Equity compensation 101: ISOs, NSOs, RSUs, and when each one actually makes sense

The most expensive equity compensation conversations happen between a founder and an employee who’s about to leave. The employee discovers, during the offer-acceptance phase with their next company, that the options they thought were worth something either expired, or trigger a tax bill they can’t afford to exercise, or were structured in a way that gave them less than they assumed. The conversation always ends the same way: “I wish someone had explained this to me three years ago.”

Three years ago, the founder didn’t know either. Most early-stage equity grants are made by founders working from intuition, a generic template their lawyer provided, and a vague sense that “options are part of the package.” The mechanics of what was actually granted, what the tax implications are, when the option expires, and what happens if the employee leaves — these get figured out, often badly, later.

This post is the operator’s primer on the three grant types you’ll actually use at a Series A/B startup: ISOs, NSOs, and RSUs. What they are, what the tax math looks like, when each one makes sense, and what we recommend you do at each stage. The goal is that you can have a clear conversation with employees, with your cap table provider, and with your employment counsel about what you’re granting and why.

The three instruments at a glance

The right instrument depends on three things: who’s getting the grant (employee vs. contractor), what the company’s valuation looks like, and what stage you’re at. Each instrument has a specific tax and operational profile that makes it the right answer in some scenarios and the wrong answer in others.

ISOs: the default for early-stage employee grants

An Incentive Stock Option (ISO) is a U.S. tax-code-defined instrument available only to W-2 employees of the granting entity. It gives the employee the right to purchase shares at a fixed exercise price (the strike price), set at the time of grant equal to the then-current 409A fair market value.

The tax appeal: if structured and exercised correctly, the employee pays no tax at grant, no regular tax at exercise (subject to the AMT caveat below), and long-term capital gains on the entire spread between strike price and eventual sale price — provided the shares are held for at least one year after exercise and at least two years after grant.

The AMT trap. ISOs are subject to the Alternative Minimum Tax (AMT). When you exercise an ISO, the spread between the strike price and the fair market value at exercise is a “preference item” for AMT purposes. For employees exercising ISOs on shares that have appreciated meaningfully — which is the whole point of an ISO — this can produce a sizable AMT bill in the year of exercise, even though the employee has not sold the shares and has no liquidity.

This is the single most common source of equity-comp shock for startup employees. We’ve seen engineers with $50K-200K AMT bills they had no idea were coming, with no liquidity to pay them. The mitigation: either early exercise (before the shares have appreciated meaningfully), or model the AMT before exercising, or wait to exercise until there’s a tender offer or secondary that provides liquidity.

The $100K limit. ISO tax treatment is limited to $100K of grants that become exercisable in any single calendar year (measured at the strike price). Above that threshold, the excess is automatically treated as NSOs. For early-stage companies with low strike prices, this rarely binds. For later-stage companies with higher strike prices, it often does.

The 90-day post-termination rule. Standard ISO terms require exercise within 90 days of termination of employment to preserve the ISO tax treatment. After 90 days, unexercised ISOs convert to NSOs (or expire entirely, depending on the plan terms). This rule has stranded countless employees who couldn’t afford to exercise at termination and lost the grant entirely. Some startups have started extending the post-termination exercise window to 7-10 years; this is increasingly common at later stages and is something employees explicitly negotiate for.

When to use ISOs. Default grant type for W-2 employees at seed through Series B, when the 409A is low enough that AMT exposure is manageable. Founders, engineers, GTM, operations — all standard employee grants are typically ISOs.

NSOs: the general-purpose instrument

A Non-qualified Stock Option (NSO) is the more permissive cousin of the ISO. It gives the holder the right to purchase shares at a fixed exercise price, but without the ISO tax preferences. NSOs can be granted to anyone — employees, contractors, advisors, board members — and they have no $100K limit and no 90-day post-termination rule by default.

The tradeoff: NSOs are taxed less favorably than ISOs. At exercise, the holder owes ordinary income tax (and, for employees, payroll tax) on the spread between strike price and fair market value. That tax bill is due in the year of exercise, regardless of whether the shares have liquidity. Subsequent appreciation between exercise and sale is taxed as capital gains.

The withholding mechanics. When an employee exercises NSOs on appreciated shares, the company must withhold federal income tax, FICA, Medicare, and applicable state tax on the spread. This means the company has a real payroll tax obligation triggered by the employee’s exercise — which can come as a surprise the first time it happens. Modern payroll providers like Rippling and Gusto handle this if the cap table data is properly integrated.

