Overview
Equity compensation grants engineers ownership stake in the company, typically through stock options or restricted stock units (RSUs). Options give the right to purchase shares at a fixed "strike price"—value comes from appreciation above that price. RSUs are actual shares that vest over time, with value equal to share price at vesting.
For startups, equity represents high-risk/high-reward potential—worthless if the company fails, but potentially life-changing in a successful exit. For public companies, RSUs are liquid compensation with predictable value. The key distinction: options require purchase (and have tax complexity), while RSUs are simply granted shares.
Understanding these mechanics matters because engineers increasingly scrutinize equity offers. They've seen friends lose out on worthless options or win big on well-timed RSUs. Transparent, accurate equity communication separates respected employers from those viewed as manipulative.
Types of Equity Compensation
Understanding equity types is essential for both making competitive offers and communicating value honestly to engineering candidates.
Incentive Stock Options (ISOs)
ISOs are tax-advantaged options available only to employees. Key characteristics:
Tax treatment: ISOs receive favorable long-term capital gains treatment if holding period requirements are met (hold shares 2+ years from grant, 1+ year from exercise). No ordinary income tax at exercise—only at eventual sale.
AMT considerations: While no regular tax at exercise, the "bargain element" (difference between strike and fair market value) can trigger Alternative Minimum Tax. This catches many engineers by surprise, especially in late-stage startups with high valuations.
Limitations: ISOs have a $100K annual vesting limit (based on fair market value at grant). Amounts exceeding this become NSOs. ISOs must be exercised within 90 days of termination, creating difficult decisions for departing employees.
Best for: Employees who can hold shares long-term and manage AMT implications. Most valuable when strike price is low relative to expected exit value.
Non-Qualified Stock Options (NSOs)
NSOs lack the tax advantages of ISOs but have fewer restrictions:
Tax treatment: Taxed as ordinary income at exercise (on the spread between strike and current value). Employers can deduct this as compensation expense.
Flexibility: No $100K limit, can be granted to contractors and advisors, no 90-day post-termination deadline (company discretion).
When used: NSOs often comprise the portion of grants exceeding ISO limits. Also used when ISO requirements can't be met or when granting to non-employees.
Restricted Stock Units (RSUs)
RSUs are the dominant equity vehicle at public companies and increasingly common at late-stage startups:
Mechanics: RSUs represent a promise to deliver shares upon vesting. Unlike options, there's no strike price—you receive shares worth their current market value.
Tax treatment: RSUs are taxed as ordinary income when they vest. The company typically withholds shares to cover taxes (often ~40% depending on tax bracket).
Value clarity: RSUs have straightforward value: number of shares × current price. No complex option calculations, no exercise decisions, no AMT surprises.
Liquidity: At public companies, RSUs can often be sold immediately upon vesting. At private companies, RSUs face the same liquidity constraints as exercised options.
Comparison Matrix
| Factor | ISOs | NSOs | RSUs |
|---|---|---|---|
| Strike price | Yes (409A) | Yes (409A) | No |
| Tax at grant | No | No | No |
| Tax at vest/exercise | AMT possible | Ordinary income | Ordinary income |
| $100K limit | Yes | No | No |
| Post-termination | 90 days typical | Flexible | Varies |
| Best for | Early employees, startups | Advisors, excess grants | Public cos, late-stage |
Valuation and Vesting
Understanding 409A Valuations
The 409A valuation sets the strike price for options at private companies. Named after the IRS code section, it's an independent appraisal of company common stock value.
Why it matters: Strike price determines how much upside employees capture. A $1 strike vs. $10 strike on options that eventually sell at $50 is a 49x vs. 4x return difference.
Frequency: Typically updated annually, after funding rounds, or after significant business events. Early employees benefit from lower 409A valuations.
Common misconception: The 409A value is not the same as preferred stock price from the last funding round. Common stock typically values at 25-35% of preferred due to liquidation preferences and other terms.
Vesting Schedules
Standard vesting structures include:
Four-year with one-year cliff: The most common structure. No equity vests until 12 months of employment, then 25% vests. Remaining equity vests monthly or quarterly over the next 36 months.
Back-weighted vesting: Some companies (notably Amazon historically) use schedules like 5%/15%/40%/40% over four years to encourage long-term retention.
Acceleration clauses: Single-trigger (vesting accelerates on acquisition) or double-trigger (requires acquisition AND termination) acceleration provides protection in M&A scenarios.
Dilution Reality
Engineers need to understand that their ownership percentage decreases over time:
Funding dilution: Each funding round typically dilutes existing shareholders 15-25%. An engineer with 1% ownership pre-Series A might have 0.6% post-Series C.
Option pool expansion: Boards often expand option pools before fundraising rounds, further diluting existing stakeholders.
Total dilution modeling: Show candidates realistic dilution scenarios. A 0.1% grant today might be 0.05% by exit if the company raises several more rounds.
