Understanding Equity Compensation in Startups
By Joe Wallin, Seattle Startup Lawyer
Equity compensation is one of the defining features of the startup world. It aligns incentives, attracts talent that’s willing to bet on the company’s future, and preserves precious cash. But it also introduces complexity—especially when it comes to valuation, taxation, and timing.
Let’s unpack how it works and what to watch for.
What Equity Compensation Means
When a startup can’t pay market salaries, it often offers a slice of ownership instead. That ownership can take several forms:
- Stock options – the right to buy shares later, usually at a fixed “exercise price.”
- Restricted stock – shares issued upfront but subject to vesting and possible forfeiture.
- RSUs (restricted stock units) – promises to deliver stock (or cash) once vesting conditions are met.
- Profits interests – used in LLCs taxed as partnerships, designed to grant upside without current value.
The goal in all cases is the same: motivate and retain people by giving them a stake in the upside.
The Tax Trap: When the IRS Treats Stock as Cash
Here’s the fundamental problem: if you pay someone in stock, the IRS treats it as if you paid them cash equal to the value of that stock. That means the recipient owes tax on income they can’t actually spend yet.
When a company’s value is very low—say, right after incorporation—founders and early hires can often receive restricted stock that vests over time. They then file an 83(b) election within 30 days of the grant to be taxed immediately, while the stock’s value is still negligible. That early election prevents future appreciation from being taxed as ordinary income.
But once a company’s valuation increases, restricted stock becomes impractical: the tax bill at grant would be too high. In those cases, startups switch to stock options—typically incentive stock options (ISOs) for employees or nonqualified stock options (NSOs) for non-employees. Options defer taxation until exercise, when the recipient actually purchases the shares.
Stock Options and Fair Market Value
For options, the key rule is Section 409A of the tax code, which requires that the exercise price of a stock option be at least the fair market value of the common stock on the date of grant. Companies typically hire an independent valuation firm to issue what’s called a 409A valuation to establish that fair market value.
A 409A valuation is more than a box-checking exercise—it’s a shield against potential IRS penalties if the option is ever challenged.
Equity for Contractors, Advisors, and Board Members
Founders often want to grant equity to contractors, advisors, or directors. This can work, but it requires care. Non-employees typically can’t receive “incentive stock options” (ISOs); they can only receive nonqualified stock options (NSOs) or restricted stock. And if the recipient is providing services through an entity (like an LLC), the structure has to be reviewed carefully to avoid triggering unintended tax or securities consequences.
The Exit: When It All Becomes Real
When the company is acquired or goes public, equity becomes cash—or at least something close to it. At that point, all the early-stage decisions around 83(b) elections, option pricing, vesting schedules, and repurchase rights determine how much value each holder ultimately receives.
If you’ve done it right, equity compensation can turn a paycheck into a life-changing event. If you’ve done it wrong, it can lead to tax surprises, compliance headaches, and even rescinded grants.
Key Takeaways
- Always document grants in writing, approved by the board.
- File 83(b) elections within 30 days—no exceptions, no extensions.
- Get and refresh 409A valuations regularly.
- Think ahead about liquidity events and repurchase rights.
- Consult counsel early—before issuing any equity to service providers.
Equity compensation is both art and law. It sits at the intersection of incentive design, tax compliance, and corporate governance. Done thoughtfully, it’s one of the most powerful tools in a startup’s arsenal.
