An equity agreement is the written contract that gives you an ownership stake in a company, or the right to acquire one, and sets every rule that governs that stake: how you earn it, what it costs you, how it is taxed, when you can sell, and what happens if you leave. These documents sit under most startup job offers and early-stage investments, and the fine print inside them determines whether your equity becomes a meaningful payout or a tax bill for shares you never got to sell. Reading one carefully before you sign is not optional.
What an Equity Agreement Contains
Every equity agreement names two parties: the company issuing the ownership interest and the person or entity receiving it. From there, a handful of components define the legal and financial reality of your grant.
The agreement identifies the security being granted, whether that is common stock, preferred stock, options, restricted stock units, or something else. It states the exact number of shares, options, or units and the class or series they belong to. For an option grant, it locks in the strike price you will pay to buy shares. For a direct stock grant, it establishes the fair market value at the time of transfer.
A consideration clause describes what you give in return. For employees and contractors, that is typically continued service over a defined period. For investors, it is money. When someone receives equity without paying anything for it, the full fair market value is generally treated as taxable income under federal tax law, so how this exchange is structured has real financial consequences.1Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
The agreement also includes representations and warranties confirming that both sides have authority to enter the contract and that the grant does not violate the company’s charter or other agreements. A governing law clause identifies which state’s laws apply, almost always the state where the company is incorporated.
The Forms Equity Can Take
The label at the top of your agreement matters. Options, RSUs, and restricted stock are all “equity,” but they behave differently and get taxed on different timelines.
Incentive Stock Options
Incentive stock options, or ISOs, are available only to employees. You generally owe no regular income tax when you receive them or when you exercise them.2Internal Revenue Service. Topic No. 427, Stock Options If you hold the shares for at least two years after the grant date and one year after exercising, any profit on sale qualifies for the long-term capital gains rate rather than the higher ordinary income rate.3Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options Selling before those holding periods are satisfied triggers a “disqualifying disposition,” and the spread between your strike price and the market price at exercise is reclassified as ordinary income.
Two additional limits apply. The aggregate fair market value of stock that becomes exercisable for the first time in any calendar year cannot exceed $100,000 for ISO treatment; anything above that is automatically treated as a non-qualified option.4eCFR. 26 CFR 1.422-4 – $100,000 Limitation for Incentive Stock Options ISOs also cannot be exercised more than ten years after grant and are not transferable except through a will or inheritance.3Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
Non-Qualified Stock Options
Non-qualified stock options, or NSOs, are more flexible. Companies can grant them to employees, consultants, advisors, and board members. The trade-off is a less favorable tax result. When you exercise, the spread between the strike price and the current fair market value is immediately taxed as ordinary income and subject to payroll taxes.2Internal Revenue Service. Topic No. 427, Stock Options Any gain after exercise is taxed as a capital gain when you eventually sell.
Restricted Stock Units
A restricted stock unit is a promise from the company to deliver actual shares to you at a future date once specific conditions are met. There is no strike price. When the shares are delivered, their full fair market value on that date is taxed as ordinary income and is subject to withholding by the company. RSUs hold value even when the stock price drops from the grant date, which makes them feel more like guaranteed compensation than options do.
At public companies, RSUs are straightforward: shares vest on the scheduled dates, you receive them, and you can sell enough to cover the tax. Private companies use a different structure. If RSUs vested while the company was still private, you would owe income tax on shares you could not sell. To prevent this, most private companies use double-trigger RSUs. The first trigger is time-based vesting. The second is a liquidity event such as an IPO or acquisition. You owe no tax until both fire. The downside is concentration: when the second trigger hits, your entire vested balance may be released at once, potentially pushing you into a higher tax bracket that year. Federal withholding on supplemental wages is a flat 22% up to $1 million and 37% above that, but your actual effective rate could be higher.
Restricted Stock and the 83(b) Election
A restricted stock grant transfers actual shares to you immediately, subject to vesting and a company right to repurchase unvested shares if you leave. Under the default tax rule, you owe ordinary income tax on each batch of shares as it vests, based on the fair market value at that time.1Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services If the company’s value rises significantly between the grant date and each vesting date, your tax bill grows with it.
