An equity grant is your way of offering team members a slice of the company you're building together. It’s non-cash compensation that transforms employees from hired hands into genuine partners, giving them a real stake in your startup’s long-term success. For founders navigating the challenges of scaling a startup, understanding equity is non-negotiable.
The Founder’s Guide to Equity Grants
For a startup watching every penny, an equity grant is the single most powerful tool for attracting and retaining top-tier talent—the kind of people willing to bet on your vision. It addresses a core challenge in startup growth: competing for talent without a large cash budget.
Instead of a high salary you can't afford, you offer a piece of the company's future value. This simple act aligns incentives and builds a culture of shared ownership from day one.
Think of it this way: you're giving each key team member a small piece of the ship they’re helping you build. Suddenly, their success is directly tied to the ship's journey. This ownership mindset pushes them to solve problems, innovate, and contribute far beyond their job description. In the competitive startup ecosystem, that shared purpose is a massive advantage.
Why Equity Is a Startup Superpower
Equity compensation is more than a stand-in for cash; it fundamentally changes the dynamic between a company and its team, turning a job into a shared mission. For any early-stage company trying to scale quickly, the benefits are immediate and impactful.
Here’s a framework for why it works so well:
- A True Talent Magnet: Offering ownership lets you compete with established tech giants for elite talent, even when your salary budget is tight.
- Cash Conservation: It preserves your cash runway, freeing up capital for critical business practices like product development, marketing, or scaling operations.
- Retention and Loyalty: Vesting schedules (which we'll cover shortly) give employees a powerful financial incentive to commit to the company for the long haul.
- The Ownership Mindset: When employees are owners, they think like owners. They become more engaged, more proactive, and laser-focused on creating value that drives the company forward. This is a core attribute of founder excellence that you want to instill in your team.
For founders, an equity grant is a strategic tool that rallies your entire team around one shared goal: building a wildly valuable company. It’s the currency of commitment in the startup world.
This model is a cornerstone of startup compensation strategy. At its core, an equity grant is a form of compensation where employees are awarded shares or rights to company stock, aligning their personal financial success with that of the shareholders.
According to research from Carta, a leading equity management platform, a significant percentage of startups offer equity across all roles, not just to executives. The value of these grants is directly tied to the company's growth—a figure that hinges on hitting key milestones and securing funding rounds, all of which heavily influence startup valuations.
To apply this, let's break down the key terms you'll encounter when structuring an equity grant.
Key Components of an Equity Grant at a Glance
| Component | What It Means for Founders and Employees |
|---|---|
| Grant Type | The specific kind of equity offered, like stock options (ISOs, NSOs) or Restricted Stock Units (RSUs). This choice has major tax and legal implications for both sides. |
| Number of Shares | The total quantity of shares the employee is eligible to receive or purchase. This represents their potential ownership slice. |
| Strike Price | For stock options, this is the fixed price per share an employee will pay to buy their shares. It's usually set at the fair market value on the grant date. |
| Vesting Schedule | The timeline over which the employee earns the right to their shares. A standard schedule is 4 years with a 1-year cliff. |
| Cliff | A period (typically the first year) where no shares vest. If the employee leaves before the cliff, they walk away with nothing. It protects the company from early departures. |
| Expiration Date | The deadline by which an employee must exercise their vested options after leaving the company. This can range from 90 days to 10 years. |
Understanding these components is the first step toward creating a fair, motivating, and legally sound equity compensation plan for your team.
Navigating the Different Types of Equity
You’ve decided to offer equity—a great step in your startup growth strategy. Now you must determine what kind of equity to grant. This is not a one-size-fits-all decision; the type of grant you issue has real consequences for everything from your team’s tax bills to regulatory compliance.
Think of it like choosing the right tool for a job. The three most common tools in your equity toolkit are Incentive Stock Options (ISOs), Non-qualified Stock Options (NSOs), and Restricted Stock Units (RSUs). Let's analyze what they are and when to use them.
This decision is more than just paperwork; it’s a powerful way for founders to attract top-tier talent, conserve cash, and align everyone with a true sense of ownership.
These elements feed into each other, creating a growth engine powered by a motivated team that shares in the company's long-term success.
