How Does Equity Compensation Work in a Private Company?

Equity compensation in a private company is a right to own shares — or to receive the cash value of shares — in a business whose stock doesn’t trade on a public exchange. Depending on your grant, that right may take the form of incentive stock options, non-qualified stock options, restricted stock units, or a cash-settled instrument like phantom stock. What sets the private-company version apart from public-company equity is timing: you typically earn the equity over several years, may owe taxes when you exercise or when it vests, and cannot freely sell your shares until the company goes public, is acquired, or approves a private sale. Understanding which instrument you hold, how it vests, how it is valued, and when tax hits is the difference between a valuable payout and an expensive surprise.

What Kind of Equity You Might Be Granted

Your offer letter or grant agreement names the instrument. Each type carries different rules for who can receive it and how it is taxed.

Incentive stock options (ISOs) give you the right to buy company shares at a fixed strike price. They are available only to employees, the strike price must be at least the fair market value on the grant date, and the option term cannot exceed ten years. You owe no regular federal income tax when you exercise an ISO. To keep that treatment, you must hold the shares at least two years after the grant date and at least one year after exercise. ISOs also carry a $100,000 annual limit: to the extent the fair market value of stock becoming exercisable for the first time in a calendar year exceeds $100,000 (measured at grant), the excess is taxed as if it were a non-qualified option.¹

Non-qualified stock options (NSOs) can go to employees, consultants, advisors, and board members. They also let you buy shares at a set strike price, but the tax treatment is less favorable. When you exercise, the spread between the strike price and the current fair market value is ordinary income for that year, and your employer must withhold federal income tax, Social Security, and Medicare tax on the spread.²³

Restricted stock units (RSUs) are a promise to deliver shares (or cash) once conditions are met. In a private company, RSUs almost always use a double-trigger structure: they settle only after you complete time-based vesting and the company has a liquidity event such as an IPO or sale. That structure exists to keep you from owing income tax on shares you cannot yet sell. When the RSUs finally settle, the full value of the shares delivered is ordinary income.

Phantom stock and stock appreciation rights (SARs) are cash-settled. Phantom stock pays you the value of a set number of shares on a future date. SARs pay you only the increase in share value above a baseline. Neither gives you actual ownership, and neither dilutes existing shareholders, which is why closely held companies often use them.

How Vesting Works

You do not own the whole grant on day one. Vesting phases in ownership over time to encourage you to stay. The common schedule is four years with a one-year cliff.

During the cliff — the first twelve months — nothing vests. Leave before month twelve and you forfeit the entire grant. At the one-year mark, 25 percent vests at once. The remaining 75 percent then vests in equal monthly or quarterly increments over the next three years. Anything unvested when you leave returns to the company’s equity pool.

Acceleration if the Company Is Sold

Some grants accelerate vesting when the company is acquired. Single-trigger acceleration vests some or all of your unvested equity on the sale itself. Double-trigger acceleration requires two things: the sale, and your involuntary termination or a meaningful role downgrade within a set window afterward, often 9 to 18 months. Double-trigger is more common because it protects you while letting the acquirer retain the team. Many grants include no acceleration at all, so read your agreement rather than assume.

How the Share Price Is Set

The 409A Valuation

Because private shares have no market price, the company hires an independent appraiser to establish the fair market value of its common stock. This is called a 409A valuation, after the tax code section that governs it, and a properly conducted valuation provides a safe harbor from tax penalties for both you and the company.⁴ The valuation must be refreshed at least every twelve months and after any material event, such as a new funding round or a significant change in the company’s finances.

Your strike price is locked in at the fair market value on your grant date and does not move as the company’s value rises. The gap between that fixed strike price and the company’s later, higher value is where the upside on stock options comes from. If a company issues options with a strike price below the appraised fair market value, Section 409A imposes a 20 percent additional tax on the compensation that should have been included in income, plus an interest charge running from the year the options were granted.⁵

Dilution From Funding Rounds

Every time the company raises money, it issues new shares, and every new share reduces your percentage ownership. Hold 1 percent of a company with one million shares, and after the company issues 250,000 new shares your stake becomes 0.8 percent of 1.25 million. Across multiple rounds a founder’s stake often drops from 100 percent to under 20 percent. Dilution does not automatically mean losing money. If the new round values the company at a much higher price per share, your smaller slice can be worth more in dollars. Track price per share and total valuation together, not percentage alone.

Taxes You May Owe Before You Can Sell

The hardest part of private company equity is that taxes often come due before you have any way to turn shares into cash. The rules differ by instrument.

AMT on ISO Exercises

Exercising an ISO does not trigger regular federal income tax, but it can trigger the Alternative Minimum Tax. If you exercise and hold the shares past year-end, the spread between the strike price and the fair market value on the exercise date is an AMT adjustment added to your alternative minimum taxable income. The AMT runs at 26 percent up to a threshold and 28 percent above it. For 2026, the AMT exemption is $90,100 for single filers and $140,200 for joint filers, phasing out starting at $500,000 and $1,000,000 respectively.⁶ Exercise a large block at a company with a high 409A valuation and the AMT bill can be substantial, even though you have not sold a single share. Selling the shares in the same calendar year avoids the AMT adjustment, but it also triggers a disqualifying disposition.

Ordinary Income on NSO Exercises

When you exercise an NSO, the spread hits your W-2 (or 1099) as ordinary income. Your employer withholds federal income tax at the 22 percent supplemental wage rate, or 37 percent if your supplemental wages for the year exceed $1 million, along with Social Security and Medicare.³ In a private company you need cash for the exercise price and the withholding, but usually no way to sell shares to raise that cash. Plan around that gap.

