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Let’s go over some startup equity 101 terms and concepts to help you get your business started on the right foot.
When you join or start a company, equity can be one of the most valuable parts of your compensation package. Understanding how stock options and restricted stock work isn’t just important for maximizing value—it’s essential for avoiding costly mistakes. In this startup equity 101 guide, we’ll break down the key equity types—ISOs, NSOs, and RSUs—and dive into tax timing, the 83(b) election, and common founder pitfalls.
What Are ISOs, NSOs, and RSUs?
Incentive Stock Options (ISOs)
ISOs are granted only to employees and come with favorable tax treatment if certain conditions are met. When exercised, ISOs are not immediately taxable for regular income tax purposes, though they may trigger the Alternative Minimum Tax (AMT). If you hold ISOs for more than two years from the grant date and one year from exercise, your profits may be taxed at long-term capital gains rates.
Non-Qualified Stock Options (NSOs)
NSOs can be granted to employees, contractors, and advisors. Unlike ISOs, exercising NSOs triggers ordinary income tax on the “spread” (the difference between the exercise price and fair market value). While less tax-advantaged than ISOs, NSOs are more flexible in terms of who can receive them.
Restricted Stock Units (RSUs)
RSUs represent a promise of company stock that vests over time or upon hitting milestones. They don’t require you to purchase shares, but they are taxed as ordinary income when the stock is delivered. RSUs are common at later-stage startups and public companies because they’re straightforward and tied directly to value at vesting.
Tax Timing and Why It Matters
Equity compensation isn’t just about ownership—it’s about timing. Here’s how tax rules can impact your bottom line:
- ISOs: No regular income tax at exercise, but potential AMT liability. If you hold them long enough, you may pay long-term capital gains rates.
- NSOs: Immediate ordinary income tax on the spread at exercise, plus capital gains tax on future appreciation.
- RSUs: Ordinary income tax at vesting, based on the stock’s fair market value at that time.
Poor timing can result in an unexpected tax bill, sometimes before you even have cash from selling shares.
The 83(b) Election: A Crucial Tool
The 83(b) election allows you to pay taxes on restricted stock at the time of grant rather than waiting until it vests. This can be a huge advantage if the stock’s value is low early on. By locking in a low valuation, you can potentially avoid higher taxes as the company grows.
Example
If you receive restricted stock valued at $0.10 per share and file an 83(b), you pay taxes immediately on that small amount. If the stock later grows to $10 per share, you avoid paying ordinary income tax on that growth and instead pay capital gains when you sell.
Failing to file an 83(b) election within 30 days of receiving stock can be one of the most expensive mistakes a founder or early employee makes.
Founder Pitfalls to Avoid
- Not Filing an 83(b): Missing the election window means you’ll be taxed at vesting, often at a much higher valuation.
- Not Planning for Liquidity: Exercising stock options can create tax obligations without a cash event. Founders sometimes owe taxes before they can sell shares.
- Ignoring AMT on ISOs: Many employees don’t realize ISO exercises can trigger AMT. Planning ahead is essential.
- Failing to Understand RSU Taxation: RSUs can generate large tax bills at vesting—even if you can’t sell your shares right away.
- Overlooking Vesting Schedules: Not all equity is immediately yours. Vesting cliffs and schedules can impact both ownership and tax obligations.
Final Thoughts on Startup Equity 101
Equity can be life-changing, but only if you understand the basics. ISOs, NSOs, and RSUs each have unique rules, benefits, and risks. By knowing how tax timing works, when to consider an 83(b) election, and what pitfalls to avoid, you’ll be in a stronger position to maximize the value of your equity while minimizing unnecessary tax burdens.
When it comes to equity compensation, knowledge is power—and preparation can be the difference between a tax nightmare and a financial windfall.
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