Equity 101: Fundamentals of Equity

Equity is ownership in a company, expressed as shares or as instruments that convert into shares. In compensation, equity gives employees a stake in the value they help build, payable only when the company is sold, goes public, or runs a secondary sale. This guide explains how it works from grant to exit.

Course objectives

By the end of this guide, you will be able to:

• Define the core terms used in any equity plan, including grant, vesting, cliff, strike price, dilution, and exercise.
• Identify the most common equity instruments and where each one is used.
• Read a vesting schedule and calculate what an employee owns at any point in time.
• Explain how dilution and liquidation preferences affect employee outcomes.
• Walk through a complete grant-to-exit example and pressure-test the math.
  
  

Course syllabus

1. What is equity, in plain English?
2. Why do startups give employees equity?
3. Equity vocabulary: the twelve terms every recipient should know
4. What are the different types of equity instruments?
5. How does vesting work, and what is a cliff?
6. How is the strike price set, and what is equity actually worth?
7. What is the difference between common and preferred shares?
8. What is an option pool, and what is dilution?
9. What happens when you exercise stock options?
10. What happens to equity when an employee leaves?
11. A complete worked example: from grant to exit
12. Equity 101 recap: ten things to remember
13. Frequently asked questions

Module 1: What is equity, in plain English?

Equity is ownership of a company. A share is a single unit of that ownership, and the total number of shares represents the entire company. If a business is a pie, each share is a slice.

In a public company, shares trade on a stock exchange and any investor can buy or sell them at any time. In a private company, which is the world most equity-compensation programmes operate in, shares cannot be freely traded. Their value is real, but it is locked up until a specific event lets shareholders convert ownership into cash. This single fact, the absence of a public market, shapes every other concept in this guide.

A note on vocabulary. The words equity, shares, and stock are used interchangeably in everyday conversation. Stock options are something different: they are not shares, but the right to acquire shares on agreed terms in the future. The distinction matters and will return in Module 4.

Key takeaway: Equity is ownership. In a private company, that ownership is real but illiquid until a defined event releases its value.

Module 2: Why do startups give employees equity?

Cash is scarce in early-stage companies, talent is expensive, and a salary alone rarely matches what a strong candidate could earn elsewhere. Equity closes the gap and aligns the people building the company with the company's long-term outcome.

Four reasons explain almost every employee equity programme:

1. Recruiting and retention. A candidate accepting a below-market salary needs a reason to take the risk. A meaningful equity grant supplies that reason and rewards employees who stay long enough to help the company succeed.
2. Competitive total compensation at low cash burn. Equity is a non-cash benefit. It conserves runway today and pays out only if the company creates value, which makes it one of the few tools that can scale with a startup's budget.
3. Long-term incentive rather than short-term reward. A cash bonus rewards the past quarter. Equity rewards the next several years, because it pays out only at a future event such as an acquisition or initial public offering.
4. Ownership culture. Employees who own a piece of the company tend to think and act like owners. The behavioural lift is real, particularly in small teams where individual contributions are visible.

For executives designing a plan, these four motives anchor every later decision: how big the pool should be, who gets a grant, how vesting is structured, and how the programme is communicated.

Key takeaway: Equity exists to align long-term outcomes between the company and the people who build it. Plan design should follow that intent.

Module 3: Equity vocabulary, the twelve terms every recipient should know

The single biggest barrier to equity literacy is vocabulary. The terms below are the working set for almost any conversation about employee equity.

Grant

A grant, also called an allocation or award, is the package of equity offered to a recipient. The grant document defines what is offered, when it vests, the price to convert it into shares, and the conditions under which it can be lost.

Share

A share is a unit of ownership. Most employee plans deliver common shares (also called ordinary shares). Investors typically receive preferred shares, which carry additional rights covered in Module 7.

Stock option (ESOP, ISO, NSO, EMI, CSOP, BSPCE)

A stock option is the right, but not the obligation, to buy a fixed number of shares at a fixed price within a defined window. ESOP is a generic acronym for an Employee Stock Option Plan. ISO and NSO are the two main US option types. EMI and CSOP are UK tax-advantaged schemes. BSPCE is the French equivalent. Different jurisdictions offer different tax-advantaged routes, and the right vehicle depends on company size, location, and stage.

Strike price (also called exercise price)

The strike price is the per-share price an employee pays to convert a vested option into an actual share. The strike price is set at the time of grant and is intended to reflect the share's value on that date.

