may vest early, be converted to options in the acquiring company, be cashed out, or, in some cases, be canceled. You may also have an opportunity to exercise vested options and potentially sell the resulting shares. Review your option agreement carefully and consult with a tax advisor before an exit event, if possible.
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. Creating or increasing the pool dilutes all shareholders, including you, meaning your percentage ownership of the company may decrease.
Will my stock options be diluted if the company raises more money?
Yes. When the company raises capital and issues new shares to investors, your stock options are diluted, reducing your percentage ownership in the company. Share dilution is a normal part of startup fundraising.
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 hold. At a private company, you can’t sell shares until a liquidity event, so this value is theoretical until then.
Can I sell my vested shares before an IPO or exit event?
In most cases, no. Company restrictions typically prevent you from selling shares before an IPO or exit event. Some companies do 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.
What is the $100,000 rule for stock options?
The $100,000 rule, also called the ISO $100K limit, caps the total value of incentive stock options that can become exercisable for the first time in any single calendar year at $100,000 (based on the FMV at the time of grant). Any options above that threshold are automatically treated as NSOs for tax purposes. This limit applies per employee and is set by the IRS.
DISCLOSURE: This communication is on behalf of eShares, Inc. dba 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. © 2026 Carta. All rights reserved. Reproduction prohibited.