Explaining Equity to Candidates
Transparent equity communication builds trust and attracts sophisticated candidates who appreciate honesty.
What to Share Proactively
The basics:
- Number of shares and type (ISO/NSO/RSU)
- Strike price and current 409A valuation
- Vesting schedule and cliff
- Total shares outstanding (to calculate percentage)
The context:
- Latest funding round details and valuation
- Liquidation preferences and preference stack
- Current runway and fundraising plans
- Realistic liquidity timeline expectations
The scenarios:
- Exit scenarios at various valuations (2x, 5x, 10x)
- Impact of future dilution on current grants
- Historical data on similar company outcomes
How to Frame Equity Honestly
Do say:
- "This represents X% ownership today, which will likely dilute to Y% by exit if we raise Z more rounds"
- "Options require you to pay the strike price to exercise—here's what that would cost at current 409A"
- "There's no guaranteed liquidity—this is speculative compensation tied to company outcomes"
Don't say:
- "Your equity will be worth $X million" (without heavy caveats)
- "We're definitely going to IPO in two years"
- "The equity alone will make you rich"
Red Flags Sophisticated Candidates Watch For
Experienced engineers have seen equity go wrong. They're alert to:
- Refusal to share total shares outstanding or cap table basics
- Vague descriptions of liquidation preferences
- No discussion of dilution expectations
- Overly optimistic exit valuations without basis
- Unusual vesting terms (extended cliff, nonstandard clawbacks)
- Pressure to make decisions without time to consult financial advisors
Startup vs. Public Company Equity
Startup Equity Considerations
Risk profile: Startup equity is essentially a lottery ticket. Most startups fail, and even successful ones often return little to common shareholders after liquidation preferences are paid.
Liquidity constraints: Private company shares typically can't be sold. Secondary markets exist but are limited and often restricted. Engineers may hold illiquid equity for 7-10+ years.
Exercise decisions: When leaving a startup, employees must decide whether to exercise options (potentially for tens of thousands of dollars) without knowing if they'll ever be worth anything.
Upside potential: The reason people accept these risks is transformational upside. Early Stripe or Airbnb employees became wealthy from their equity.
Public Company Equity
Predictable value: RSUs at public companies have clear, marketable value. Candidates can calculate exactly what their grant is worth today.
Liquidity: Shares can typically be sold immediately upon vesting (after trading windows open). This is real, accessible compensation.
Refresh grants: Public companies typically provide annual refresh grants to incentivize retention. Initial grants plus refreshers create "golden handcuffs."
Lower upside: While more certain, public company equity rarely provides the 100x+ returns possible at early-stage startups.
Communicating the Tradeoff
Help candidates understand what they're choosing:
Startup message: "Our equity is speculative—most of its value depends on outcomes we can't guarantee. But if we succeed at the level we're targeting, it could be substantial. We're offering X shares because we believe you'll contribute directly to that success."
Public company message: "Your RSU grant has clear, liquid value—$X based on today's price. You'll receive annual refreshes, and the shares vest into real money you can use immediately. It won't make you a millionaire overnight, but it's meaningful, reliable compensation."
Common Equity Mistakes
Mistakes Companies Make
Overselling value: Presenting equity at inflated valuations or implying guaranteed outcomes. Engineers compare notes and recognize manipulation.
Hiding terms: Not sharing cap table basics, liquidation preferences, or dilution expectations. This breeds distrust and causes problems when employees eventually learn.
Complex or punitive terms: Extended cliffs, unusual vesting schedules, aggressive clawbacks, or short post-termination exercise windows. These signal that the company values extraction over partnership.
Inconsistent grants: Equity that varies dramatically between similar employees (especially by negotiation skill or demographics) creates morale and legal problems.
Poor ongoing communication: Equity grants without context—no 409A updates, no dilution notifications, no education on exercise implications.
Mistakes Recruiters Make
Not understanding the math: Inability to explain strike price, vesting, dilution, or tax implications. Candidates notice and lose confidence.
Using equity to offset low salary: Presenting equity as justification for below-market base. "The equity makes up for it" only works if the equity is real and the candidate is risk-tolerant.
One-size-fits-all pitches: Not adapting the equity conversation to candidate circumstances. A new grad has different risk tolerance than a senior engineer with a family.
Ignoring candidate sophistication: Assuming candidates don't understand equity or treating questions as adversarial. Informed candidates should be welcomed, not avoided.
How to Avoid These Mistakes
Build internal expertise: Ensure recruiters and hiring managers can answer equity questions accurately. Create documentation and training.
Standardize transparency: Develop consistent materials explaining your equity program—cap table overview, dilution scenarios, exercise logistics.
Welcome scrutiny: Candidates who ask hard questions are often the best ones. Engage substantively rather than deflecting.
Document everything: Provide equity details in writing. Verbal overselling without written backup creates legal and ethical problems.