A stock option is a right to buy, and five numbers decide what it is worth.

An option is a right to buy, not a share

The single most common misunderstanding in employee equity is that a grant makes someone a shareholder. It does not. A stock option is a contract that says: on these dates, if you are still here, you may buy up to this many shares at this price. Until the holder exercises and pays, they own an option and nothing else. They do not appear on the cap table as a holder of common stock, they do not vote, they receive no dividends, and if the company is sold before they exercise they are paid — if at all — under whatever the option plan and the merger agreement say happens to unexercised options.

That distinction is not pedantry. It determines the tax treatment, the timing of every cash outflow, and what happens when someone leaves. Restricted stock units are a different instrument again: an RSU is a promise to deliver shares later, with no purchase price and nothing to exercise, which is why the comparison is worth reading on its own terms at /equity/rsu-vs-stock-options.

The five numbers that define every grant

A grant notice is usually one page. Five of the values on it decide everything that follows. Read them before the headline share count, because four of the five are the ones that quietly destroy value.

A share count without a denominator tells you nothing

An offer letter that says "10,000 stock options" is not telling the recipient how much of the company they are being offered. Ten thousand shares out of a million is one percent. Ten thousand out of a hundred million is one hundredth of a percent. Both letters read identically. Companies that quote only the numerator are not necessarily hiding anything — many simply have not thought about it — but the number cannot be evaluated as written.

Three figures make the grant legible. First, fully diluted shares outstanding: common, preferred on an as-converted basis, all outstanding options and warrants, and the unissued pool. Second, the most recent 409A fair market value per share of common, which is the strike price the grant will carry and the number the company already knows. Third, the price per share the last priced round paid for preferred, which is the number investors used and which is almost always higher than the 409A price for reasons explained at /equity/strike-price.

With those three, a grant of 10,000 shares against 10,000,000 fully diluted is 0.1% before future dilution, and can be sanity-checked against both the common and preferred marks. Without them, the share count is a number with no units. Asking is normal and not adversarial: the fully diluted count and the 409A price are routine disclosures, and a company that treats the question as impertinent has told the candidate something useful anyway.

Strike price and the 409A valuation

The strike price is fixed at grant at or above the fair market value of the common stock on that date. For a private company that value comes from a 409A valuation — an independent appraisal that supports a presumption of reasonableness under Treas. Reg. §1.409A-1(b)(5)(iv)(B) when it is as of a date no more than 12 months before the grant and no material event has intervened. Keeping the strike at or above that value is what keeps the option outside §409A entirely under Reg. §1.409A-1(b)(5)(i).

The consequence of getting it wrong is severe and lands on the employee, not the company: a discounted option is deferred compensation, which means income inclusion as it vests plus an additional 20% tax and a premium interest charge under §409A(a)(1)(B). This is why boards do not grant options at a price they invented, and why a fresh valuation follows a priced round. The full mechanics, including why the 409A common price sits below the preferred price, are at /equity/strike-price.

ISO or NSO

Incentive stock options are a creature of statute. IRC §422 defines them, and they may only be granted to employees of the corporation or its parent or subsidiary. Their appeal is timing: no regular income tax at grant and none at exercise under §421(a), and if the shares are held more than two years from grant and more than one year from exercise, the entire gain is long-term capital gain. The catch is the alternative minimum tax — the spread at exercise is an AMT adjustment item in the year of exercise under §56(b)(3), reported on Form 6251, and whether it actually produces a bill is fact-specific.

Nonstatutory options carry no such restrictions. They can be granted to contractors, advisors, and directors as well as employees. In exchange, the spread between fair market value and the exercise price is ordinary income at exercise under §83(a) and Treas. Reg. §1.83-7 — W-2 wages for an employee, subject to income tax and FICA withholding and reported in box 12 with code V. The employer takes a corresponding deduction under §83(h), which it does not get on a qualifying ISO disposition. The full comparison, including the §422(d) $100,000 limit and disqualifying dispositions, is at /equity/iso-vs-nso.

