October 13, 2026 · 5 min read
What Is Equity Compensation? Definition, How It Works and Examples
Learn how options, RSUs and restricted stock work at a private company, how each is taxed, and what risks come with the stake.
- Equity compensation
Private company equity compensation is pay in the form of ownership. A company gives employees stock options, restricted stock units or shares on top of salary. The pay turns into money only if the company is sold, lists on an exchange or lets staff sell in a tender offer.
It matters to you whether you work at a private company or invest in one. As an employee, you hold a stake you cannot sell freely, and tax can arrive before cash does. As an investor, the grants shape who owns the company and how much your own stake can shrink.
$100,000
Stock value, measured at grant, that can first become exercisable as ISOs in one calendar year
85%
Lowest price, as a share of market value, at which a tax-favored ESPP may sell stock
30 days
Time after receiving restricted stock in which an 83(b) election must be made
$10M
Equity sold to employees in 12 months above which a private company owes extra disclosure under Rule 701
General Information, Not Tax Advice
The tax rules on this page are United States federal rules. They change, and the right answer depends on your own facts. Check your grant documents and talk to a qualified tax adviser before you exercise, sell or make an election.
How Does Equity Compensation Work?
- GrantThe company gives you an award, such as options, restricted stock units or restricted stock. The grant sets how much you get and on what terms.
- VestingYou earn the award over time. A common pattern is four years with a one-year cliff, which means nothing vests until the first anniversary.
- Exercise or deliveryWith options, you pay the strike price, the fixed price per share set at grant, to turn them into shares. With restricted stock units, the company delivers the shares for free once they vest.
- HoldingThe shares are restricted securities. You cannot sell them on an exchange, and the company’s documents may limit transfers.
- SaleYou sell in a tender offer, a secondary deal, an acquisition or after an IPO and its lock-up.
The strike price of an option is usually set from a 409A valuation, an independent estimate of what the company’s common stock is worth. A private company has no public price, so the valuation fills the gap. The same stock-based award can be taxed in different ways depending on its type, as the next section shows.
Types of Private Company Equity Compensation
The five main types and when each is taxed
As of October 2026 · IRS Topic 427 (reviewed 09.24.2026); 26 USC 83, 422, 423; IRS Publication 5992 · checked 10.13.2026
Options are the most common form at early-stage companies. The page on ISO vs NSO compares the two kinds, and the page on how to exercise stock options shows the steps. RSUs often use double-trigger vesting at private companies. That means you need to meet a time condition and a liquidity condition, such as an IPO, before the shares are yours. Read the full terms on the RSU page.
An ESPP lets staff buy stock at a discount. It is rare at private companies. A tax-favored plan must set the price at no less than 85% of market value, limit purchases to $25,000 of stock per calendar year, and exclude anyone who owns 5% or more of the company.
Example of Equity Compensation: One Option Grant
Take a hypothetical engineer who receives 10,000 non-qualified stock options at a strike price of $4. The 409A valuation sets that price. The numbers below are illustrative.
Illustrative figures for a hypothetical employee. The tax comes at exercise, before any cash arrives from a sale
Mechanics per IRS Topic 427 and Publication 15 (2026) · as of October 2026
The example shows the cash problem. She pays $40,000 to exercise and owes tax on $80,000 of income while she still cannot sell. The page on cost basis explains why her basis is $12 a share and not $4. An early exercise is a related choice, buying options before they vest, that some plans allow.
Key Rules and Limits for Employee Equity
The main limits that shape an employee equity plan
As of October 2026 · 26 USC 83, 422, 423; 17 CFR 230.701 · checked 10.13.2026
Rule 701 is the SEC rule that lets a private company grant equity to employees without registering the offering. Shares issued under it are restricted securities, so resale needs registration or another exemption. For what happens to employee shares after an IPO, see the page on lock-up expiration.
Key Risks of Private Company Equity Compensation
- No market to sell intoThe shares are restricted securities, and a private company may never list or be sold. Liquidity depends on events you do not control.
- Tax before cashExercising nonstatutory options creates income at exercise. Exercising ISOs can create alternative minimum tax. Neither depends on whether you can sell.
- Leaving the companyAn ISO keeps its tax status only if you exercise within 3 months after you stop being an employee (1 year if disabled). Your plan may set its own, shorter window to exercise at all.
