# 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](/content/features/stock-options/index.html) 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](/content/guides/equity-compensation/index.html) 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.