Exercise

To exercise an option is to act on the right it grants: pay the strike price and receive a share in return. Vested options that are not exercised within their permitted window are lost.

Exercise window

The exercise window is the period during which an option holder can exercise vested options. Windows can open at certain calendar events, on departure from the company, or at a liquidity event. The post-termination exercise window, the time after leaving, is the one that creates the most confusion and is covered in Module 9.

Vesting

Vesting is the schedule on which a recipient earns the right to their grant. Until equity has vested, the recipient does not have any claim to it. Vesting is almost always tied to time, and sometimes to performance milestones or a future exit.

Cliff

A cliff is the minimum tenure required before any portion of a grant vests. The most common cliff is one year, meaning a recipient who leaves before their first anniversary forfeits the entire grant.

Valuation, including tax valuation

A valuation is a formal assessment of the company's value, expressed as a per-share price or an aggregate enterprise value. Tax valuations are a specific form, used to set a defensible strike price for option grants. They are commissioned from a third-party valuation provider and approved by the relevant tax authority. A 409A valuation is the US name. The UK uses an EMI or HMRC valuation. Other jurisdictions refer to it as fair market value, or FMV. The tax valuation acts as the floor for the strike price during its validity period.

Option pool

The option pool, also called the employee equity pool, is the slice of the company's ownership reserved on the cap table for employee grants. Founders and investors agree on its size at each financing round. Typical sizes are 10 to 15 percent at seed, 15 to 17 percent at Series A, and 18 to 20 percent at Series B and beyond.

Dilution

Dilution is the reduction in an existing shareholder's percentage ownership when the company issues new shares. It happens whenever the cap table grows: a new financing round, a top-up of the option pool, or option exercises that issue new shares. Dilution is unavoidable in a growing company and, on its own, is not a negative event. Module 8 unpacks why.

Liquidity event

A liquidity event is a transaction that allows shareholders to convert their ownership into cash. The three main forms are an acquisition, an initial public offering, and a secondary sale (a structured sale of existing shares to new buyers, often during a financing round). Until a liquidity event, shares in a private company carry value only on paper.

Module 4: What are the different types of equity instruments?

Most employees do not receive shares directly. They receive an instrument that converts into, or pays out like, shares under defined conditions. The choice of instrument is driven by jurisdiction, company size, and the trade-off between simplicity, tax treatment, and

cap-table impact.

The headline pattern is straightforward. Early-stage companies in most jurisdictions use stock options because they are simple, employee-friendly when designed well, and inexpensive on the cap table. Larger and later-stage companies often shift to RSUs once liquidity is on the horizon, because RSUs are easier to value and more familiar to employees joining from public companies. Phantom schemes solve specific tax or legal constraints in markets where issuing real shares is administratively heavy.

Key takeaway: The instrument is a means to an end. Choose the vehicle that matches the company's stage, geography, and the experience the plan should create for employees.

Module 5: How does vesting work, and what is a cliff?

Vesting is the schedule that converts a grant on paper into a grant the recipient can actually claim. The cliff is the minimum tenure that must pass before any of it begins to vest.

The market default is a four-year vesting schedule with a one-year cliff. At the one-year mark, 25 percent of the grant vests in a single tranche. The remaining 75 percent vests in equal monthly instalments over the following 36 months.

A simple worked example: a new joiner receives a grant of 4,800 options on a four-year, one-year-cliff schedule. After 12 months, 1,200 options have vested. From month 13 onward, 100 options vest each month. By month 48, the full 4,800 are vested.

Five vesting types appear in the wild:

Acceleration is the second variable to understand. If the company is acquired before vesting completes, what happens to the unvested portion? Three positions:

• No acceleration. The acquirer assumes the plan and employees keep vesting under the original schedule.
• Single trigger. All unvested equity vests on the change of control, regardless of employment status.
• Double trigger. Unvested equity vests only if both an acquisition and a qualifying termination occur within a defined post-acquisition window.
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Double trigger is the balanced market default. Single trigger is more employee-friendly. No acceleration is most company-friendly, and can be a deterrent to top candidates.

Key takeaway: Vesting and acceleration together define how, and how fast, an employee earns the right to their grant. Both should be set deliberately, not inherited from a template.

Module 6: How is the strike price set, and what is equity actually worth?

The strike price is what an employee pays per share to convert a vested option into an actual share.