- Value can fall to zeroA strike price is a cost. If the company’s value falls below it, the options are worth nothing.
- DilutionNew rounds and new grants reduce each existing holder’s percentage of the company.
- Missed deadlinesAn 83(b) election, a plan’s exercise window and a tax filing each have their own dates.
Equity compensation is a bet on one company’s future. Read the grant, know the vesting, the strike price and the exercise window, and plan the tax before you act.
What Does Equity Compensation Mean for a Private-Company Investor?
For an investor, employee equity is part of the cap table, the list of who owns what. Options and RSUs that are granted but not yet exercised still count in a company’s fully diluted share total. Large grants therefore dilute existing holders, including a fund or an SPV.
Employees also create supply in the market. When a company runs an employee tender offer, staff sell shares to outside buyers at a set price. The general rules are on the page about tender offers. After an IPO, employees face the IPO lock-up before they can sell on the exchange.
The Terms This Page Uses
- Equity compensation
- Pay in the form of company ownership, such as options, restricted stock units or shares.
- Vesting
- The schedule on which you earn an award. A cliff delays the first vesting date, often by one year.
- Strike price
- The fixed price per share you pay to exercise an option.
- Incentive stock option
- A statutory option with special tax treatment, available to employees only.
- Non-qualified stock option
- An option that does not meet the ISO rules. The gain at exercise is ordinary income.
- Restricted stock unit
- A promise to deliver shares or cash when conditions are met.
- 83(b) election
- A choice to be taxed on restricted stock when you receive it, made within 30 days.
- 409A valuation
- An independent estimate of a private company’s common stock value, used to set option prices.
- Rule 701
- The SEC rule that lets a private company grant equity to employees without registration, within set limits.
Questions About Equity Compensation
Where Every Rule on This Page Comes From
Figures were last checked on October 13, 2026. The tax rules are United States federal rules. Other countries and states tax equity differently.
- 01US Code (Cornell LII)Current law26 USC 422: incentive stock options, holding periods, $100,000 limit
- 02US Code (Cornell LII)Current law26 USC 423: employee stock purchase plans, 85% price floor, $25,000 limit
- 03US Code (Cornell LII)Current law26 USC 83: taxation of property transferred for services, 83(b) election within 30 days
- 04Internal Revenue Service09.24.2026Topic 427: stock options, statutory and nonstatutory
- 05Internal Revenue Service06.2024Publication 5992: equity-based compensation audit technique guide (RSUs, option income as wages)
- 06Internal Revenue Service2026Publication 15 (2026): 22% flat rate on supplemental wages
- 07Code of Federal Regulations (Cornell LII)Current rule17 CFR 230.701: employee benefit plan exemption, 12-month cap, $10 million disclosure trigger
This page explains how a market works. It is not investment advice, not a recommendation of any security, strategy or company, and not an offer to sell or a solicitation to buy anything. Private companies may never list or be acquired, positions in them can be illiquid for years, and the entire amount invested can be lost. Figures are accurate as of the dates shown and change. Requirements for investor status, and the tax treatment of a private holding, differ by jurisdiction — the jurisdiction is named wherever this page discusses either. Prepared by the AXEVIL Capital research team. Tax rules described here are United States federal rules unless another jurisdiction is named; they change every year and depend on your own facts. Nothing here is tax advice — take your documents to a qualified adviser.
What closed on the private market in the past two weeks
The rounds that priced, the tender offers that opened and the listings that filed — with the structure of each deal and the date on every figure. Written by the team that reads the paperwork.
Where to go from here
Equity compensationWhat Are Restricted Stock Units (RSUs)? How They Work and ExamplesAn RSU, or restricted stock unit, is a company’s promise of shares that vest over time. How RSUs work at a private company, the second trigger and an example.
Equity compensationIncentive vs Non-Qualified Stock Options: Key Differences ExplainedISOs and NSOs are both stock options. The difference is tax: when each is taxed, the AMT risk of ISOs, who can receive them and a side-by-side example.
Equity compensationWhat Is an Employee Stock Purchase Plan (ESPP)? How It Works, ExamplesAn ESPP lets employees buy company shares through payroll, often below the market price. How offering periods, the lookback and qualified plans work.