The 83(b) election lets you short-circuit that result. By filing it, you choose to pay ordinary income tax on the full fair market value of all the shares at the time of the grant, before they vest. If the shares are worth little at that point, the tax bill is small, and all future appreciation qualifies for capital gains treatment when you sell.5Internal Revenue Service. Form 15620 Instructions – Section 83(b) Election
The deadline is 30 days from the date the stock is transferred to you, with no exceptions and no extensions.5Internal Revenue Service. Form 15620 Instructions – Section 83(b) Election Miss that window and the election is gone permanently. Thirty days goes by fast when you are starting a new job.
Some startup equity plans also allow early exercise of unvested options. The point of doing so is usually to pair the early exercise with an 83(b) election, starting the clock on capital gains treatment while the fair market value is still low. The company retains the right to repurchase any unvested shares at cost if you leave.
LLC Profits Interests
If the company is a limited liability company taxed as a partnership rather than a corporation, your grant will not be stock or options at all. It will likely be a profits interest, which entitles you to a percentage of the company’s future growth above a baseline value set at the time of the grant, called the liquidation threshold or hurdle. Under IRS guidance, receiving a profits interest for services is generally not a taxable event for either the recipient or the partnership, provided certain conditions are met.6Internal Revenue Service. Rev. Proc. 2001-43 The recipient is treated as a partner from the grant date and reports a share of partnership income and losses on their own tax return. When the interest is eventually sold or the company is acquired, appreciation above the hurdle is taxed at the long-term capital gains rate if the required holding period is met.
How Vesting Works
Vesting is the process by which you earn a permanent right to your equity. Until shares or units vest, the company can take them back if you leave. The most common schedule is four years with a one-year cliff.
The cliff means that if you leave before your first anniversary, you forfeit everything. Once you pass the cliff, 25% of your grant vests at once. The remaining 75% then vests in equal monthly or quarterly installments over the next three years. After 48 months of continuous service, you are fully vested.
Performance-based vesting ties some or all of the grant to hitting specific targets: revenue milestones, product launches, or other operational goals. Long tenure alone will not vest a performance grant if the target is missed.
Accelerated Vesting
Acceleration provisions let equity vest ahead of schedule when specific events occur. A single-trigger clause vests some or all of your equity automatically upon a change in control, such as an acquisition. This protects you if the acquiring company cancels unvested grants, but acquirers dislike it because it removes the retention incentive for key employees.
Double-trigger acceleration is more common. It requires two events: a change in control plus your termination without cause (or constructive termination) within a defined period afterward. This structure protects you from being fired shortly after an acquisition while giving the acquiring company confidence that the team will stay.
How Your Shares Get Priced
The price attached to your equity directly affects your tax outcome. For publicly traded companies, fair market value is simply the trading price on the relevant date. Private companies have a more complex obligation.
Fair market value represents the price a willing buyer and a willing seller would agree on, with neither under pressure to transact. For private companies, FMV must be established through a formal, independent valuation process, because getting it wrong triggers penalties.
Section 409A of the Internal Revenue Code requires private companies to set option strike prices at or above fair market value. To establish that value defensively, companies obtain an independent appraisal known as a 409A valuation. This creates a “safe harbor,” meaning the IRS will generally accept the valuation as reasonable. A 409A valuation is valid for up to 12 months, but a material event like a new funding round can render it stale sooner and require a fresh appraisal.
If a company grants options with a strike price below fair market value, the consequences fall on the option holders. The deferred compensation is included in gross income immediately, plus a 20% additional tax, plus interest calculated at the underpayment rate plus one percentage point.7Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans The penalty hits the employee, not the company, which is why 409A compliance matters to you even though the company controls the process.
The strike price is the per-share price you pay when exercising a stock option. For both ISOs and NSOs, it must equal or exceed the fair market value on the grant date. Your potential profit is the difference between the eventual sale price and the strike price you paid.
Restrictions on Selling
Equity agreements almost always restrict your ability to sell or transfer shares, and those restrictions determine when you can actually turn ownership into cash.
For private companies, the most common restriction is a right of first refusal. If you find a buyer for your shares, the company or its designees have the contractual right to purchase those shares on the same terms the outside buyer offered. In practice, this means you cannot sell private company stock without the company’s knowledge and cooperation.
Co-sale rights, sometimes called tag-along rights, protect minority shareholders when a major shareholder sells a large block. If a founder or early investor negotiates a sale to a third party, co-sale rights let you participate in that transaction on the same terms, selling your proportional share alongside the larger seller.
Public companies impose lock-up periods after an IPO, typically around 180 days, during which insiders and employees cannot sell. Even after the lock-up expires, officers and directors face ongoing restrictions under securities regulations and must file notices before selling above certain thresholds.
