How Do Stock Options Work in a Private Company?

Stock options in a private company give you a contractual right to buy a set number of shares in your employer at a fixed price, earned over time through vesting, with the catch that the shares you eventually own cannot be freely sold until the company goes public, gets acquired, or runs a sponsored secondary sale. Everything else — the tax treatment, the deadlines, the paperwork — flows from those two facts: you are buying something on a schedule, and you are buying something illiquid.

What You Actually Receive in a Grant

An option grant has four core terms. The grant date is when the board formally approves your award. The strike price (or exercise price) is what you will pay per share when you buy. The share count sets the size of the grant. The vesting schedule sets when you can act on it.

The strike price is not arbitrary. Federal tax law effectively requires it to be set at or above the fair market value of the shares on the grant date. Pricing options below that value pulls them into Section 409A of the Internal Revenue Code as deferred compensation, which triggers a 20 percent penalty tax plus interest for the option holder on top of ordinary income tax.¹ To establish that fair market value, private companies hire an independent appraiser to produce a 409A valuation, which is generally valid for up to 12 months unless a significant event like a new funding round changes the picture.

Every grant expires. For incentive stock options, federal law caps the term at ten years from the grant date; if you have not exercised by then, the options are worthless.² Most companies apply the same ten-year limit to non-qualified options by convention, though no statute forces them to.

ISOs vs. NSOs

Your grant will be one of two types, and the distinction shapes almost every tax question that follows.

Incentive Stock Options

ISOs get preferential tax treatment. You owe no regular federal income tax when you exercise them; the taxable event is when you sell.³ If you hold the shares at least two years from the grant date and one year from exercise, the profit is a long-term capital gain, taxed at lower rates than wages.² Selling before both holding periods are met is a disqualifying disposition, and the spread between fair market value at exercise and your strike price is taxed as ordinary income instead.

ISOs come with real limits. Only employees can hold them — not contractors or board members. The value of ISOs that first become exercisable in any single calendar year is capped at $100,000, measured by fair market value at the grant date; anything above that is automatically treated as an NSO. ISOs cannot be transferred during your lifetime, and you must exercise them within three months of leaving the company to keep the ISO tax status.²

Non-Qualified Stock Options

NSOs are more flexible. Companies can grant them to employees, contractors, advisors, and directors. The tradeoff is that the spread between fair market value and strike price is taxed as ordinary income the moment you exercise.³ Your employer withholds federal and state income tax as well as Social Security and Medicare on that spread, just as with wages. Any further appreciation between exercise and sale can qualify for capital gains treatment if you hold long enough.

How Vesting Works

A grant is not a purchase. You earn the right to buy your shares over time. The most common schedule runs four years with a one-year cliff: nothing vests for the first 12 months, 25 percent vests all at once on your first anniversary, and the rest vests in equal monthly installments over the next three years — roughly 1/48th of the original grant per month.⁴ Leave before the cliff and you walk away with nothing. Some companies tie vesting to performance milestones instead of time, and missing the milestone forfeits those shares.

What Happens if the Company Is Sold

An acquisition does not automatically cash out your unvested options. Many option agreements include a double-trigger acceleration clause: unvested shares vest immediately only if two things happen together — the company is sold, and you are terminated without cause or your role is significantly diminished within a set period after the acquisition, often 3 to 12 months. Without that language, an acquirer can leave your unvested options on their original schedule or, in some cases, cancel them. Read your agreement for acceleration terms before you assume a sale locks in your equity.

What It Costs to Exercise

Exercising is a two-part cost: the cash you send the company for the shares, and the tax you owe on the built-in gain.

The cash part is straightforward. Multiply your strike price by the number of vested shares you want to buy. Exercise 1,000 shares at a $2 strike and you owe the company $2,000, usually by wire or check. Before you send it, confirm two numbers with the company: the current 409A fair market value and your exact vested share count. The fair market value at the time of exercise — not the strike price — drives your tax calculation.

NSOs: Ordinary Income the Year You Exercise

Exercising an NSO makes the spread wages. If fair market value is $10 and your strike is $1, you owe ordinary income tax on $9 per share, and your employer withholds income and payroll taxes on that amount.³ In a private company that is uncomfortable, because you owe cash tax on shares you cannot sell to raise the cash.

ISOs and the AMT Problem

ISOs skip ordinary income tax at exercise, but the spread is a preference item for the alternative minimum tax. A large ISO exercise can generate a significant AMT bill even though no cash changed hands on your side of the transaction.³ For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly; spreads that push you past those thresholds can produce a tax bill you did not plan for.⁵ Running numbers with a tax professional before a large ISO exercise is one of the most valuable things you can do.

