An ESOP (Employee Stock Option Plan) is the pool of stock options a startup reserves to grant to employees, advisors, and sometimes directors. Options are typically 10–20% of the fully diluted cap table.

How options work

1. Grant: The board grants N options at a strike price equal to the most recent 409A valuation (U.S.).
2. Vesting: The employee earns the right to exercise options over time — typically 4 years with a 1-year cliff and monthly vesting thereafter.
3. Exercise: At any point after vesting, the employee can pay the strike price to convert options to shares.
4. Sale / exit: Shares are sold at exit; the employee’s gain is (sale price − strike price) × shares.

Key terms

• Strike price: Fixed at grant; equals 409A FMV.
• Vesting schedule: Commonly 4 years, 1-year cliff, monthly.
• Expiration: Usually 10 years from grant.
• Post-termination exercise window (PTEW): Traditionally 90 days; some progressive companies extend to 10 years.
• Acceleration: Single-trigger (on acquisition) or double-trigger (on acquisition + termination).
• Early exercise: Some plans allow exercise before vesting (with reverse-vesting).

ISO vs NSO (U.S.)

What a 409A valuation is (and why it matters)

A 409A is an independent valuation of the company’s common stock, required for setting ISO strike prices. Updated annually or after a material event. Options granted below 409A FMV trigger harsh IRS penalties.

Dilution impact at funding

When a VC requires a post-money 10% option pool refresh, that 10% comes out of pre-money — i.e., founders + existing shareholders — not out of the new investor’s ownership.

This is one of the most common founder-negotiation failures.

Exit economics for employees

• At a clean exit, option holders typically receive proceeds pro-rata with common shareholders.
• If preference stack is deep, common (including exercised options) can get zero on a low-value exit.
• Unvested options are usually forfeited; vested unexercised options depend on acquirer treatment.

Common mistakes

1. Grant letters inconsistent with board minutes — can void grants.
2. Pricing options below 409A — triggers IRC 409A penalties (20% + taxes).
3. Not extending PTEW — employees forfeit unexercised options on departure.
4. Inflating the pool: Over-sizing to please investors and over-diluting founders.
5. No refresh grants: Key employees are under-equity’d as the company grows.

Practical takeaway

1. Founders: Set up your ESOP early with proper 409A + board resolutions.
2. Employees: Always ask about strike price, 409A date, PTEW length, and preference stack before signing.
3. Investors: Push for clean option plan documentation in diligence; sloppy grants are a real liability risk.

Further reading

• Carta Equity 101: https://carta.com/learn/equity/
• IRS 409A guidance: https://www.irs.gov/irm/part4/irm_04-041-012