How Do Stock Options Work in a Private Company?

Stock options in a private company give you the right to buy shares in your employer at a fixed price, earned over a vesting schedule, with taxes owed at exercise or sale depending on the option type, and no practical way to sell those shares until the company goes public, gets acquired, or runs a secondary program. Understanding how stock options work in a private company matters before you sign the offer, before you exercise, and especially before you leave, because each of those moments can create a tax bill or forfeit real money if handled wrong.

What a Stock Option Grant Actually Contains

A grant is a contract, and four numbers do most of the work. The grant date is when the board formally approves your award. The strike price is what you’ll pay per share if you exercise. The share count is how many shares the grant covers. The vesting schedule controls when you earn the right to buy them.

Federal tax law effectively forces the strike price to be set at or above the fair market value of the common stock on the grant date. Pricing below fair market value turns the option into deferred compensation under Section 409A of the Internal Revenue Code, which triggers a 20 percent penalty tax plus interest for the option holder on top of regular income tax.¹ To avoid that, private companies commission an independent 409A valuation, a formal appraisal of the common stock’s fair market value, generally valid for up to 12 months unless a significant event like a new funding round resets the number.

Grants also expire. Incentive stock options are capped by statute at a ten-year term; miss that window and the options are worthless.² Most companies apply the same ten-year limit to non-qualified options even though no statute requires it.

ISOs vs. NSOs: The Tax Fork

Your option agreement will label your grant as either incentive stock options (ISOs) or non-qualified stock options (NSOs). That label determines nearly everything about how you’re taxed.

Incentive Stock Options

ISOs receive favorable tax treatment. You owe no regular federal income tax when you exercise; the taxable event comes at sale.³ Hold the shares at least two years after the grant date and one year after exercise, and the profit qualifies as a long-term capital gain, taxed at lower rates than ordinary income.² Sell earlier and it becomes a disqualifying disposition, with the spread between fair market value and strike price taxed as ordinary income.

ISOs come with real constraints. Only employees can receive them, not contractors or board members. The value of ISOs that first become exercisable in any single calendar year is capped at $100,000, measured by fair market value at grant; anything above that is automatically treated as an NSO. ISOs cannot be transferred during your lifetime, and they must be exercised within three months of leaving the company to keep their ISO status.²

Non-Qualified Stock Options

NSOs are more flexible on who can receive them (employees, contractors, advisors, board members) but less flexible on tax. When you exercise an NSO, the spread between fair market value and your strike price is taxed as ordinary income that year.³ Your employer withholds federal and state income tax plus Social Security and Medicare on that spread, just like wages. If you later sell the shares at a higher price, the additional gain is capital gain.

Vesting: When Shares Actually Become Yours

A grant doesn’t give you shares you can buy today. You earn the right to exercise through vesting. The most common schedule is four years with a one-year cliff. Nothing is exercisable in the first 12 months. On your first anniversary, 25 percent vests all at once. The remainder usually vests in equal monthly installments over the next three years, roughly 1/48th of the original grant per month.⁴ Leave before the cliff and you walk away with nothing.

Some grants tie vesting to performance milestones instead of time, such as a revenue target or product launch. Miss the milestone and those options are forfeited.

Acceleration in a Sale

Many option agreements include a double-trigger acceleration clause. Unvested shares accelerate only if two events occur: the company is sold, and you are terminated without cause or your role is significantly diminished within a set window after the acquisition, often 3 to 12 months. Without that language, an acquirer can keep your unvested options on their original schedule or cancel them. Read your agreement for acceleration terms before assuming a sale protects you.

Taxes at Exercise and at Sale

Exercising a private company option is one of the few moments in employment law where you can owe real tax on something you cannot sell.

NSO Exercise Creates Immediate Income

When you exercise an NSO, the spread is wages. If fair market value is $10 and your strike is $1, you owe ordinary income tax on $9 per share, and your employer withholds income and payroll taxes on that amount.³ In a private company, the shares are illiquid, so you need outside cash to cover a tax bill on paper gains.

ISO Exercise and the AMT

ISOs aren’t hit with ordinary income tax at exercise, but the spread is an adjustment for the alternative minimum tax. A large exercise can produce a sizable AMT bill even though no cash changed hands.³ For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly; spreads pushing you past those thresholds can create unexpected liability.⁵ Running the numbers with a tax professional before a large ISO exercise is one of the most consequential financial steps involved.

When You Sell

Selling triggers a separate taxable event regardless of option type. If you held long enough for long-term capital gains, the profit above the fair market value at exercise is taxed at the capital gains rate. For ISOs, that means at least two years from the grant date and one year from exercise.² Sell before meeting those periods and the gain is ordinary income.

Early Exercise and the 83(b) Election

Some companies allow early exercise, letting you buy shares before they vest. If you do, you can file a Section 83(b) election with the IRS to pay tax on the spread at purchase rather than later as the shares vest and (hopefully) rise in value.⁶ Exercise right after a grant, when the strike price and fair market value match, and the taxable spread can be zero.

The deadline is non-negotiable: 30 days from the exercise date. You file by mailing Form 15620 to the IRS office where you file your return and giving a copy to your employer.⁷ Miss the window and the election is gone; it cannot be extended or made retroactive. The downside is real too: leave before your shares vest and you forfeit them, and you cannot deduct the taxes already paid.