Incentive Stock Options (ISOs)
Think of Incentive Stock Options (ISOs) as a specialized tool for employees. They are reserved exclusively for employees and come with a significant tax advantage: if an employee holds the stock for a specified period after exercising, their profit is taxed at the lower long-term capital gains rate.
This tax benefit makes ISOs a fantastic recruiting tool, especially for early-stage companies. You're competing with larger companies that can offer higher salaries, but you can offer something they can't: massive potential upside with a much friendlier tax outcome. It’s a strategic way to reward the core team who took a bet on your vision.
Non-qualified Stock Options (NSOs)
Non-qualified Stock Options (NSOs) are the workhorse of the equity world. They’re far more flexible than ISOs and can be granted to anyone who contributes to your company’s growth—employees, contractors, and advisors.
The trade-off for this flexibility is the tax treatment. When someone exercises an NSO, the discount they receive (the spread between the strike price and the stock's current value) is taxed as ordinary income. This straightforward approach makes NSOs essential for rewarding the extended team that contributes to your success.
Restricted Stock Units (RSUs)
Unlike options, which grant the right to buy stock, Restricted Stock Units (RSUs) are a promise of actual shares. Once the vesting conditions are met, the shares are delivered to the recipient, with no purchase required.
RSUs are more common in later-stage startups or public companies where the stock has a clear, established value. Because they hold value as long as the company's stock isn't worthless, employees often see them as less risky than options. The downside? The value of the shares is taxed as ordinary income the moment they vest, which can create a significant tax event.
Choosing the right grant type depends on your company’s stage and who you are compensating. It's also critical to understand how these equity plans fit into your broader financing strategy. For a deeper dive into how instruments like SAFEs can affect your equity pool, explore our guide on SAFE financing for startups.
To make this even clearer, this table compares the key features of each equity type head-to-head.
Comparing Equity Grant Types: ISOs vs. NSOs vs. RSUs
| Feature | Incentive Stock Options (ISOs) | Non-qualified Stock Options (NSOs) | Restricted Stock Units (RSUs) |
|---|---|---|---|
| Who Can Get Them? | Employees only. | Anyone (employees, contractors, advisors). | Anyone (employees, contractors, advisors). |
| How They Work | Right to buy shares at a fixed price. | Right to buy shares at a fixed price. | Promise of receiving shares later. |
| Tax on Exercise | No tax at exercise (unless AMT applies). | Taxed as ordinary income on the "spread." | Not applicable (no exercise). |
| Tax on Vesting | No tax at vesting. | No tax at vesting. | Taxed as ordinary income on the shares' value. |
| Tax on Sale | Long-term capital gains if holding rules met. | Capital gains (long or short-term). | Capital gains (long or short-term). |
| Best For… | Early-stage startups rewarding key employees. | Compensating a wide range of contributors. | Later-stage companies with stable stock value. |
This framework provides a solid foundation for deciding which instrument aligns best with your startup's compensation philosophy and strategic goals.
How Vesting Schedules Build Long-Term Commitment
An equity grant is a powerful promise of ownership, but vesting is what turns that promise into a strategic tool for retention. You don't hand a new hire the keys to the kingdom on day one. Instead, they earn their ownership over time by staying with the company and contributing to its growth.
This time-based approach ensures that equity rewards genuine, long-term commitment, not a brief stopover. It aligns the entire team by tying an employee's financial success directly to the startup's growth. Without a vesting schedule, a key employee could receive a significant equity stake and depart shortly after—a nightmare scenario for any founder.
The Standard Vesting Schedule Explained
In the startup world, the gold standard for vesting is the four-year schedule with a one-year cliff. It has become the default because it strikes a fair balance between protecting the company and giving employees a meaningful stake in its future.
Here’s a practical breakdown of how this framework operates:
- The One-Year Cliff: For the first 12 months, no equity vests. If an employee leaves before their first anniversary, they forfeit their entire grant. This "cliff" is a critical safeguard against giving away precious ownership to someone who isn't a long-term fit.
- The First Vesting Event: On their one-year anniversary, 25% of their total grant vests at once. This is a major milestone that rewards them for their commitment through the crucial first year.
