How Does Equity Compensation Work in a Private Company?

Equity compensation in a private company gives you a stake, or the right to a stake, in a business whose shares don’t trade on any public exchange. Instead of paying you entirely in cash, the company grants you options, restricted stock units, or actual shares that you earn over time and that could become valuable if the business succeeds. The mechanics matter more than they would at a public employer, because you generally cannot sell whenever you want, you may owe tax before you can, and the specific type of equity you receive controls almost everything that follows.

What Form Your Equity Takes

Your offer letter or grant agreement will name the instrument. Each one carries different rights and different tax consequences.

Incentive stock options (ISOs) let you buy shares at a fixed strike price set on the grant date, which must equal at least the fair market value of the stock that day. ISOs go only to employees, run for a maximum of ten years, and trigger no regular federal income tax at exercise. To keep that treatment, you have to hold the shares at least two years from the grant date and one year from the exercise date. There’s also a ceiling: ISOs lose their favorable status to the extent the total fair market value of stock becoming exercisable for the first time in any calendar year exceeds $100,000, measured at grant. Anything above that line is taxed as a non-qualified option.¹

Non-qualified stock options (NSOs) work similarly but can go to employees, consultants, advisors, and board members. The tax treatment is less favorable. When you exercise, the spread between the strike price and the current fair market value is taxed as ordinary income that year, and your employer must withhold federal income tax, Social Security, and Medicare on that spread at exercise.²³

Restricted stock units (RSUs) are a promise to deliver shares (or cash of equal value) once conditions are met. In private companies, RSUs almost always use a double-trigger structure: they settle only after both time-based vesting and a liquidity event such as an IPO or acquisition. That structure keeps you from owing income tax on shares you can’t sell. When RSUs finally settle, the full value of the delivered shares is ordinary income.

Phantom stock and stock appreciation rights (SARs) are cash-settled. Phantom stock pays you the value of a set number of shares on a future date. SARs pay you only the increase in share value above a baseline. Neither gives you actual shares, and neither dilutes existing owners, which is why closely held companies sometimes use them instead of real equity.

How Vesting Turns a Grant Into Ownership

You don’t own the full grant on day one. Vesting phases ownership in over time to keep you around. The most common schedule is four years with a one-year cliff.

During the cliff, the first twelve months after your start or grant date, nothing vests. Leave in that window and the entire grant is forfeited. Reach the one-year mark and 25 percent vests at once. The remaining 75 percent then vests in equal monthly or quarterly increments over the next three years, until you’re fully vested at year four. Anything still unvested when you leave goes back to the company’s equity pool.

What Happens if the Company Is Sold

Some grants include acceleration provisions that speed up vesting if the company is acquired or merges. Single-trigger acceleration vests some or all of your unvested equity automatically upon the sale itself. Double-trigger acceleration requires two events: the sale, and your involuntary termination or a significant downgrade in role within a defined window afterward, often 9 to 18 months. Double-trigger is more common because it balances employee protection against the acquirer’s interest in retaining the team. Many grants include no acceleration at all, so read yours before assuming anything.

How the Share Price Gets Set Without a Market

The 409A Valuation

Because there’s no market quote, the company hires an independent appraiser to establish the fair market value of its common stock. This is called a 409A valuation, after the tax code section that governs it. A properly conducted appraisal gives the company a safe harbor for setting strike prices and protects both sides from tax penalties.⁴

The valuation has to be refreshed at least every twelve months and whenever something material happens, such as a new funding round or a big change in financial position. Your strike price is locked at the fair market value on your grant date and doesn’t change as the company grows. The gap between that fixed strike and the rising fair market value is where the upside on options comes from.

If the company issues options with a strike below the appraised fair market value, the affected options fall under Section 409A’s penalty rules: a 20 percent additional tax on the compensation that should have been included in income, plus an interest charge running from the year of grant.⁵

How Funding Rounds Change Your Slice

Each time the company raises money, it issues new shares, and every new share reduces your ownership percentage. That’s dilution. Across a seed round, a Series A, and successive later rounds, even a founder’s original stake can shrink from 100 percent to well under 20 percent.

Dilution doesn’t automatically mean you’re worse off. If the new round values the company at a much higher price per share, your smaller percentage can be worth more in dollars than your larger percentage was before. Watch both figures when your company announces a raise: the price per share and the total valuation, not just the percentage you hold.

What You’ll Owe in Tax, and When

Tax planning matters more here than at a public employer, because you often owe money before you have any way to sell shares for cash.

AMT on ISO Exercises

Exercising an ISO doesn’t create regular federal income tax, but it can create Alternative Minimum Tax liability. When you exercise and hold the shares past the end of the calendar year, the spread between your strike price and the fair market value on the exercise date becomes an AMT adjustment added to your alternative minimum taxable income.

The AMT runs at 26 percent up to a threshold and 28 percent above it, with an exemption amount that phases out at higher incomes.⁶ If you exercise a large ISO block at a company with a high 409A valuation, the bill can be significant, and you owe it in April even though you haven’t sold anything. Selling the shares in the same calendar year you exercise eliminates the AMT adjustment, but it also disqualifies the sale from ISO treatment, discussed below.

Ordinary Income and Withholding on NSO Exercises

When you exercise an NSO, the spread hits your W-2 (or 1099 for non-employees) as ordinary income. Federal withholding runs at a flat supplemental wage rate of 22 percent, or 37 percent once your total supplemental wages for the year exceed $1 million, plus Social Security and Medicare.³ The practical problem is liquidity: you need cash both to buy the shares and to cover withholding, but there’s usually no way to sell shares to fund it. Time your exercises with that gap in mind.