A separate provision, Section 83(i), can let employees at certain private companies defer tax on exercised options for up to five years, but the eligibility rules are narrow enough that it rarely applies in practice. Among other requirements, the company must grant equity to at least 80 percent of its U.S. employees in the same calendar year, and senior executives and one-percent owners are excluded.⁸

How You Actually Exercise

When you’re ready to exercise, you submit a notice of exercise to the company, usually through legal or HR or an equity platform such as Carta or Shareworks. The notice states how many vested shares you want to buy.

You then pay the total strike price, typically by wire or check. Exercise 1,000 shares at a $2 strike and you owe the company $2,000. For NSOs, you also need to cover tax withholding on the spread, which can push your total out-of-pocket well above the strike. Once payment clears, the company updates the capitalization table to list you as a shareholder.

Before you send the money, confirm two numbers with the company: the current 409A fair market value and your exact number of vested shares. The fair market value at exercise, not your strike price, drives the tax calculation for both ISOs and NSOs.

You Own Shares, But You Can’t Just Sell Them

Private company stock is bound by contract in ways public stock is not. The most common restriction is a right of first refusal: before selling to any outside buyer, you must offer your shares to the company or existing shareholders at the same terms. If they match the outside offer, you sell to them. Many companies also require board approval for any transfer, even to family.

Two other provisions matter in a sale. Drag-along rights let majority shareholders force minority shareholders, including employees, to sell on the same terms in an acquisition; you cannot hold out. Tag-along rights work the other way, letting minority shareholders join a majority sale on the same terms so they aren’t stranded. Both live in the shareholders’ agreement, which you should read after exercising.

Dilution Shrinks Your Percentage

Your grant covers a fixed number of shares, but your percentage of the company will almost certainly drop over time. Every new funding round and every expansion of the employee option pool issues more shares, and each new share reduces the ownership percentage of every existing one.

Own 1,000 shares out of 100,000 and you hold one percent. Issue 50,000 new shares to Series B investors and the total is 150,000; your 1,000 shares now represent about 0.67 percent. The dollar value of your shares can still rise if each round values the company higher, but the slice gets thinner. Several rounds before a liquidity event can meaningfully dilute early employees.

What Happens When You Leave

Leaving, whether by choice or layoff, forces one of the hardest decisions option holders face. For ISOs, you must exercise within three months of your last day to keep ISO tax treatment.² Your option agreement sets a post-termination exercise period, often 90 days, and any vested options you don’t exercise in that window expire.

The cash pressure is real. You need the full strike price plus any tax liability, all for shares you still can’t sell. A large ISO exercise can trigger AMT on an illiquid asset. Many employees end up choosing between walking away from potentially valuable equity and writing a five- or six-figure check with no guaranteed return.

Some companies have extended their post-termination exercise window well beyond 90 days, in some cases up to 10 years, but 90 days remains the standard. If you exercise more than three months after leaving, ISOs automatically convert to NSOs for tax purposes, costing you the ISO treatment.

Getting to Cash: Liquidity Events

Shares stay locked up until a corporate event creates a way to sell. Three paths are common.

Initial Public Offering

Going public converts your private shares into publicly traded stock, but you usually can’t sell right away. Lockup agreements prohibit insiders, employees included, from selling for a set period after the IPO, most often 180 days.⁹ After it expires, you can sell on the open market.

Acquisition

In a sale, the deal may be cash, a stock swap into the acquirer’s shares, or a mix. In a cash deal, you receive the per-share price minus your strike for each vested option. If the acquisition price per share is below your strike, your options are underwater and worthless. Drag-along rights can require you to sell whether you want to or not.

Secondary Sales and Tender Offers

Some companies run secondary transactions before any public exit, letting employees sell a portion of vested shares to institutional buyers or back to the company. These programs often cap how much each employee can sell. Outside a company-sponsored program, most private companies require board approval before any transfer to a third party, which makes informal secondary sales difficult without company cooperation.

Documents to Pull Before You Decide Anything

Before you exercise, leave, or make an 83(b) election, read these:

The Equity Incentive Plan, which governs all option grants at the company and sets default terms for things like post-termination exercise and acceleration.
Your Stock Option Agreement, with your specific share count, strike price, vesting schedule, option type (ISO or NSO), and expiration.
The current 409A valuation, needed to estimate taxes before exercising.
The Shareholders’ Agreement, which governs your rights and restrictions once you’re a shareholder, including right of first refusal, drag-along and tag-along provisions, and any non-compete or non-solicitation terms tied to your equity.

Your legal or HR team should hand these over on request. If the company refuses to share the 409A valuation or the capitalization table, treat that as a warning before you commit any cash.

1
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
2
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
3
Internal Revenue Service. Topic No. 427, Stock Options
4
Carta. Vesting: A Guide to Equity Schedules
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
7
Internal Revenue Service. Section 83(b) Election Form 15620
8
Internal Revenue Service. Guidance on the Application of Section 83(i) – Notice 2018-97
9
Investor.gov. Initial Public Offerings: Lockup Agreements