Reading a stock option agreement: the clauses that decide what the grant is worth

Three documents, and the one that actually governs

People say "my option agreement" and mean the single page they were emailed. A grant is normally three instruments. The equity incentive plan is the rulebook: eligibility, share reserve, what happens on a change of control, what the board may do without asking you. The grant notice is the one-page form with your numbers on it. The option agreement carries the standard terms and is where exercise mechanics, transfer restrictions and forfeiture live.

The order matters. Grant notices say they are subject to the plan, and the plan governs on any conflict. If you have only been sent the notice, you have seen the least important of the three. Ask for the plan and any stockholders' agreement you must sign on exercise — that second document holds rights of first refusal, drag-along and transfer bans, and restricts what you can do with shares you have already paid for.

Where the strike price comes from, and why you cannot argue with it

The exercise price is set at the fair market value of the common stock on the grant date. That is not company policy — it is what keeps the option outside section 409A. A stock right granted below grant-date fair market value is deferred compensation, and the holder faces income recognition on vesting, a 20% additional federal tax, a premium interest charge and often a state penalty. The exposure lands on the employee, not the company that priced it wrong.

For a private company that means a 409A valuation: a written appraisal the regulations presume reasonable if a qualified independent appraiser produced it within the previous twelve months and nothing material has happened since. A funding round, an acquisition offer or a large change in the business breaks the presumption and forces a refresh.

ISO or NSO: what the box on the notice decides

Incentive stock options exist only under section 422, and the statute is prescriptive. They go to employees only — never a contractor, adviser or non-employee director. The price cannot be below fair market value at grant, and the option cannot be exercisable more than ten years after it. For a holder of more than ten per cent of the voting power, the price must be at least 110% of fair market value and the term five years.

There is also a ceiling. Only $100,000 of stock, measured at grant-date value, may become exercisable for the first time in any calendar year; the excess is treated as a non-qualified option automatically. That figure is fixed in the Code and is not indexed, so on a large grant at a company whose valuation has risen, part of an "ISO" grant is quietly an NSO. Most plans contain a clause saying exactly that, and most people have never read it.

The tax mechanisms differ in kind, not degree. Exercising an NSO produces ordinary income on the spread between strike and fair market value, in that year, with payroll withholding — cash out of your pocket for shares you may not be able to sell. Exercising an ISO produces no regular income tax, but the same spread is a preference item for alternative minimum tax, which is how people generate a tax bill in a year they received no money at all. Employee stock options: vesting, cliffs and tax works through the comparison and the holding periods in detail.

The dates, and the two that are not what people assume

Two clauses around that last date deserve a careful read rather than a glance. The first is the definition of Termination of Service — whether it runs from your last working day or the end of a notice period, and what a leave of absence does. The second is the definition of Cause. Most plans forfeit unvested options on any departure, but a termination for cause commonly cancels vested options as well. It is the only provision in the package capable of taking back something you have already earned, and the breadth of the definition is genuinely negotiable at offer stage.

Early exercise is a plan feature, not a right

If the grant notice says the option is early exercisable, you may buy shares before they vest. What you receive is restricted stock, subject to a company repurchase right that lapses on the original vesting schedule — the same structure founders use, described in founder vesting and what the cliff protects. The point is to start the capital-gains clocks while the spread is near zero, and it only works if a section 83(b) election reaches the IRS within thirty days of the transfer. There is no late filing.

If the notice says nothing about early exercise, the answer is no. It is a feature the plan must permit and the board must approve, and asking for it after the grant is issued is a request to amend the grant.

Acceleration only works if the grant survives the closing

Single-trigger acceleration vests unvested shares on a change of control alone. Double-trigger needs two events: the change of control, then a qualifying termination — dismissal without cause or resignation for good reason — usually within a stated window after closing, commonly nine to eighteen months. Double trigger is standard below founder level, because an acquirer that vests the whole team at closing has bought a company with no retention left in it.

What an acquirer can actually do with your options

The plan's change-of-control clause is usually written as a menu of things the administrator "may, in its discretion" do. That phrasing is the honest answer to "what happens to my options if we are bought": it depends on the deal, and you have no vote.

• Assumed — the option continues on the same vesting schedule over the acquirer's stock. The outcome double-trigger acceleration assumes.
• Substituted — replaced with an equivalent grant in the acquirer, converted at the exchange ratio in the merger agreement.
• Cashed out — cancelled in exchange for the spread between the deal price and your strike, often net of escrow and holdback amounts released a year or more later.
• Cancelled for nothing — the standard treatment of options that are underwater, where the deal price per share is below your strike price.

The escrow point catches people. Where the deal has an indemnity holdback, cashed-out option holders are usually paid like shareholders: something at closing, the rest when the escrow releases, less any claims against it. The consideration is not one cheque, and the delayed part is at risk.

Ten minutes with the document

Every item has a short factual answer somebody at the company already has. Where a grant turns out to be worth far less than it looked, the reason is almost never the share number in the offer. It is one of the last four lines, agreed without being read, in a document that was attached rather than discussed. The equity compensation agreement checklist is a quick way to test whether what you were sent is complete.