Two share-related numbers matter alongside it:

• The share price is the company's per-share value at any given time, set by the most recent priced financing round or by a current internal valuation.
• The tax valuation (409A in the US, EMI/HMRC in the UK, or fair market value in other jurisdictions) is a third-party assessment used to set a defensible floor for the strike price. It must usually be refreshed annually or after a material event.

The relationship is straightforward. The strike price cannot be set below the tax valuation. The share price is the number against which an option's "in the money" value is measured.

A worked example: a recipient holds 4,800 vested options with a strike of 1.00 per share. The current share price, set by a recent funding round, is 5.00 per share. The paper spread per option is 4.00. The full paper value is 4.00 multiplied by 4,800, or 19,200. If the company is later acquired at 20.00 per share, the spread becomes 19.00 per option, and the gross value rises to 91,200, before any taxes or transaction costs.

Two cautions belong with the math.

First, paper value is not realised value. Until a liquidity event, the value of options in a private company is hypothetical. A strong company on a strong trajectory still produces no cash for option holders until it is acquired, goes public, or runs a secondary sale.

Second, the strike price strategy itself evolves with stage. Early-stage companies often grant at the lowest defensible strike price (frequently the tax valuation, sometimes nominal value). Later-stage companies more often set strikes closer to the last preferred share price. The shift reflects a different deal: early employees take more risk and receive more upside per option; later employees take less risk and receive less upside per option.

Key takeaway: Strike price and share price are not the same number. The gap between them is where employee value is created. Until a liquidity event, that value is on paper.

Module 7: What is the difference between common and preferred shares?

Not all shares are created equal. Employees almost always receive common shares (or instruments that convert into common shares). Investors almost always receive preferred

shares.

The single most important asymmetry for employees to understand is the liquidation preference. At an exit, preferred shareholders are paid first, up to the agreed multiple of their investment. Common shareholders are paid from what remains. In a strong exit, this rarely matters. In a soft exit, it can matter a great deal: the gross sale price can be substantial, and common holders can still receive little or nothing.

This is why the headline grant size, expressed as a percentage or a number of shares, is only one input into an employee's eventual outcome. The terms of the cap table above the common line are the other.

Key takeaway: Common and preferred shares behave differently at exit. Designing an employee plan without considering the existing preference stack tells employees only half the story.

Module 8: What is an option pool, and what is dilution?

The option pool is the slice of the company's ownership reserved for employee equity. It sits on the cap table alongside the founders' shares and the investors' shares, and it is the source from which every employee grant is drawn.

Pool size is reviewed at each financing round, because grants over the prior period have used some of it and the company will need headroom for future hires. After Series B, investors typically expect quarterly reporting on burn rate (the percentage of fully diluted equity allocated to employees over the past year) and pool utilisation.

Dilution is the natural consequence of issuing new shares. It happens for three principal reasons:

1. Financing rounds. Investors receive new preferred shares, increasing the total share count.
2. Pool top-ups. A new financing round usually expands the option pool to support hiring through the next stage.
3. Option exercises. When employees exercise, new common shares are issued.
   
   

Dilution reduces the percentage held by every existing shareholder. It does not, by itself, reduce the value of those holdings. Consider a simple comparison. A 1 percent stake in a company worth 10 million is worth 100,000. If the company raises capital and grows to a value of 100 million, and the same shareholder is now diluted to 0.7 percent, their stake is worth 700,000. The percentage fell. The value rose by 7x.

Dilution can be costly when a round happens at a lower valuation than the previous one (a down round), or when pool top-ups are too aggressive. Both are real risks. Neither makes dilution itself a negative concept.

Key takeaway: Dilution is the cost of growth. Whether it benefits or harms an employee depends on the trajectory of the company's value, not the trajectory of their percentage.

Module 9: What happens when you exercise stock options?

Exercising is the act of paying the strike price to convert vested options into actual shares. Three scenarios cover almost every case.

Pre-exit exercise during employment. Some plans allow employees to exercise vested options at any time. This converts options into shares, requires the employee to fund the strike price out of pocket, and may have tax consequences depending on jurisdiction.

Exercise at a liquidity event. Most employees first exercise at the moment of an acquisition or initial public offering. The strike price is paid, the spread between strike and exit price is realised, and the proceeds, less taxes and fees, are paid out.

Post-termination exercise. When an employee leaves, they typically have a defined window in which to exercise their vested options. After the window closes, vested but unexercised options are forfeited.

