Employee equity and 409A

Choosing between restricted stock, options and units

The four instruments differ in when income is recognised and in what has to be paid to acquire the shares. At an early-stage company where the common value is low, restricted stock purchased outright is the cheapest to hold and the most exposed if the company fails. At a later stage the same instrument is unaffordable and units become the only workable form.

Field	Value
Formula	Cash required at acquisition: restricted stock = shares * price; options = shares * strike; units = 0. Income recognised: restricted stock with an 83(b) election = spread at purchase; without = spread at each vesting date; options = spread at exercise for a non-qualified option, nothing for an incentive option; units = full value at settlement
Restricted stock at the seed ladder	400,000 shares at 0.2550 costs 102,000 and, with a timely 83(b) election, recognises no income at all
The same 400,000 at the Series C ladder	1,101,600 of cash, which is why restricted stock stops being used
Options at the Series C ladder	No cash until exercise, and the exercise cost is the same 1,101,600
Units at any ladder	No cash ever, and ordinary income on the full value at settlement rather than on a spread
Why units arrive late	A unit is taxed on its whole value, so it is only workable when there is a market to sell into or a company willing to withhold in shares

• The instrument follows the common value, not the stage label. Restricted stock works while the strike is small enough to write a cheque for and stops working the moment it is not; nothing else about the company has to change.
• Units avoid the exercise problem and create a withholding problem: ordinary income arises with no liquidity to pay it. At a private company that means either a company loan, a tender, or a settlement date deferred until a liquidity event.
• Incentive options are the only instrument with no ordinary income at exercise, and the price of that is a statutory holding period, an annual limit, and alternative minimum tax exposure on the spread.
• Whatever the instrument, the payout comes out of the residual after the preferred stack. The instrument decides the tax and the cash; it does not change the position in the waterfall.

The 409A ladder - why the strike lags the round price

Options must be granted at no less than the fair market value of common stock, determined under section 409A. Preferred stock carries a liquidation preference and other rights that common does not, so the appraised value of common sits below the price paid for preferred in the same round. The gap narrows as the company grows into its stack.

Field	Value
Formula	Strike = common fair market value. Discount to the preferred price = 1 - (common fair market value / preferred price). The level is an appraisal output and cannot be derived from the round price
Seed	Preferred 0.8500, assumed common fraction 30 percent, strike 0.2550, discount 70.0 percent
Series A	Preferred 2.0400, 35 percent, strike 0.7140, discount 65.0 percent
Series B	Preferred 5.1000, 40 percent, strike 2.0400, discount 60.0 percent
Series C	Preferred 6.1200, 45 percent, strike 2.7540, discount 55.0 percent
What drives the discount	The size of the aggregate preference relative to enterprise value, the probability weighting across exit scenarios, and marketability
Timing effect	A grant made before a refresh that follows a strong round carries a lower strike than the identical grant made after it. On this ladder that is a 1.3260 per share difference between the Series A and Series B strike

• The fractions in this ladder are inputs. They are chosen so the arithmetic can be followed, and any real strike is the output of an independent appraisal that considers the preference overhang, the scenario weighting and marketability. Modelling a target discount and backing into the value inverts the rule.
• The gap is the same arithmetic as the dead zone between the invested capital and the conversion indifference point, expressed as a valuation input rather than as a payout. A large new preference widens both at once.
• Two numbers are correct on the same day - the preferred price and the common fair market value - and quoting either as the share price will mislead somebody. Always say which one.
• Grant timing relative to a refresh is a scheduling decision with a compensation consequence, and it is one of the few levers a company has that costs it nothing. A refresh triggered by a closing should be planned around, not discovered.

Source: IRC section 409A

Early exercise and the 83(b) election, worked

Buying unvested shares and filing an 83(b) election within thirty days fixes the taxable event at the purchase date, when the spread is zero. Without the election, income is recognised at each vesting date on that date's spread, which on a company that works is the whole of the appreciation.

