Employee Stock Options in Startups — Legal Guide

What an option actually is

An option is a right to purchase shares in the future at a predetermined price. It is not a share: the employee does not own equity, vote, or receive dividends until the option is exercised. The option gives the holder the economic upside if the company's value grows, without transferring ownership immediately.

Options are used because they let a startup align employees with the company's success, defer the question of who owns shares until exercise, and — through the option plan — control the terms under which equity is granted. They are a core part of how startups compensate teams when cash is limited.

The option plan and grant agreement

Options are granted under an option plan — a framework document approved by the board and shareholders that sets the rules for all grants. Each recipient signs a grant agreement that applies the plan's terms to their specific grant: number of options, exercise price, vesting schedule and other details.

The plan defines the pool size, eligibility, exercise mechanics, transfer restrictions and what happens on termination. The grant agreement personalizes these terms. Both documents matter: the employee's rights come from the combination of the two, and both should be read and understood before signing.

• Option plan: the framework governing all grants (pool, rules, mechanics).
• Grant agreement: the individual terms of a specific grant.
• Board and shareholder approvals authorizing the plan and each grant.
• Tax track election (in Israel, under Section 102).

Vesting, cliff and exercise

Options typically vest over time, on the same logic as founder vesting: the employee earns the right to exercise options gradually, rather than all at once. The most common schedule is four years with a one-year cliff, vesting monthly or quarterly thereafter. Before the cliff, no options vest; after the cliff, a block vests and the remainder continues.

Exercise is the act of paying the exercise price to convert a vested option into a share. The exercise window — the period after termination during which vested options can be exercised — is a critical term. A short window (e.g., 90 days) can force a former employee to exercise quickly or lose the options, which can be difficult if the exercise price is high.

For the underlying vesting mechanics, see the Vesting and Cliff guide.

Exercise price and valuation

The exercise price (also called the strike price) is the price the employee pays to convert an option into a share. It is typically set at the fair market value of the shares at the time of grant, supported by a valuation (commonly a 409A-style valuation). If the exercise price is set too low, the grant may create immediate tax exposure for the employee.

The lower the exercise price relative to the eventual share value, the more valuable the option. But the exercise price cannot be arbitrary — it must reflect fair market value at grant to avoid tax and accounting problems.

Israeli tax: Section 102 tracks

In Israel, Section 102 of the Income Tax Ordinance provides tax-favored tracks for option grants to employees. The two main tracks are the capital gains track and the ordinary income track. Under the capital gains track, subject to conditions and a holding period, the employee is generally taxed at capital gains rates on the sale of the shares — often a better outcome.

The choice of track is made by the company (through a trustee), and it must be elected before grants are made. The track affects when and how the employee is taxed, and the conditions that must be met to qualify. This is a specialized area that should be handled with tax and legal advice.

What happens when an employee leaves

When an employee leaves, the treatment of their options is defined by the plan and grant agreement. Typically, vested options can be exercised within a defined window (commonly 90 days), and unvested options are forfeited and return to the pool.

The exercise window and the consequences of not exercising are among the most important terms for an employee. A short window combined with a high exercise price can make exercising difficult, and the employee may lose options they have earned. These terms should be understood at the time of grant, not at departure.

What founders should get right

From the founder's side, a clean option setup requires an approved plan, a properly elected tax track, a defensible exercise price, documented grants, and accurate cap table records. Promise-based grants — verbal commitments to employees without documentation — create uncertainty and disputes.

• Establish an option plan approved by the board and shareholders.
• Elect the appropriate tax track before making grants.
• Set the exercise price based on a defensible valuation.
• Document every grant with a signed grant agreement.
• Record grants in the cap table as they happen.
• Define vesting, exercise window and termination terms clearly.

If you are setting up an option plan or fixing undocumented grants, the Equity Compensation service covers this end to end.