Employee stock option plans, a guide for startup teams

What is an employee stock option plan, how does it work, and how are they vested and exercised?

Charlie Ross
COO
Jul 7, 2026
Last update

What are employee stock options

Employee stock options is a way to give equity (or ownership) in your company to employees. A slice of the cake, if you will. 🍰

There are several ways employees can gain a slice of their company's stock option. For example, employees can buy the company's stock directly, obtain stock through a profit sharing plan or via worker cooperatives. But stock options are by far the most common, simple, and effective way to slice up the equity cake.

Issuing stock options to employees gives them the right (but not the obligation) to purchase company stock for a specific period of time at a predetermined price, known as "strike price".

Benefits of an employee stock option plan

• Attracting talent. It’s no secret that cash can be tight for startups, which makes it hard to pay top dollar for talent. Using an ESOP, start-ups can offer tasty equity compensation to top-up slightly lower remuneration packages.

• Retaining talent. It’s hard to attract top talent and even harder to keep it. Stock options are usually subject to vesting, which encourages sticking with a company until the stock options vest.

• Opportunity for significant employee financial gain. By taking a slice of the equity cake, an employee can benefit from the increase in value of the stocks over the company lifetime.

• Salary top-ups. Tough times can often mean a company has to reduce staff salaries. To keep employee morale up, you can use equity compensation to ‘top-up’ paycuts with proportionate equity.

• Incentivization. Potential ownership of a slice of the company means employees start thinking like business owners.

• Tax benefits. In many countries, start-ups and their employees are eligible to receive substantial tax concessions when implementing employee stock options.

Stock option terminologies

• ESO / ESOP means Employee Stock Options or Employee Stock Ownership Plan.
• Exercise means the process of converting a vested option into an ordinary stock.
• Exercise period means the period in which an employee can exercise stock options.
• Exercise price means the amount to be paid by the employee to exercise the option.
• Exit event means when the owners of a company “exit” the business by selling.
• Lapse means what happens to an option when specific vesting criteria is not met.
• Offer letter means the agreement setting out the number of stock options being allocated.
• Option means an option to purchase a stock.
• Option-holder means any employee or contractor who has been offered stock options.
• Start date means the date the vesting period starts ticking.
• Vesting means the process by which the option-holder earns full rights to their stock options.

How employee stock option plans work

The company creates an ‘Option pool,’ setting aside stock options that can be allocated to employees or contractors.

There are 3 main things that needs to happen before stock option holders can eat their cake:

1. Granting
2. Vesting
3. Exercising

Vesting stock options: The option-holder is not able to exercise until those stock options have vested. Vesting conditions tie some obligation of performance (or time) to the stock options.

Time-based vesting:

• Can occur by way of a cliff or periodic vesting.

• Cliff vesting: A period of time before any stock options vest, usually set at one year.

• Periodic vesting: Options that vest gradually over a period of time.

Milestone Vesting: Options will vest on the achievement of some defined milestone or performance hurdle.

Most common vesting arrangements

• 25% of options vest after a 12 month cliff;
• The remaining 75% of options vest quarterly, over 36 months after the cliff date.

Vesting FAQs

• What is an accelerated vesting? The Plan Rules set out what happens to unvested options in the case of an exit event.

• What if options do not vest? They lapse and can be recycled back into the option pool.

• What if the employee leaves? The Plan Rules may contain general ‘buy-back’ provisions.

• What happens if the company is sold or listed? The Plan Rules will specify what happens to the options if an exit event occurs.

• Will the options and stocks be diluted? Just because an option-holder might be offered options equal to ‘3% ownership’, it does not mean they will always own that percentage.

Exercising stock options

Exercising stock options means you’re taking action to purchase shares of the company that has issued you equity, typically through a stock option grant.

How to exercise options

Usually, an option-holder must pay the exercise price to exercise any options.

Why stock options

ESOPs are the most popular method of granting employee ownership for start-up companies.

Less admin

They require much less admin compared to issuing stocks directly.

No upfront payment

Under an ESOP, the option-holder is not required to pay anything upfront to accept the offer.

Exercising FAQs

• How many options should I allocate to my team members? It is important to specifically consider your own staff and your plans for the next few years.

• How do I value my company for an ESOP? A company will initially be valued internally to determine how much equity they want to give.

How are stock options taxed

In the US, stock options are either incentive stock options (ISO) or non-qualified stock options (NSO).

Under ISOs:

• Grant: No tax paid at the time.
• Exercise: No ordinary income tax incurred at that time.
• Sale: If the employee meets the holding period requirements, profits are taxed as a long-term capital gain.

For NSOs:

• Grant: No tax paid at the time.
• Exercise: Difference treated as ordinary income.
• Sale: Differences treated as capital gain or loss.

It's recommended to consult with a tax professional or financial advisor for specific guidance based on your situation.