Two patterns dominate:

• The 90-day window. The post-termination standard in the US, and a tax-driven requirement under UK EMI rules. After 90 days, EMI options lose their tax-advantaged status and revert to higher-tax treatment.
• The extended window. A growing number of plans offer two to ten years post-termination, sometimes with a hybrid approach (90 days for tax-advantaged status, longer for the rest).
  
  

Tax treatment varies by jurisdiction, instrument, and personal circumstances, and a guide of this length cannot do it justice. The headline rule is that some part of the spread is usually taxed as ordinary income at exercise, and the remainder may be taxed as capital gains on a later sale. Employees should consult a tax advisor before exercising any meaningful grant.

Key takeaway: Exercising is a financial decision, not just a paperwork step. The strike price is real money, the tax treatment is jurisdiction-specific, and the window to act is finite.

Module 10: What happens to equity when an employee leaves?

The mechanics of departure are the single most common source of equity disputes. Most of them can be avoided by clarity at the point of grant.

The general rule, in plans with employee-friendly terms now standard in much of Europe and increasingly common in the US: vested equity stays with the departing employee, subject to the exercise window. Unvested equity returns to the option pool.

Three further variables decide the rest:

Bad-leaver definitions deserve specific attention. The narrower the definition, the more employee-friendly the plan. A common market position is to limit bad-leaver treatment to fraud or gross misconduct. Broader definitions, particularly those that capture voluntary resignations or moves to competitors, create real retention pressure but also real reputational risk if applied harshly.

Key takeaway: What happens at departure is set at the point of grant. Clear, fair, and documented leaver provisions protect both the company and the employee.

Module 11: A complete worked example, from grant to exit

The following example connects every concept above into a single narrative. Numbers are illustrative, not prescriptive.

Setup. An engineer joins a Series A company. The company has 10 million fully diluted shares, an option pool of 1.5 million (15 percent), and a current share price of 2.00 per share, set by the most recent priced round. The engineer is granted 30,000 options on a four-year, one-year-cliff schedule, with a strike price of 0.40, set by the most recent tax valuation.

Grant value at start. Paper spread per option is 2.00 minus 0.40, or 1.60. Total paper value of the grant on day one is 1.60 multiplied by 30,000, or 48,000.

At month 12. The cliff is reached. 7,500 options have vested. From month 13, the engineer accrues 625 options per month.

At month 30. The company raises Series B at a share price of 6.00. The option pool is topped up by 2 percent of the new fully diluted total. Existing shareholders are diluted, but the per-share price has tripled. The engineer's vested holdings (18,750 options at this point) now carry a paper spread of 5.60 per option, or 105,000. The unvested portion has revalued similarly.

At month 36. The engineer leaves voluntarily and in good standing. Of the original 30,000 options, 22,500 have vested. 7,500 are forfeited and return to the pool. The plan provides a 90-day exercise window. The engineer chooses to exercise inside the window, pays a strike total of 22,500 multiplied by 0.40, or 9,000, and receives 22,500 common shares.

At month 54. The company is acquired at 12.00 per share. Preferred shareholders take their liquidation preferences first. After the preference stack is paid, common shareholders, including the engineer, receive their pro-rata share of the remaining proceeds. Assuming the preference stack does not consume more than the difference, the engineer's common shares pay out at, say, 11.00 per share, for a gross of 247,500. After the cost of exercise (9,000 already paid) and applicable taxes, the realised after-tax outcome is what reaches the engineer's bank account.

Reading the example. Every concept covered in this guide appears in those five paragraphs: grant size, strike price, vesting, cliff, dilution, exercise window, the cost of exercise, the preference stack, and the gap between paper and realised value.

Key takeaway: Grants do not pay out at the headline number. They pay out as the residual after vesting, dilution, exercise, preferences, and tax. Designing and communicating a plan should account for all five.