Field	Value
Formula	With an 83(b) election: ordinary income at purchase = shares * (fair market value - price paid), and all subsequent appreciation is capital. Without it: ordinary income at each vesting date = shares vesting * (fair market value at that date - price paid)
Setup	400,000 shares purchased at the seed strike of 0.2550 for 102,000, vesting 100,000 a year over four years
With a timely 83(b) election	Ordinary income at purchase = 400,000 * (0.2550 - 0.2550) = 0. Everything after is capital gain
Without it, year 1 at a 0.7140 fair market value	100,000 * (0.7140 - 0.2550) = 45,900
Year 2 at 2.0400	178,500
Year 3 at 2.7540	249,900
Year 4 at 10.2000	994,500
Total ordinary income with no election	1,468,800, against zero with the election

• The thirty-day window is the whole term. It runs from the transfer of the property, it cannot be extended, and there is no cure. A filing made on day thirty-one produces the right-hand column above for the rest of the grant's life.
• The election accelerates risk as well as tax. Cash goes out at purchase, the shares can become worthless, and there is no deduction for the loss of an amount that was never included in income. It is the correct choice when the purchase price is small and a poor one when it is not.
• The income in years two to four is recognised with no liquidity to pay it, at a private company with no market in its stock. That is the failure mode: a tax bill on paper appreciation that cannot be sold.
• Early exercise combined with 83(b) also starts the capital gains holding period and, for stock that qualifies, the section 1202 holding period at the purchase date rather than at vesting. On a five-year test, three years of difference is the whole exclusion.

Source: IRC section 83(b)

The 100,000 limit on incentive stock options

Incentive stock options are limited by the aggregate fair market value of the underlying stock, measured at grant, that first becomes exercisable in any one calendar year. Options above the limit are treated as non-qualified. The limit is a value, so the share count it permits falls as the strike rises.

Field	Value
Formula	Shares that can be incentive options in one year = 100,000 / strike, using the fair market value at grant. Anything in excess is non-qualified
At the Series A strike of 0.7140	100,000/0.7140 = 140,056 shares a year
A 200,000-share tranche vesting in one year	140,056 shares are incentive options and 59,944 are non-qualified
At the seed strike of 0.2550	100,000/0.2550 = 392,157 shares a year - the limit is not reached by a 200,000-share tranche
At the Series C strike of 2.7540	100,000/2.7540 = 36,311 shares a year
Measured at grant	The relevant value is the fair market value when the option was granted, so a later increase in value does not retroactively breach the limit
First becomes exercisable	A four-year monthly schedule spreads a grant across four calendar years, which is why standard vesting rarely breaches the limit and a cliff-heavy or accelerated schedule can

• The limit bites on acceleration, not on ordinary vesting. A change of control that accelerates several years of vesting into one calendar year can convert a large part of an incentive grant into non-qualified options at the worst possible moment.
• It also bites on late grants at a high strike. The same 200,000 options are entirely incentive at a 0.2550 strike and largely non-qualified at 0.7140, from nothing but the passage of two rounds.
• The split is determined at the plan and grant level and should appear on the grant documentation. A holder that assumes a grant is entirely incentive and exercises accordingly will find withholding due on the non-qualified part.
• Non-qualified treatment is not a disaster; it is ordinary income on the spread with withholding, and no alternative minimum tax exposure. In a year when the spread is small it is arguably the better outcome.

Source: IRC section 422(d)

Alternative minimum tax on an incentive option exercise

An incentive option produces no ordinary income at exercise, and the spread is an item of adjustment for alternative minimum tax. The result is a cash tax liability in the year of exercise, on stock that cannot be sold, computed on a value nobody received.

Field	Value
Formula	Adjustment amount = shares exercised * (fair market value at exercise - strike). This enters the alternative minimum tax base in the year of exercise, whether or not the shares are sold
Setup	Series A vintage options at a 0.7140 strike, exercised when the common fair market value is 2.0400
Exercising 140,056 shares	Spread = 140,056 * (2.0400 - 0.7140) = 185,714
Cash paid to exercise	100,000
Cash available from the shares	None - the stock is illiquid
Exercising 200,000 instead	Spread = 265,200, and the excess over the incentive limit is ordinary income rather than an adjustment
If the shares are sold in the same year	The disposition is disqualifying, the spread becomes ordinary income, and the adjustment does not arise

• The structural problem is that the adjustment is recognised on exercise and the liquidity arrives on sale, which can be years later or never. Exercising into a falling private valuation is the case that has bankrupted employees.
• Selling in the same calendar year as the exercise is a disqualifying disposition and converts the whole spread to ordinary income, which removes the adjustment. That is a real planning choice rather than a failure, and it is the only route available where a tender is the source of liquidity.
• The exposure scales with the spread, so exercising early - immediately after a grant, when the spread is zero - avoids it entirely. That is the main argument for early exercise on top of the 83(b) point.
• This corpus states the mechanism, not the computation of anyone's liability. Rates, exemptions, credits and the interaction with ordinary tax are outside its scope.