The Section 83(b) Election

If you receive restricted stock, or if your company allows you to exercise options early on unvested shares, you can file a Section 83(b) election. This lets you pay ordinary income tax on the value at the grant or early-exercise date, which is often very low in an early-stage company, rather than at the higher value when the shares vest. Future appreciation is then taxed at long-term capital gains rates when you sell, if you meet the holding period.

The deadline is strict: file with the IRS within 30 days of receiving the stock, no extensions.⁷ Miss the window and the election is gone for that grant. RSUs are not eligible, because an RSU is a promise of future shares rather than property you currently own.² The risk: if the shares never vest or lose value, you cannot recover the tax you already paid.

Disqualifying Dispositions of ISO Shares

Sell ISO shares before completing both holding periods — two years from grant and one year from exercise — and the sale is a disqualifying disposition.¹ The spread at exercise becomes ordinary income on your W-2, and any additional gain above the exercise-date value is a capital gain. In some cases a disqualifying disposition is the better outcome, because it eliminates the AMT adjustment in exchange for ordinary income treatment.

Qualified Small Business Stock

If your company is a C corporation with $75 million or less in gross assets when your stock was issued, your shares may be qualified small business stock under Section 1202. Hold QSBS for at least five years and you can exclude 100 percent of the gain from federal income tax, up to the greater of $10 million or ten times your adjusted basis.⁸ The stock must have been acquired at original issuance, and the company must meet active business requirements throughout your holding period. For early employees of successful startups the savings can be large, so it is worth confirming eligibility early.

Section 83(i) Deferral

Section 83(i) allows eligible employees of certain private companies to defer income tax on exercised options or settled RSUs for up to five years. The requirements are narrow: the company must grant equity to at least 80 percent of its U.S. employees under the same terms, and you cannot be a 1-percent owner, a current or former CEO or CFO, or among the four highest-paid officers. The election must be made within 30 days of vesting or transferability.⁹ Few companies meet the 80-percent coverage threshold, so the deferral rarely applies in practice.

Exercising Your Options

Options have a life. Most agreements set a ten-year term from the grant date, after which unexercised options expire. Before you exercise, know the strike price, the number of vested shares, and the expiration date, all of which appear in your grant agreement or your company’s equity portal.

The out-of-pocket cost is more than strike price times shares. For NSOs, add withholding: at least 22 percent of the spread for federal tax, plus payroll taxes.³ For ISOs, model the AMT you may owe the following April. Talk to a tax advisor before exercising a large block.

The Post-Termination Exercise Window

Vested options do not follow you forever if you leave. Most agreements give you a limited window — commonly 90 days after your last day — to exercise. For ISOs, federal law imposes its own deadline: exercise within three months of leaving employment or the options lose ISO treatment and become NSOs for tax purposes.¹ Some employers offer extended windows of several years, but even then the ISO-to-NSO conversion still happens at the three-month mark. Unvested options are forfeited when you leave.

Paying for the Exercise

In a private company, exercising almost always means writing a check. There is no public market to run a same-day cashless exercise against, unless the company is simultaneously running a tender offer or other liquidity event. Employees typically use personal savings, borrow against other assets, or, occasionally, sign a promissory note with the company. Some startup-focused lenders offer exercise financing, but those loans charge interest and put you at risk if the shares are ultimately worth less than you paid.

How and When You Can Actually Sell

IPO or Acquisition

The two ordinary paths to cash are an initial public offering and an acquisition. In an IPO, your private shares become publicly traded stock, but you usually cannot sell right away. A lock-up agreement typically bars insiders from selling for 180 days after the offering.¹⁰ In an acquisition, you receive cash, shares of the acquirer, or a mix, based on the deal terms. Unvested equity at the time of the sale is handled according to your grant agreement and any acceleration provisions.

Tender Offers and Secondary Sales

Some employees reach liquidity before an IPO through secondary market sales to accredited investors.¹¹ These sales almost always require company approval and may trigger a right of first refusal, letting the company buy the shares back at the offered price before an outside buyer can. The company may also run a formal tender offer, in which the company or an outside investor buys shares from employees at a set price. Neither is guaranteed, and both are at the company’s discretion.

Transfer Restrictions

Private shares carry transfer restrictions that public stock does not. Your stock purchase agreement, the company’s bylaws, or a stockholders’ agreement may require board approval for any transfer, limit who you can sell to, or bar sales entirely until a liquidity event. Check these documents before any sale, even to a family member, and confirm the company will authorize the transfer. Private shares are also usually unregistered securities, so reselling them requires an exemption from federal and state registration.

What Can Go Wrong

Equity in a private company is not a guaranteed payout. If the company fails, your options and shares are worthless, regardless of what they were once appraised at. Cash you spent exercising options, or tax you paid on an 83(b) election, is gone.

Illiquidity is the other defining risk. You may hold valuable equity on paper for years with no way to sell, while owing AMT on ISO exercises or ordinary income tax on NSO exercises without any proceeds to pay the bill. Dilution from later funding rounds can reduce your ownership percentage, though a rising valuation can still leave your stake worth more in dollars. And when a large share of your total compensation rides on one company, your financial picture is tied to a single outcome. Knowing which instrument you hold, when tax hits, and how far away liquidity realistically is remains the most effective way to keep those risks in view.

1
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
2
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
3
Internal Revenue Service. Publication 15 (2026), Circular E, Employers Tax Guide
4
eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
5
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
6
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
7
Internal Revenue Service. Form 15620 Section 83(b) Election
8
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
9
Internal Revenue Service. Guidance on the Application of Section 83(i)
10
U.S. Securities and Exchange Commission. Initial Public Offerings: Lockup Agreements
11
U.S. Securities and Exchange Commission. Accredited Investors