Module 12: Equity 101 recap, ten things to remember

1. Equity is ownership. In private companies, that ownership is real but illiquid until a defined event releases it.
2. The single biggest barrier to equity literacy is vocabulary. Investing in education is the highest-leverage move a leadership team can make.
3. Stock options are not shares. They are the right to acquire shares at a fixed strike price, on agreed terms, within a defined window.
4. Vesting and the cliff define how and how fast equity is earned. The four-year, one-year-cliff schedule is the market default.
5. The strike price is set at grant and cannot be lower than the prevailing tax valuation. The share price is set by the market.
6. Common shares and preferred shares behave differently at exit. The liquidation preference stack is decisive in soft exits.
7. The option pool is finite. Pool burn and unallocated pool size are the two metrics every leadership team should track.
8. Dilution is the cost of growth, not the symptom of bad decisions. Whether it helps or hurts an employee depends on company trajectory, not on percentage alone.
9. Exercising is a financial decision. Strike price, tax treatment, and exercise window all need careful planning.
10. Leaver provisions, written clearly and applied consistently, are the foundation of trust in any equity plan.

Frequently asked questions

Is equity the same as stock?

In ordinary usage, yes. Equity is ownership of a company, and stock (or shares) is the unit of that ownership. The terms are used interchangeably in most conversations. Stock options, however, are different: they are the right to acquire shares at a fixed price in the future, not the shares themselves.

What is the difference between an ESOP and stock options?

ESOP is shorthand for Employee Stock Option Plan, the framework that governs how options are granted and managed. Stock options are the individual instruments granted under that plan. In US contexts, ESOP can also refer to Employee Stock Ownership Plans, a different retirement-style structure used in employee buyouts. Most startup conversations mean the option-plan version.

What is a 409A valuation?

A 409A valuation is a third-party appraisal used to set a defensible per-share value for a US private company. It establishes the floor for the strike price of any options granted during its validity period. Other jurisdictions use equivalent processes: an EMI or HMRC valuation in the UK, and a fair market value (FMV) assessment elsewhere.

What does a four-year vesting schedule with a one-year cliff actually mean?

It means the recipient earns the full grant only by staying four years, with no equity vesting at all in the first 12 months. At the one-year mark, 25 percent of the grant vests in a single tranche. The remaining 75 percent vests in equal monthly instalments over the following 36 months.

Why is the strike price higher for newer hires than for early employees?

Strike prices reflect the company's value at the time of grant. Early employees join when the share price is low, so their strike price is low. Later employees join after one or more priced rounds, when the share price is higher and the tax valuation has moved up accordingly. The plan still rewards future value creation, but the entry point is higher.

Do employees pay anything to receive equity?

Receiving the grant itself is free. Exercising vested options requires paying the strike price, and exercising can also create a tax liability depending on the instrument and the jurisdiction. Restricted stock units do not have a strike price but are taxed at the moment they vest.

Can employees sell startup equity before an exit?

Sometimes. A secondary sale, often run alongside a financing round, lets existing shareholders sell some of their shares to incoming or existing investors. Outside structured secondaries, private-company shares are generally illiquid, and the company's articles often restrict transfers entirely.

What is the difference between RSUs and stock options?

RSUs are a promise of shares, delivered automatically when they vest, with no purchase price. Stock options are a right to buy shares at a fixed strike price during a defined window. RSUs are simpler to value and explain, but are taxed at vesting, which can create cash-flow pressure for employees of private companies.

How much equity should an early employee expect?

There is no universal answer, but ranges exist. The first few hires at a seed-stage company often receive between 0.5 and 2 percent each, depending on role and seniority. By the time a company reaches Series A, individual grants typically fall well below 1 percent and are usually expressed in monetary value rather than percentage.

What happens to unvested options if the company is acquired?

That depends on the plan's acceleration terms. With no acceleration, the acquirer assumes the plan and vesting continues. With single-trigger acceleration, all unvested options vest on the acquisition. With double-trigger acceleration, they vest only if the employee is also terminated or constructively terminated within a defined post-acquisition window.

What is a secondary sale?

A secondary sale is a structured transaction that lets existing shareholders, often including employees, sell some of their shares to new or existing investors before a full exit. Secondaries are usually run at the company's discretion, alongside a primary financing round, and are subject to caps on the percentage of an individual's holdings.

How is equity taxed?

The general pattern: some part of the value is taxed as ordinary income at the moment of exercise (or at vesting, for RSUs), and the rest is typically taxed as capital gains when the underlying shares are sold. Specific treatment varies significantly by instrument, country, and personal circumstances, and any meaningful exercise decision should involve a tax advisor.

This guide is educational, not legal, tax, or financial advice. Specific equity-plan decisions should be made with the appropriate professional advisors.

Sources and further reading: Carta, Ravio, Pave, Figures, HMRC EMI guidance, IRS Section 409A guidance.