Source: IRC section 56(b)(3)

Qualified small business stock - the tests and the ceiling

Section 1202 excludes gain on qualified small business stock from federal income tax, subject to a holding period, tests on the issuer, and a per-issuer ceiling. The structure is what matters here: the exclusion is capped, and the cap is the greater of a statutory dollar amount and ten times the holder's basis - which is nothing at all for a founder who paid par.

Field	Value
Formula	Excluded gain = tier fraction * min(gain, ceiling), where ceiling = max(K, 10 * aggregate adjusted basis of the stock disposed of) and K, the tier fractions and the holding periods are statutory parameters
Structural requirements	Stock acquired at original issue from a domestic C corporation; the corporation's gross assets below a statutory ceiling at and immediately after issuance; an active business requirement; a minimum holding period
Parameters used below	A ceiling K of 15,000,000 and a 100 percent tier at five years. These are inputs to the arithmetic. Read the current statute for the figures that apply to a given holding, which were amended for stock acquired after 4 July 2025
Worked, a founder position	8,000,000 founder shares with an aggregate basis of 8,000, sold at an exit of 250,000,000 where the shares are worth 10.2000 each
Proceeds and gain	81,600,000 of proceeds, 81,592,000 of gain
The ceiling	max(15,000,000, 10 * 8,000) = max(15,000,000, 80,000) = 15,000,000
Excluded and taxable	15,000,000 excluded, which is 18.384 percent of the gain; 66,592,000 remains taxable

• The ten-times-basis alternative is the part that surprises founders. It is designed for holders who paid real money for their stock, and a founder who paid par has a basis so small that the alternative is irrelevant. The dollar ceiling is the whole benefit.
• The gross assets test is measured at and immediately after issuance, so it is the early rounds that qualify and the later ones that can fail. Stock issued after the company has crossed the asset ceiling is not qualified stock, which means a single cap table can contain both.
• The holding period runs from issuance. Early exercise with an 83(b) election starts it years earlier than exercise at a liquidity event, which on a five-year test is frequently the difference between the full exclusion and none.
• A conversion of the company to a limited liability company or an S corporation, or an issuance by a non-corporate entity, breaks the test at the root. This is one of the few tax attributes that is destroyed by an entity choice rather than by a transaction.

Source: IRC section 1202

Repricing and exchange offers for underwater options

After a down round the outstanding grants have strikes above the new common value and no retention effect. The two remedies are to reprice the existing options to the new value, or to offer an exchange of old options for a smaller number of new ones. Both are a real cost and neither is arithmetic alone.

Field	Value
Formula	A value-for-value exchange ratio is old options per new option, set so the model value of the new grant equals the model value surrendered. The ratio is an option-pricing output, not a spread calculation, because both grants are usually at or above the money
Setup	200,000 options at a 2.0400 strike from the Series B ladder. A down round resets the common fair market value to 0.7140
Intrinsic value of the old grant	200,000 * max(0, 0.7140 - 2.0400) = 0 - the grant is underwater and its spread carries no information
A straight reprice	Strike moves to 0.7140, the share count is unchanged, and the accounting charge is the incremental fair value of the modification
An exchange at 2 old for 1 new	100,000 new options at 0.7140. Whether that is value-for-value depends on the volatility and term assumptions, not on the strikes alone
Value at a 10.2000 exit	Repriced: 200,000 * (10.2000 - 0.7140) = 1,897,200. Exchanged: 100,000 * (10.2000 - 0.7140) = 948,600
Incentive option consequences	A reprice is a new grant for incentive option purposes, which restarts the holding period and re-tests the annual limit at the new strike

• The exchange ratio is where the negotiation happens and it cannot be settled from the strikes. Two grants both at the money have the same intrinsic value and very different model values depending on term and volatility, so the ratio is an assumption dressed as arithmetic.
• A reprice is simpler, more generous, and harder to justify to investors who have just taken a markdown. An exchange at a ratio above one recovers pool shares, which is often the real reason it is chosen.
• Both need board approval, usually a plan amendment, and often stockholder approval; tender offer rules can apply to an exchange offered broadly to employees. The process is a larger obstacle than the arithmetic.
• The alternative that costs nothing in shares is to leave the old grants outstanding and make new grants at the new strike. It dilutes the pool faster and it avoids every process question above.

