"We can't pay market salary yet, but there's equity." For private companies, equity compensation is how you compete for talent without cash. It is also one of the easiest places to create expensive legal problems: promised shares that were never issued, option grants that violate securities laws, tax surprises that hit employees years later. This primer covers the main forms of equity compensation, how vesting works, and the compliance basics every private California company should know before making the first grant.
The main forms of equity compensation
- Restricted stock — actual shares issued now, subject to the company's right to repurchase unvested shares if the person leaves. Common for founders and the earliest employees, while the stock is still cheap enough to buy outright.
- Stock options — the right to buy shares later at a price fixed today. Incentive stock options (ISOs) offer favorable tax treatment for employees within statutory limits; nonqualified options (NSOs) work for contractors, advisors, and grants exceeding ISO limits. Options are the workhorse of private-company equity.
- Restricted stock units (RSUs) — a promise to deliver shares upon vesting (and often a liquidity event). More common at later-stage companies, because RSUs trigger tax at settlement whether or not the shares can be sold.
- Profits interests — the LLC analogue, granting a share of future appreciation. LLC equity compensation follows partnership tax rules and is meaningfully more complex than corporate grants; if your LLC plans broad equity compensation, that fact alone sometimes argues for converting to a corporation.
Vesting: the terms that matter
Vesting is what makes equity an incentive rather than a gift. The dominant pattern is four years with a one-year cliff — nothing vests before the first anniversary, 25% vests then, and the rest monthly thereafter. Beyond the schedule, three terms deserve real negotiation:
- Acceleration. "Single trigger" vests equity on an acquisition; "double trigger" — more common and more acquirer-friendly — requires both an acquisition and a qualifying termination afterward.
- Post-termination exercise window. Standard plans give departing employees 90 days to exercise options or lose them, which forces a cash-and-tax decision at a bad moment. Longer windows are increasingly common and worth considering deliberately.
- Repurchase rights and transfer restrictions. Private companies almost always restrict transfers and retain rights of first refusal, keeping the cap table from filling with strangers.
Securities law: grants are securities offerings
Every option grant and share issuance is an offer and sale of securities that needs an exemption at both the federal and state level. Two provisions do most of the work for compensatory grants:
- Federal Rule 701 exempts offers and sales under a written compensatory benefit plan to employees, directors, and certain consultants, subject to 12-month volume limits — and once sales exceed a threshold in a 12-month period, the company must deliver specified disclosures, including financial statements, to grantees.
- California Corporations Code § 25102(o) exempts securities issued under compensatory plans that qualify under Rule 701, with a notice filing to the Department of Financial Protection and Innovation generally due within 30 days after the initial issuance.
These rules have technical conditions beyond this overview — the point to internalize is that skipping them is not a paperwork foot-fault. Unexempted issuances can carry rescission rights and regulatory consequences, and they surface at exactly the wrong time: financing or acquisition diligence.
Tax basics: 409A valuations and the 83(b) election
Two tax concepts drive private-company equity mechanics. First, to avoid treatment as deferred compensation under Internal Revenue Code § 409A, options generally must be granted with an exercise price at or above the fair market value of the underlying shares on the grant date; pricing below fair market value can trigger severe tax consequences for the recipient. Private companies establish fair market value through an independent "409A valuation," typically refreshed at least every 12 months and after any material event like a financing. Do not let anyone promise options "at a penny" without a valuation supporting that price. Second, recipients of restricted stock can file an 83(b) election with the IRS within 30 days after the stock is transferred, electing to be taxed on any spread between the stock's fair market value and the amount paid at transfer rather than as the stock vests. For early-stage stock with a low value, the election is often enormously favorable — and the 30-day deadline generally cannot be extended. The company should flag it in every restricted stock grant; the recipient makes the choice with their own tax advisor.
Process: the paperwork that makes grants real
Equity exists only if the corporate steps actually happened. A clean plan-based grant requires an equity incentive plan adopted by the board and, when required, approved by shareholders; proper corporate approval of each specific grant, with the exercise price and vesting stated; a grant agreement signed by both sides; and an updated cap table. The most common startup equity failure is the casual promise — an offer letter mentioning "1% of the company" that no board ever approved. Years later, the promised percentage of a bigger company becomes a dispute. Make grants promptly, paper them completely, and reconcile the cap table against board consents at least annually. Our business formation practice sets up equity plans and first grants, and our corporate governance practice cleans up cap tables and grant records before diligence finds the gaps.
Talk to a California business attorney
If you are about to promise equity to your first hires — or worried about promises already made — a review now costs far less than a cleanup at financing. Schedule a free consultation or call (949) 418-2113.
This article is attorney advertising and provides general information only. It is not legal advice and does not create an attorney–client relationship. The law changes, and this article reflects the law as of its publication date. Every situation is different — contact us to discuss how the law applies to your exact circumstances. See our full disclaimer.