- Monthly Vesting: After the cliff, the remaining 75% of the shares typically vest in equal monthly installments over the next three years (36 months). This creates a consistent, ongoing incentive for them to stay invested in the company's journey.
A vesting cliff is essentially a one-year trial period for ownership. It ensures only those who are truly committed to the mission begin to earn their stake.
This time-based model offers a clear and predictable path to ownership. Employees can easily see how their commitment translates into value, making it a cornerstone of any solid startup compensation plan.
Beyond Time-Based Vesting
While the four-year schedule remains prevalent, it's not the only model. Startups are increasingly experimenting with frameworks that tie equity more directly to performance. This has led to the rise of performance-based vesting, where shares are earned by hitting specific goals—such as reaching a revenue target, launching a new product, or achieving a key business objective.
This shift creates results-oriented incentives. According to a 2023 report from Morgan Stanley, a growing number of companies are incorporating performance metrics into their equity plans, particularly for leadership roles. This approach is powerful for focusing senior leaders on the most critical business outcomes.
Understanding the Financial and Tax Implications
Issuing equity involves more than motivating your team—it comes with significant financial and tax responsibilities for everyone involved. As a founder, you must understand these details to build a program that’s both compliant and fair.
One of the first and most important hurdles is determining the Fair Market Value (FMV) of your company’s common stock. This isn't a number you can estimate. It requires a formal, independent appraisal known as a 409A valuation, as stipulated by IRS regulations.
This valuation is critical because it sets the strike price (or exercise price) for the stock options you grant. A proper 409A valuation provides a "safe harbor," meaning the IRS is likely to accept your pricing. For early employees, a low strike price is a huge advantage, as it maximizes their potential profit when they eventually exercise and sell their shares.
The Role of 409A Valuations
A 409A valuation is the official price for a share of your private company. If you skip this step and set a strike price that the IRS later deems too low, your employees could face significant tax penalties.
As a best practice in financial management, you should obtain your first 409A valuation before issuing any equity. Thereafter, you must refresh it at least annually or after any material event that could affect your company's value, such as a new funding round. Staying on top of this protects both the company and your team.
Key Tax Events for Employees
It is your responsibility to ensure your team understands the tax implications of their equity. Being transparent manages expectations and helps them see the real-world value of their compensation. There are two primary moments when taxes come into play.
- Exercising Options: This is when an employee executes their right to buy their vested shares at the original strike price. This action can trigger a tax liability, depending on the option type. With Non-qualified Stock Options (NSOs), the difference between the strike price and the current FMV is taxed as ordinary income immediately.
- Selling Shares: This is the liquidity event—when an employee sells their stock. The profit, which is the difference between the sale price and their cost basis (strike price plus any taxes paid at exercise), is subject to capital gains tax. The tax rate is generally lower if they’ve held the stock for more than a year.
By proactively educating your team about these financial milestones, you empower them to make informed decisions and fully appreciate the wealth-building potential of their equity.
As a founder, your job isn’t done when you deliver the grant letter. You need to create a transparent culture where your team understands the entire journey—from grant to a potential liquidity event, including taxes. That clarity builds trust and shows them you're truly invested in their success.
How to Structure Your Startup Equity Plan
Your equity plan is a blueprint for your company's growth, not just a formality. A fair, motivating, and scalable plan is one of the most powerful tools a founder has. The decisions you make now will set the foundation for your hiring and team-building strategy for years to come.
Your first major decision is determining the size of your employee option pool—the slice of company equity set aside for your team. For most early-stage companies, this pool typically falls between 10% and 20% of the company's total shares, a figure often negotiated during funding rounds.
This is a strategic decision. As reported by sources like TechCrunch, the size of an option pool is a key point of discussion between founders and investors, as it directly impacts dilution for all shareholders. Your plan must be competitive enough to attract talent while being sustainable for the company's long-term capital structure.
Standardizing Grants for Fairness and Scalability
With your option pool established, the next challenge is allocating it. It's tempting to negotiate each offer individually, but this can lead to an inconsistent and inequitable cap table. The more effective approach is to standardize your grants based on a clear framework.
Build a framework that ties grant sizes to a few key factors:
- Role and Level: Your VP of Engineering will receive a different grant than an entry-level software engineer. Group roles into tiers based on seniority and responsibility.
