Stock Options Explainer

The 4 Types of Equity Compensation

Companies give you ownership through different vehicles. Each has different tax treatment.

ISO - Incentive Stock Options

Used by: Startups and private companies

ISOs give you the right to buy company stock at a locked-in price (the "strike price") set when you were hired. You do not own anything until you "exercise" (buy) the options. ISOs get favorable tax treatment: no regular income tax when you exercise, only capital gains when you sell. However, the "bargain element" (difference between strike and FMV) can trigger AMT (Alternative Minimum Tax).

Example: You get 10,000 ISOs at $2 strike price. Company goes public at $20. You exercise for $20,000 (10k x $2). Shares are now worth $200,000. Your profit of $180,000 is taxed at long-term capital gains rate (15-20%) if you hold 1 year after exercise AND 2 years after grant. That is $27,000-$36,000 in tax vs. ~$66,000 if taxed as income.

NSO - Non-Qualified Stock Options

Used by: Startups, private companies, public companies

NSOs work like ISOs but with worse tax treatment. When you exercise, the spread (FMV minus strike price) is taxed as ordinary income immediately, plus you owe payroll taxes. However, NSOs have no AMT risk and can be granted to contractors and advisors, not just employees. After exercise, future gains are taxed at capital gains rates.

Example: Same 10,000 options at $2, company at $20. You exercise and the $180,000 spread is immediately taxed as W-2 income. At 35% tax bracket, that is $63,000 in taxes owed right away, plus ~$14,000 in payroll taxes. Total tax: ~$77,000. You need cash to cover this.

RSU - Restricted Stock Units

Used by: Public companies (Google, Amazon, Meta, etc.)

RSUs are a promise to give you actual shares on a schedule. No strike price, no exercise needed. When shares vest, they become yours automatically and are taxed as ordinary income at their market value. This is the simplest form of equity: company gives you shares, you pay income tax on them. Most public tech company offers are RSU-heavy.

Example: You receive 1,000 RSUs vesting over 4 years (25% per year). Stock is at $150. Year 1: 250 shares vest = $37,500 taxable income added to your W-2. Your company withholds ~40% for taxes, so you receive approximately 150 shares in your brokerage and 100 shares are sold to cover taxes.

ESPP - Employee Stock Purchase Plan

Used by: Public companies offering a stock discount

ESPP lets you buy company stock at a discount, typically 15% off the lower of the stock price at the start or end of the purchase period. You contribute via payroll deduction (up to $25,000/year). This is often called "free money" because the 15% discount is guaranteed even if the stock price drops. Many financial advisors recommend maxing this out if available.

Example: Stock was $100 at period start, $120 at end. You buy at 15% off the lower price: $100 x 0.85 = $85/share. Immediate paper gain of $35/share (41%). Even if you sell right away, you net a ~15% guaranteed return minus taxes. If stock dropped to $80, you buy at $80 x 0.85 = $68.

How Vesting Works

Most equity vests over 4 years with a 1-year cliff. Here is what that means:

Month 1-11

THE CLIFF

25%

Year 1

Cliff vests

50%

Year 2

Monthly/Quarterly

75%

Year 3

Monthly/Quarterly

100%

Year 4

FULLY VESTED

The cliff: If you leave before 12 months, you get NOTHING. At 12 months, 25% vests all at once. After that, the remaining 75% typically vests monthly or quarterly over years 2-4. This is why the cliff matters so much for job-hopping decisions.

The 4 Types of Equity Compensation

ISO - Incentive Stock Options

NSO - Non-Qualified Stock Options

RSU - Restricted Stock Units

ESPP - Employee Stock Purchase Plan

How Vesting Works

Stock Options Calculator

Pre-Built Scenarios

Startup Pre-IPO

Public Company RSUs

ESPP Purchase

Stock Compensation Glossary

Chester's Analysis