The Section 83(b) Election

If you receive restricted stock or early-exercise unvested options, you can file a Section 83(b) election. This pays ordinary income tax on the shares’ value at the time of the grant or early exercise, when the value is often very low, instead of on the higher value at vesting. Any appreciation after that is treated as long-term capital gain when you sell, if you meet the holding period.

The deadline is strict: 30 days from receipt of the stock, with no extensions.⁷ Miss it and the opportunity is gone for that grant. The election applies only to restricted stock and early-exercised shares. It cannot be used for RSUs, because RSUs are a promise of future shares, not property you currently own.²

The risk of an 83(b) is that you prepay tax on shares that may never vest or may fall in value. If you leave before vesting completes and forfeit the shares, you don’t get that tax back.

Disqualifying Dispositions

Sell ISO shares before satisfying both holding periods, two years from grant and one from exercise, and the sale becomes a disqualifying disposition.¹ The spread between strike and exercise-date fair market value converts to ordinary income on your W-2, and any additional gain above the exercise-date value is capital gain. In an AMT-heavy year, this can actually be the better move: it kills the AMT adjustment in exchange for ordinary income treatment.

The QSBS Exclusion

If the company is a C corporation with $75 million or less in gross assets when your stock was issued, your shares may qualify as qualified small business stock under Section 1202. Hold QSBS for five years and you can exclude 100 percent of the gain from federal income tax, up to the greater of $10 million or ten times your basis.⁸ The stock must be acquired at original issuance (bought directly from the company or received as compensation), and the company must meet active business requirements the whole time you hold it. This can be one of the largest single tax benefits available to early employees, so check eligibility early.

A narrower provision, Section 83(i), lets some employees defer income tax on option exercises or RSU settlements for up to five years, but the company has to grant equity to at least 80 percent of its U.S. employees on the same terms, and few companies do.⁹ For most people it won’t apply.

Exercising Options in a Private Company

Deadlines and Documents

Before you exercise, pull your grant agreement (share count, strike price, expiration date) and the company’s equity incentive plan (the overall rules). Options typically expire ten years from the grant date. Companies with an online equity portal usually host these documents and the exercise forms; otherwise, ask legal or HR.

What It Actually Costs

The purchase cost itself is simple: vested shares multiplied by strike price. The full out-of-pocket cost is higher. For NSOs, add withholding: at minimum 22 percent of the spread for federal income tax, plus payroll taxes.³ For ISOs, factor in the AMT you may owe the following April. Run the numbers with a tax advisor before exercising a large block.

The Post-Termination Window

Vested options don’t last forever after you leave. Most agreements give you around 90 days to exercise. For ISOs, federal law sets a hard three-month deadline: exercise later than that and the options lose ISO treatment and are taxed as NSOs.¹ Some companies offer extended windows of several years, but the ISO-to-NSO conversion still happens at three months. Unvested options are forfeited outright when you leave.

Finding the Cash

Exercising private-company options almost always takes real cash out of your pocket. There’s no public market to sell into simultaneously, so a cashless exercise generally isn’t available unless the company is running a tender offer or other liquidity event at the same time. People fund exercises from savings, by borrowing against other assets, or in some cases through a promissory note from the company. Startup-focused lenders offer exercise financing, but the loans carry interest and the risk that the shares end up worth less than you paid.

When You Can Actually Sell

IPO or Acquisition

The two ordinary paths to cash are an initial public offering and an acquisition. In an IPO, your private shares convert into publicly traded stock, but a lock-up agreement typically prevents insiders from selling for 180 days after the offering.¹⁰ In an acquisition, you receive cash or acquirer stock based on the deal terms. Any unvested equity at the time of a sale is handled according to the deal and whatever acceleration provisions your grant contains.

Secondary Sales and Tender Offers

Some employees get partial liquidity before an IPO through secondary market platforms, where accredited investors buy private shares in negotiated transactions.¹¹ These sales almost always need company approval and often trigger a right of first refusal that lets the company buy the shares at the offered price before an outside buyer can. Companies also sometimes run formal tender offers themselves, or work with an investor to do so. None of this is guaranteed; it happens at the company’s discretion.

Transfer Restrictions to Watch For

Private shares carry restrictions that public shares don’t. Your stock purchase agreement, the bylaws, or a separate stockholders’ agreement may require board approval for any transfer, limit who you can sell to, or prohibit sales entirely before a liquidity event. Review those documents before attempting any sale, even to a family member, and confirm the company will authorize the transfer. Securities laws add another layer: private shares are usually unregistered, and reselling them requires an exemption from registration at both the federal and state levels.

The Risks That Come With the Territory

Private company equity is not a guaranteed payout. The most basic risk is that the company fails, in which case your options and shares are worth nothing regardless of any prior paper value. If you paid to exercise options or paid tax on an 83(b) election, that money is gone.

Illiquidity is the other defining feature. You can hold valuable equity on paper for years without any way to convert it to cash, and during that stretch you may owe AMT on ISO exercises or ordinary income tax on NSO exercises without any sale proceeds to pay it. Successive funding rounds will dilute your percentage, though as noted that doesn’t necessarily reduce the dollar value of your stake.

Concentration is worth thinking about too. When a large share of your total compensation is tied to a single company’s stock, your financial outcome depends heavily on that one business. Understanding the type of equity you hold, the tax bill at each step, and the realistic timeline to liquidity is the practical way to keep those risks in view.

1
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
2
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
3
Internal Revenue Service. Publication 15 (2026), Circular E, Employers Tax Guide
4
eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
5
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
6
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
7
Internal Revenue Service. Form 15620 Section 83(b) Election
8
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
9
Internal Revenue Service. Guidance on the Application of Section 83(i)
10
U.S. Securities and Exchange Commission. Initial Public Offerings: Lockup Agreements
11
U.S. Securities and Exchange Commission. Accredited Investors