Selling the Shares

Whichever option type you hold, the sale is a second taxable event. Gain above the fair market value at exercise is taxed at long-term capital gains rates if you held long enough. For ISOs specifically, that means two years from grant and one year from exercise; selling early converts the gain to ordinary income.²

Early Exercise and the 83(b) Election

Some plans let you buy shares before they vest. If yours does, and you exercise early, you can file a Section 83(b) election to pay tax on the spread at the time of purchase, using the stock’s current fair market value, rather than later when the shares vest and may be worth much more.⁶ Exercise right after the grant, when strike price and fair market value are the same or close, and the taxable spread can be zero or near it.

The deadline is unforgiving: you must file within 30 days of exercising by mailing a completed Form 15620 to the IRS office where you file your return, with a copy to your employer.⁷ Miss the 30 days and you cannot make the election at all; it cannot be extended or filed retroactively. The downside is real too: if you leave before the shares vest, you forfeit them and cannot recover the tax you already paid.

A separate Section 83(i) election exists that would let some employees defer tax on exercised options for up to five years, but the eligibility rules are narrow enough that the file notes it is rarely available in practice — the company has to grant equity to at least 80 percent of its U.S. employees in the same year, and certain executives and one-percent owners are excluded.⁸ Worth asking about, not worth counting on.

Getting Cash Out: Liquidity Events

Owning private shares is not the same as owning something you can sell. Three events typically create a way to convert your shares into money.

Initial Public Offering

When the company goes public, your private shares convert into publicly traded stock. You usually cannot sell right away. Lockup agreements bar insiders, including employees, from selling for a set period after the IPO, most commonly 180 days.⁹ After the lockup, you sell on the open market like any other shareholder.

Acquisition

If a larger company buys your employer, the deal can be cash, a stock swap in the acquiring company, or a mix. In a cash deal, you receive the per-share acquisition price minus your strike price for each vested option. If the acquisition price is below your strike, the options are underwater and pay nothing.

Secondary Sales

Some private companies run sponsored secondary transactions that let employees sell a portion of their vested shares to institutional investors or back to the company. These programs typically cap how much any one employee can sell. Outside a sponsored program, private companies almost always require board approval before a shareholder can transfer stock to a third party, which makes informal sales difficult without company cooperation.

Transfer Restrictions to Expect

The most common contractual restriction is a right of first refusal: before you sell to any outside buyer, you must offer the shares to the company or existing shareholders at the same terms, and if they match the offer, you sell to them. Drag-along rights allow majority shareholders to force minority shareholders, including employees, to sell on the same terms in an acquisition. Tag-along rights work the other way, letting minority shareholders join a sale the majority is making rather than be left behind under new ownership. These sit in the shareholders’ agreement, which becomes binding on you once you exercise and become a shareholder.

Leaving the Company

Departure is where option holders feel the illiquidity most sharply. For ISOs, the statute requires that you exercise within three months of your last day to keep the ISO tax treatment.² Your option agreement will also specify a post-termination exercise period, often 90 days, after which vested options you did not exercise simply expire.

The pressure is financial. You need cash for the strike price and, for NSOs, cash for tax withholding on the spread, all to own shares you still cannot sell. A large ISO exercise can trigger AMT on an illiquid asset. Some employees end up choosing between walking away from equity that might be valuable and writing a five- or six-figure check with no guarantee they will ever see it back.

A growing number of companies have extended the post-termination window past 90 days, sometimes as long as 10 years. Most still use the 90-day standard. Extend beyond three months and your ISOs automatically convert to NSOs for tax purposes, so the favorable ISO treatment at exercise goes away.

Dilution Over Time

Your grant is a fixed number of shares, but the percentage of the company those shares represent almost always shrinks. New funding rounds and expansions of the employee option pool issue new shares, and each issuance reduces the ownership percentage of every existing share.

Own 1,000 shares out of 100,000 and you have one percent of the company. If a Series B issues 50,000 new shares, there are 150,000 outstanding and your 1,000 shares are about 0.67 percent. The dollar value can still climb if the new round values the company higher, but the percentage falls. Several rounds before a liquidity event can meaningfully dilute early employees.

Documents to Pull Before You Decide

Before you exercise anything or make an election, ask the legal or HR team for:

The Equity Incentive Plan, which governs all grants at the company and sets defaults for things like the post-termination exercise period and acceleration.
Your individual Stock Option Agreement, specifying share count, strike price, vesting schedule, option type, and expiration.
The current 409A valuation, which you need to estimate the tax on any exercise.
The Shareholders’ Agreement, which controls what happens after you exercise — right of first refusal, drag-along and tag-along provisions, and any non-compete or non-solicit clauses tied to your equity.

If the company refuses to share the 409A valuation or the capitalization table, treat that as a warning sign before you commit any cash.

1
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
2
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
3
Internal Revenue Service. Topic No. 427, Stock Options
4
Carta. Vesting: A Guide to Equity Schedules
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
7
Internal Revenue Service. Section 83(b) Election Form 15620
8
Internal Revenue Service. Guidance on the Application of Section 83(i) – Notice 2018-97
9
Investor.gov. Initial Public Offerings: Lockup Agreements