When to use NSOs. Three main scenarios:

1. Contractor, advisor, and board grants. Anyone who isn’t a W-2 employee must be granted NSOs (or RSAs); ISOs aren’t available.
2. Late-stage employee grants where the strike price exceeds the ISO threshold. Once your 409A is high enough that an annual grant would exceed $100K in exercisable strike price, the excess auto-converts to NSO treatment anyway.
3. Companies that have chosen NSO-as-default. Some startups grant NSOs to everyone for simplicity and uniformity, accepting the less favorable tax treatment in exchange for a single instrument across the cap table. Less common at Series A/B but defensible.

RSUs: the post-Series B story

A Restricted Stock Unit (RSU) is a promise to deliver shares — or cash equivalent — at vesting, subject to specified conditions. There’s no exercise and no exercise price. The holder doesn’t get the shares until the vesting condition is met, at which point the shares are delivered and the holder owes ordinary income tax on the fair market value of the delivered shares.

Why RSUs become the default at later stages. Two reasons. First, options become impractical at later stages because the strike price gets high enough that employees can’t afford to exercise — and the AMT exposure on ISOs at scale becomes prohibitive. RSUs sidestep this entirely: no exercise, no upfront cost, no AMT.

Second, RSUs are easier to value and communicate. “You’re getting 1,000 RSUs worth $50,000 today” is a clearer statement than “you’re getting 1,000 options at a $50 strike, currently worth $5 per share if we IPO at $150.” The former is what late-stage and pre-IPO companies have shifted toward.

Double-trigger RSUs. Most private-company RSUs use a “double-trigger” vesting structure: the RSUs vest on the service-based schedule (typically 4 years), but they don’t settle (deliver actual shares) until a liquidity event (IPO, acquisition, or tender offer). This solves the problem of employees owing tax on shares they can’t sell. Without the double-trigger, an employee whose RSUs vest before liquidity would owe tax on shares with no market — which is the same trap that derailed many tech employees in the dot-com era.

The 7-year limit and the IPO countdown. Privately-held RSUs typically have a service-based vesting schedule with a maximum 7-year deadline before the liquidity-event condition. If the liquidity event doesn’t happen within 7 years of grant, the RSUs typically expire. This is uncommon in practice — most companies that grant RSUs are within 3-5 years of a liquidity event — but worth being aware of.

When to use RSUs. Generally not at Series A. Sometimes at Series B for senior hires. Often at Series C and beyond as the company approaches liquidity. We don’t usually recommend transitioning the whole grant program to RSUs until the company is within 2-3 years of expected liquidity and the 409A has moved meaningfully (typically $5+ per share).

The vesting structure

The 4-year vest with 1-year cliff is still the standard, and we recommend sticking with it unless you have a specific reason to deviate.

• 4-year vest. 25% of the grant vests after 12 months (the “cliff”); the remaining 75% vests monthly or quarterly over the following 36 months. This is what employees and recruiters expect.
• 3-year vest. Some startups have experimented with this to compete for senior hires. Faster equity = more recruiting appeal, but also more equity erosion per grant. We’ve seen this work at companies with strong hiring momentum and seen it create equity-budget problems elsewhere.
• 5-year vest. Common at late-stage companies and post-IPO; rare at Series A/B.
• No cliff. Some companies eliminate the 1-year cliff to make grants more employee-friendly. The cost: an employee who leaves in month 3 still keeps the 3 months of vested equity. The benefit: removes one of the most-disliked features of standard grants. We’re agnostic on this one.

The cliff exists for a reason — it’s the company’s protection against a bad hire who leaves after 6 months with a meaningful equity stake. Don’t eliminate it casually.

The 409A and what it actually does for you

A 409A valuation is an independent fair-market-value assessment of your common stock, required to set defensible strike prices on options grants. The Internal Revenue Code Section 409A is what gives the practice its name. The valuation is performed by a 409A specialist (Carta, Aranca, Scalar are the most common providers, but several exist) and is typically refreshed annually or upon a material event (financing round, significant business change).

What the 409A does. Sets the strike price floor for any options you grant. As long as the strike price equals or exceeds the 409A FMV, the IRS treats the grant as not creating immediate taxable compensation to the grantee. Mess this up and you have a 409A violation, which triggers a 20% federal excise tax on the grantee, plus state penalties, plus the underlying tax — a real disaster.

The “safe harbor.” A 409A valuation performed by a qualified independent appraiser within the last 12 months is presumed reasonable by the IRS, unless the company knows or has reason to know the valuation is grossly unreasonable. This presumption is what makes 409A valuations operationally useful — they shift the burden of proof.