What Happens When You Leave
The termination section of an equity agreement is the one most people do not read carefully until it is too late.
Unvested equity is forfeited immediately upon termination, regardless of the reason, unless your agreement contains an acceleration clause that applies to your departure. Vested equity treatment depends on the type of grant and the reason for leaving. If you hold vested stock rather than options, you generally keep it, though the company may retain a right to repurchase your shares at fair market value. Termination for cause, typically defined as fraud, willful misconduct, or similar serious behavior, can trigger harsher terms, including repurchase at a nominal price.
If you hold vested but unexercised stock options, you face a ticking clock. The post-termination exercise period is the window you have to pay the strike price and buy your vested shares before they expire. The standard window at most startups is 90 days after your last day. This short window exists partly because ISOs must be exercised within three months of termination to retain their favorable tax treatment.3Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
Exercising within 90 days can require significant cash, especially if you have been at a growing company for several years. Some companies offer extended post-termination exercise periods, but extending the window beyond three months automatically converts ISOs to NSOs, changing the tax treatment. Any extension is at the company’s discretion unless your original agreement guarantees it. Miss the window and your vested options expire worthless. No refunds, no second chances.
When you evaluate an offer with equity, doing the math on what exercising would cost is as important as understanding the grant size.
How Dilution Affects Your Ownership
An equity grant gives you a specific number of shares, but your percentage ownership will almost certainly shrink over time. Each time the company issues new shares, whether for a funding round, a new employee option pool, or converting debt, the total share count increases and your slice of the company gets smaller. This is dilution, and it is a normal part of a growing company’s lifecycle.
A simple example: if you own 1,000 shares out of 100,000 total, you hold 1%. If the company issues 25,000 new shares to investors, the total becomes 125,000 and your stake drops to 0.8%, even though you still hold the same 1,000 shares. The hope is that each funding round increases the company’s total value by more than enough to offset the dilution, so your smaller percentage is worth more in dollars.
Your equity agreement may reference “fully diluted capitalization,” which is the total share count assuming every outstanding option, warrant, and convertible instrument is exercised. That is the denominator that matters when calculating what your shares are worth as a percentage of the company. Ask what your grant represents on a fully diluted basis, not just as a fraction of currently outstanding shares.
Tax Traps to Watch For
Equity compensation generates tax surprises for people who understand their grant in broad strokes but skip the details. Three scenarios cause most of the damage.
The first is AMT on ISO exercises. Exercising incentive stock options and holding the shares through the end of the tax year creates an Alternative Minimum Tax preference item equal to the spread between the strike price and fair market value at exercise. At fast-growing companies, this can produce a six-figure tax bill on income you have not actually received in cash. Running the AMT calculation with a tax advisor before you exercise is the only way to avoid the surprise.
The second is missing the 83(b) deadline. The 30-day window on restricted stock is absolute. If you receive a restricted stock grant worth $1,000 today and it vests over four years while the company grows to a $50 million valuation, the difference between filing and not filing the election can be hundreds of thousands of dollars in ordinary income tax you could have avoided.5Internal Revenue Service. Form 15620 Instructions – Section 83(b) Election
The third is 409A penalties on mispriced options. If the company sets the strike price below fair market value, the 20% penalty tax plus interest falls on you, not on the company.7Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans You have limited ability to verify the valuation yourself, but you can ask when the last 409A valuation was performed and whether any material events have occurred since.
Disclosures You May Be Entitled To
Private companies issuing equity to employees and service providers generally rely on Rule 701 under the Securities Act, which exempts compensatory equity grants from the full registration requirements that apply to public offerings. Once a company’s equity sales exceed $10 million in a consecutive 12-month period, it must provide enhanced disclosures to award recipients, including a copy of the equity plan, a summary of material terms, information about investment risks, and financial statements prepared under GAAP.8eCFR. 17 CFR 230.701 – Exemption for Offers and Sales of Securities Pursuant to Certain Compensatory Benefit Plans and Contracts
If you receive equity from a private company and are not given these disclosures, it does not necessarily mean anything is wrong. The company may not have crossed the threshold. But if you are at a later-stage startup with significant equity issuance, you are entitled to that financial information, and asking for it is reasonable.
None of the traps above are theoretical. They happen to employees at startups who sign equity agreements without understanding the tax mechanics and then make decisions months or years later without revisiting the terms. Read the agreement carefully when you receive it, and read it again before you exercise or sell.