The post-termination exercise window, and what it costs to use

A departing holder typically has a short window - commonly three months - to exercise vested options or lose them. Exercising means paying the strike and, for a non-qualified option, the tax on the spread, in cash, for stock that cannot be sold.

Field	Value
Formula	Cash required = shares * strike + ordinary rate * shares * (fair market value - strike) for a non-qualified option. For an incentive option the second term is replaced by alternative minimum tax exposure on the same spread
Setup	200,000 vested non-qualified options at the Series A strike of 0.7140. The holder leaves after the Series C round, when the common fair market value is 2.7540
Exercise cost	200,000 * 0.7140 = 142,800
Spread	200,000 * (2.7540 - 0.7140) = 408,000
Tax at an assumed 40 percent	163,200
Total cash within the window	306,000, for stock with no market
If the window lapses	The options are cancelled and the shares return to the pool, available for regrant to somebody else
Value forgone at a 10.2000 exit	200,000 * (10.2000 - 0.7140) = 1,897,200

• The window converts a grant into a purchase decision taken at the worst moment, with the least information and usually the least cash. That is the design: a short window transfers the value of unexercised grants back to the company and its remaining holders.
• Extended windows - measured in years rather than months - solve it and have a cost. An incentive option becomes non-qualified three months after termination as a matter of statute, so an extended window converts the instrument even if the plan says nothing.
• The shares returning to the pool are the quiet economics of the term. On a large workforce, forfeited grants are a material source of pool capacity, which is why the term survives.
• Where the window is short and the strike is high, the option is worth what the holder can borrow against it, which is usually nothing. Financing arrangements exist for exactly this and they are secured on an asset with no market.

Net exercise and sell-to-cover, worked

Both mechanics let a holder exercise without writing a cheque, and they are different transactions. A net exercise withholds shares to pay the strike and delivers the balance. Sell-to-cover exercises in full and sells shares into the market to fund the strike and the tax.

Field	Value
Formula	Net exercise delivers n*(FMV - strike)/FMV shares. Sell-to-cover delivers n - (n*strike + tax)/FMV shares, where tax is the ordinary rate applied to the full spread
Setup	200,000 options at the Series A strike of 0.7140, exercised at 10.2000 a share. Assumed ordinary rate 40 percent
Net exercise	200,000 * (10.2000 - 0.7140)/10.2000 = 186,000 shares delivered
Value of those shares	1,897,200, exactly equal to the spread
Sell-to-cover, cash needed	Strike 142,800 plus tax 758,880 = 901,680
Shares sold	901,680/10.2000 = 88,400, leaving 111,600 shares
Comparison	Net exercise leaves 186,000 shares and an unpaid tax bill; sell-to-cover leaves 111,600 shares and nothing outstanding

• Net exercise does not pay the tax. It funds the strike out of shares and leaves the withholding to be settled separately, which is why it is usually combined with share withholding for taxes rather than used alone.
• The share count delivered on a net exercise is independent of the tax rate and depends only on the ratio of strike to fair market value. That makes it the cleaner mechanic to model and the one to use when the tax treatment is uncertain.
• Both mechanics reduce the shares outstanding relative to a cash exercise, so both reduce dilution. A company that permits net exercise across a large pool has a materially smaller fully diluted count at exit than the grant totals suggest.
• Sell-to-cover needs a market. At a private company the equivalent is a tender or a company-arranged sale, which means the mechanic is only available at the company's discretion and on its timetable.

What a one percent grant is worth after four rounds

A grant quoted as a percentage is a share count computed on the fully diluted count on the day of the grant. The percentage then behaves exactly like any other static holding: it is multiplied by every subsequent round's retention factor, and nobody sends a notice when it changes.