- Timing of Hire: Your first ten employees are taking a significant risk. Their equity grants should reflect that. Later hires, joining a more de-risked company, will naturally receive smaller grants.
- Strategic Impact: Is this a hire who could unlock a new market or solve a game-changing technical problem? That level of strategic importance should be factored into their compensation.
A standardized formula makes the process more transparent and fair, simplifying hiring conversations and building a culture of trust.
The Role of Refresh Grants and Legal Diligence
An equity plan is not a "set it and forget it" document. Your top performers will eventually vest their entire initial grant. Refresh grants are the tool to keep them engaged and focused on the long-term vision.
These are additional equity grants given to high-performing employees, often tied to a promotion or as part of an annual performance review. Refresh grants are a powerful best practice for rewarding and retaining the talent you can't afford to lose.
Of course, none of this matters if the legal foundation is weak. A poorly executed equity plan can become a legal and financial nightmare.
An equity grant is not just a promise; it's a legal contract. Meticulous documentation, board approval, and clear communication are non-negotiable elements for protecting your company and your team.
Ensure you have a rock-solid process in place. Follow this actionable checklist:
- Create the Plan Document: Have your legal counsel draft the official equity incentive plan.
- Obtain Board Approval: The plan and the option pool size must be formally approved by your board of directors.
- Issue Grant Agreements: Every grant requires a formal, signed agreement between the company and the employee.
- Track and Manage: Use a cap table management platform. Tracking vesting and ownership in a spreadsheet is prone to error and not scalable.
Following these steps is critical. For a deeper dive into the rules and regulations, explore our other resources on legal compliance for startups.
Common Questions Founders Ask About Equity Grants
Even with the most carefully crafted equity plan, you will receive questions. This is a positive sign; it means your team is engaged and thinking like owners. Anticipating these common concerns and having clear, authoritative answers ready will build trust and ensure everyone understands the value of their stake.
Let's address some of the most frequent questions.
What Happens to Vested Equity if an Employee Leaves?
When an employee with vested options leaves the company, a specific window of time begins, known as the Post-Termination Exercise Period (PTEP), during which they must decide whether to purchase their shares.
This period is typically 90 days. If they do not exercise their options within that timeframe, the options expire and return to the company’s option pool.
Unvested equity is always forfeited upon departure. Ensure this is clearly stated in your grant agreements to prevent future misunderstandings.
How Do I Decide How Many Shares to Grant Someone?
Determining grant sizes is more art than science, but it should be guided by data. Founders typically balance a few key factors: the person’s role and seniority, their potential impact, and market benchmarks. Compensation platforms like Carta or Pave provide invaluable market data for technology and startup roles.
You can benchmark grants as a percentage of the company or, more commonly, as a target dollar value.
A solid rule of thumb is that early hires who assume more risk receive larger grants. Someone joining a three-person founding team is taking a much greater leap of faith than someone joining a 100-person, Series B company, and their equity should reflect that.
Can I Give Equity to Contractors or Advisors?
Yes. It is common for startups to grant equity to advisors and key contractors, usually in the form of Non-qualified Stock Options (NSOs).
However, the vesting schedules often differ. An advisor’s grant, for example, might vest monthly over their one or two-year engagement, rather than on a standard four-year employee schedule.
Always consult your legal counsel to structure these grants properly. Missteps can lead to serious compliance issues with securities laws, so it's critical to ensure you're protecting both the company and the grantee.
What Is the Difference Between Exercising and Selling Stock?
This is a crucial distinction that often confuses employees. They are two separate steps in converting options into cash.
- Exercising: This is the purchase. An employee uses their option to buy the company shares they have vested at the locked-in strike price. At this point, they own the stock but have not yet realized a cash profit.
- Selling: This is the liquidation. It occurs when they sell the shares they own, either on a public market after an IPO or through a private secondary sale. Their profit is the difference between the sale price and their total cost to acquire the shares (exercise price plus any taxes paid).
At Spotlight on Startups, we deliver the actionable knowledge founders, investors, and startup teams need to build successful companies. Explore our expert insights to navigate your entrepreneurial journey with confidence. Learn more on our website.