The two main types of equity awards used by startups are restricted stock and stock options.
Restricted stock is common stock that is subject to vesting (usually over time, occasionally upon milestone events). Companies can charge recipients for shares of restricted stock or give them to recipients for free (or in exchange for past or future services). If a startup sells shares below their fair market value (FMV), the difference between the purchase price and the FMV is taxable income to the recipient. If shares are issued for free, the recipient must count the FMV of the shares as taxable income.
A stock option gives an employee the right to purchase a specified number of shares for a fixed price (the “exercise price”) during a prescribed period. The principal benefit of a stock option is the potential to profit from any increase in the value of the company’s common stock during the period in which the option is exercisable, without risking any money. If the value of the common stock increases above the exercise price during its term, the employee can buy the shares at a discount from that increased price. On the other hand, if the value of the common stock does not increase above the exercise price, the employee will not recognize a benefit from the option.