Field	Value
Formula	Shares = q * FD_grant. Ownership at exit = shares / FD_exit = q * product of PRE_i/POST_i over the rounds after the grant. Value = shares * exit price per share
A 1.000 percent grant at the seed ledger	0.01000 * 11,764,706 = 117,647 shares
The same shares after Series C	117,647/24,509,805 = 0.480 percent
Check by retention factors	1.000 * 0.75000 * 0.80000 * 0.80000 = 0.480 percent
Value at a 250,000,000 exit	117,647 * 10.2000 = 1,200,000
Value at a 90,000,000 exit	Common and pool receive 24,000,000 across 9,411,765 shares, or 2.5500 a share, so the grant is worth 300,000
Value at a 60,000,000 exit	Zero - the aggregate preference is 60,000,000 and common receives nothing at or below it

• The percentage falls by more than half over four rounds with no pool refresh, and every round it falls is a round the company describes as good news. A grant negotiated as a percentage should be recorded as a share count, because the share count is the thing that was actually granted.
• The value at a 90,000,000 exit is a small fraction of the naive 0.480 percent of 90,000,000, because common shares only the residual after the preference. The naive calculation is correct only above the last conversion flip point, which here is 150,000,000.
• Three numbers make a grant legible: the share count, the fully diluted count on the grant date, and the aggregate preference. All three are known to the company and none of them is normally on the grant notice.
• Refresh grants exist to offset exactly this decay, and they are made at the current strike. A holder whose original grant has halved in percentage terms and whose strike has risen eightfold is not made whole by a top-up of the same percentage.

A grant is priced on common and paid from the residual

The strike is set to the fair market value of common. The payout comes from whatever is left after the preferred stack. Those two facts are consistent - the appraisal reflects the overhang - and together they mean the exit value at which a grant becomes worth anything is the aggregate preference, not the strike.

Field	Value
Formula	Payout per share = max(0, residual to common per share - strike). The residual per share is (E - non-converting preferences - carve-out) / (common shares + converting preferred shares), which is zero for E at or below T
Setup	A 200,000-share grant at the Series A strike of 0.7140. Aggregate preference T = 60,000,000
At E = 60,000,000	Residual per share 0.0000, so the grant is worth nothing despite a 2.0400 common valuation at the time of the Series B
At E = 90,000,000	Common and pool receive 24,000,000 over 9,411,765 shares = 2.5500 a share; the grant is worth 200,000 * (2.5500 - 0.7140) = 367,200
At E = 150,000,000	Everything converts; the residual per share is 150,000,000/24,509,805 = 6.1200; the grant is worth 1,081,200
At E = 250,000,000	1,897,200
Break-even exit value	The grant is worth nothing below E = 60,000,000 and turns positive once the residual per share exceeds 0.7140

• The grant is an option on the residual, struck at the common fair market value. Describing it as an option on the company overstates it by the entire preference, which on this cap table is 60,000,000 of exit value.
• This is why the aggregate preference is the number to tell a grantee. The strike and the share count are on the grant notice and neither of them says at what outcome the grant pays anything.
• The residual is shared with the unallocated pool in many structures, so a grantee dividing by the common it knows about will overstate its own share. Divide by the full residual group.
• The company's own 409A appraisal already contains this analysis, because the scenario weighting is exactly a calculation of the residual across exit values. The information exists; it is simply not the part that gets communicated.

Why units are hard at a private company

A restricted stock unit is taxed on its full value at settlement, with withholding due in cash. At a public company the shares are sold to fund it. At a private company there is nothing to sell, so the settlement date has to be engineered around the absence of a market.

Field	Value
Formula	Tax at settlement = ordinary rate * shares * fair market value at settlement. Shares withheld to cover = shares * ordinary rate, independent of the price
Setup	100,000 units settling when the common fair market value is 2.7540. Assumed ordinary rate 40 percent
Income at settlement	100,000 * 2.7540 = 275,400
Tax	110,160
Shares withheld to cover	100,000 * 0.40000 = 40,000 - the count depends only on the rate, not on the price
The company's problem	Withholding shares means the company remits cash it has not received, so a large settlement is a cash outflow for the company as well as a tax event for the holder
The usual answer	A double-trigger settlement condition: units vest on service and settle only on a liquidity event, so the tax and the liquidity arrive together

• The share count withheld to cover is the ordinary rate multiplied by the share count, at any price. That is the one genuinely simple piece of arithmetic in employee equity and it is worth knowing: a 40 percent rate costs 40 percent of the shares.
• Double-trigger settlement is the standard fix and it creates its own problem: the units are a deferred compensation arrangement and the settlement condition has to be drafted to fit within the applicable rules. This is where section 409A applies to units rather than to option strikes.
• Restricted stock avoids all of this by transferring the shares up front, which is why it persists at the earliest stage and disappears once the purchase price becomes real money.
• For the holder the difference is stark: an option can be left unexercised and a unit cannot be left unsettled. A unit is a certainty of tax and an option is a choice.

Source: IRC section 409A (deferred compensation) and section 83