Vesting, in one paragraph

Vesting is the condition attached to the right to exercise. The common private-company shape is four years of monthly vesting with a one-year cliff: nothing vests for twelve months, then a quarter vests at once, then the remainder accrues monthly. On 4,800 shares over 48 months that is 1,200 at the cliff and 100 a month afterwards. Vesting says nothing about whether the shares can be sold, and nothing about tax — it only controls when the option becomes exercisable. Cliffs, acceleration, and what happens on an acquisition are covered at /equity/vesting.

What exercising actually costs

Exercising means paying the strike price multiplied by the number of shares being exercised, in cash, plus whatever tax the exercise triggers. For a nonstatutory option that tax is withholding on the spread and it is due at exercise, whether or not the shares can be sold. For an incentive stock option there is no regular income tax at exercise, but the spread enters the AMT calculation, and an AMT liability is payable in cash the following April all the same.

At a private company with no market, the honest framing is this: exercising means writing a real cheque for an illiquid asset. The shares cannot usually be sold, cannot usually be pledged, and may end up worth nothing. That is a genuine investment decision, not an administrative step, and it is the reason so many vested options go unexercised.

What the option is actually worth

The paper arithmetic is simple. Spread equals current fair market value minus the strike price, multiplied by the number of vested shares, before any tax. Take 10,000 vested options at a $1.00 strike with a current 409A of $4.00. The spread is $3.00 per share, so $30,000 on paper. Exercising all 10,000 costs $10,000 in cash, plus tax on that $30,000 spread if the grant is a nonstatutory option, or an AMT adjustment of $30,000 if it is an incentive stock option.

Two caveats do most of the work. The 409A price is an appraisal of common stock, not the price investors paid for preferred, and not a price anyone has offered. And the whole figure is only realisable if a buyer ever appears — a sale, an IPO, or a company-run tender. A $30,000 paper spread in a company that never exits is worth exactly the $10,000 it cost to chase it, minus that $10,000.

The six ways employees lose their options

Most equity is not lost to fraud or to a bad exit. It is lost to deadlines and arithmetic that were on the grant notice all along. Each of these is ordinary, documented, and avoidable only by knowing about it early.

1. Leaving before the cliff. With a one-year cliff, twelve months minus a day of service vests nothing at all. There is no pro-rating unless the grant says there is.
2. The post-termination exercise period running out. Vested options commonly die 90 days after employment ends. The holder has to find the strike price and the tax in cash, for shares they cannot sell, inside three months — and if they cannot, the options simply lapse.
3. The option term expiring. Ten years from grant is the statutory maximum for an incentive stock option under IRC §422(b)(3). A grant made in year one of a company that is still private in year eleven expires unexercised, no matter how much it was theoretically worth.
4. Going underwater. A down round, or a lower 409A after a fall in comparable valuations, can leave the strike price above the current value of the stock. The option is not void, and it keeps time value while the term runs, but exercising it would mean paying more than the shares are marked at.
5. Being wiped out by liquidation preference. Preferred stock is paid first in an exit. A sale that clears the preference stack and leaves nothing over pays common — and therefore option holders — zero, even though the company sold for a large headline number.
6. Cause terminations and the three-month ISO rule. Most plans cancel unvested and often vested options on a termination for cause as defined in the plan. Separately, IRC §422(a)(2) requires employment until three months before exercise, so exercising later than that converts an incentive stock option into a nonstatutory one and moves the spread into ordinary income.

Rule 701: why a private company can grant options at all

Issuing securities normally requires registration with the SEC or an exemption. Compensatory equity is securities, so private companies rely on Rule 701, 17 CFR §230.701, to grant options and issue the resulting shares to employees, directors, and certain consultants without registering. The rule has a disclosure trigger: where sales in any consecutive 12-month period exceed $10 million, the issuer must deliver additional disclosure to the recipients, including financial statements and risk factors. The SEC raised that threshold from $5 million to $10 million in 2018. Companies that blow through it without delivering the disclosure create a rescission exposure, which is why growth-stage employers watch the number.