When to refresh. Annually at minimum. Sooner if the company has had a material event: a financing round, a major business change, a significant headcount increase, a meaningful change in revenue trajectory. The IRS treats stale 409As skeptically; the cost of refreshing ($3,000-10,000 depending on provider and complexity) is much smaller than the cost of granting options at a strike price that turns out to be indefensible.

Cap table providers handle this. Carta and Pulley both bundle 409A services with cap table management. You can also use a standalone 409A provider; the question is whether you want to manage the relationship or have it bundled with cap table administration.

What to grant by role and level

At Series A and B, equity grants should be standardized by role and level. A published equity band — even an internal-only one — is what prevents the ad hoc negotiation that creates inequity and operational chaos.

Rough benchmarks for Series A startups (these vary by industry, geography, and company stage; treat them as starting points, not commitments):

• Founding engineer / first 5 hires: 0.5%-1.5%
• Senior engineer (post first 10): 0.15%-0.50%
• Mid-level engineer: 0.05%-0.20%
• Head of [function] (VP-level): 0.50%-2.00%
• Director-level: 0.15%-0.75%
• Senior individual contributor (non-engineering): 0.05%-0.25%

Series B benchmarks shift downward (the same role gets a smaller percentage at Series B than at Series A) but the dollar value of the grant typically increases because the company is more valuable. Standardize on dollar value of grants at Series B, not percentage.

The published equity band. Have one. Distribute it internally so that hiring managers and employees can self-serve. The bands should be reviewed annually and adjusted for market data. Your cap table provider (Carta, Pulley) publishes benchmark data; venture firms typically share equity-band data with their portfolio; specialized compensation-data providers exist for companies that want more granularity.

Refresh grants, early exercise, and other advanced moves

Three structures worth understanding even if you don’t use them at Series A.

Refresh grants. New grants made to existing employees on a recurring basis — typically every 2-3 years for high performers, or annually as a smaller “top-up.” The reason: standard 4-year vesting means a high-performing employee in year 3-4 has very little forward-looking equity incentive remaining. Refresh grants extend the runway. Standard at Series B and beyond; rare at Series A.

Early exercise. The right to exercise unvested options. The tax appeal: by exercising before the shares have appreciated, the employee starts the long-term capital gains clock early and minimizes AMT exposure. The employee files an 83(b) election within 30 days of exercise to lock in the tax treatment at grant.

Early exercise is powerful for founders and very early employees with the cash to exercise and the conviction to use it. It’s largely useless for later employees because the cost of exercising appreciated unvested shares is the same problem as exercising appreciated vested shares.

Extended post-termination exercise windows. Standard ISO terms require exercise within 90 days of termination, which (as noted above) strands many employees. Some companies extend this to 5, 7, or 10 years. The tradeoff: extending the window converts ISO tax treatment to NSO tax treatment (since ISO status requires the 90-day rule). It’s a meaningful employee-friendly move that’s increasingly common; the conversion to NSO is the cost.

What we recommend at Series A vs. Series B

At Series A: ISOs for all employees by default. NSOs for contractors, advisors, and board. 4-year vest with 1-year cliff. Annual 409A refresh. Published equity bands. No RSUs.

At Series B: Continue ISOs for most employees, but anticipate the $100K threshold starting to bind for senior hires — those grants will spill into NSO treatment. Begin considering refresh grants for early employees whose vesting is nearing completion. RSUs for executive-level hires if you’re within 2-3 years of expected liquidity.

At Series C and beyond: Shift the default toward RSUs as the 409A and complexity make options less practical. Implement extended post-termination exercise windows. Build out a comp committee or board-level equity governance.

When to bring in operator support

You probably don’t need outside help if you’re at seed/Series A with a standard 4-year vest, ISO grants for employees, a Carta or Pulley cap table, and an annual 409A. The structure is standardized enough that you can run it with your employment counsel and cap table provider.

You likely want operator input if:

• You’re transitioning from options to RSUs and don’t know how to communicate the change to existing employees
• You’re designing your first refresh grant program and want to know what to do for which employees
• You’re inheriting an equity comp structure (post-acquisition, post-leadership change) and aren’t sure what was actually granted
• You’re preparing for an audit or M&A event where equity comp is going to be diligenced — and ISO violations, 409A issues, and unrecorded grants are common findings
• You’re going through diligence and discovering equity-comp errors that need remediation

Pegacorn Group works with venture-backed Series A and B startups on equity comp structure, refresh planning, and the audit-prep work around equity. If you’re not sure your equity comp is set up correctly for your stage, let’s talk.

This post pairs with: The Series A/B benefits stack, How to administer payroll and 401(k) plans at a startup, Health insurance for startups, and When to hire your first HR person.