Introduction

Equity is a startup’s favorite currency. It helps attract talent, motivate employees, and compensate service providers when cash is tight.

When done right, equity compensation works beautifully. When done wrong, it creates cap table chaos, tax exposure, investor red flags, legal violations, and very awkward conversations later.

Granting options isn’t just about motivation — it’s a legal, tax, and strategic decision.

Why Startups Use Options (And Why Investors Expect It)

  • Conserving cash
  • Aligning incentives
  • Rewarding long-term contribution
  • Keeping employees invested in growth

Investors expect to see a structured option plan — not improvised equity promises.

The First Rule: Use a Proper Option Plan

Before granting a single option, the company should have:

  • A board-approved option plan
  • Shareholder approval (where required)
  • Clear and consistent grant terms

Slack messages, emails, or verbal promises are not option grants. They are future disputes.

Employees vs. Service Providers: The Legal and Tax Difference Matters

This is where many startups — especially cross-border ones — get into trouble.

Israel: Section 102 vs. Section 3(i)

Employees — Section 102 (Israeli Tax Ordinance)

Israeli employees are typically granted options under Section 102, which offers significant tax benefits if structured correctly.

  • Tax deferred until sale
  • Trustee requirements
  • Mandatory holding periods
  • Lower effective tax rates

This is the preferred route for Israeli employees and is expected by investors.

Service Providers — Section 3(i)

Consultants, advisors, freelancers, and other non-employees in Israel cannot receive options under Section 102.

  • Less favorable tax treatment
  • Potential immediate tax events
  • Higher effective tax rates

Treating a service provider like an employee for option purposes does not change the tax result — it only increases risk.

United States: ISO vs. NSO

Employees — Incentive Stock Options (ISO)

U.S. employees may be granted ISOs, which can provide favorable tax treatment if strict requirements are met.

  • No ordinary income tax at exercise (subject to conditions)
  • Capital gains taxation upon sale

Service Providers — Non-Qualified Stock Options (NSO)

Service providers and non-qualifying employees receive NSOs, which typically trigger taxation at exercise and ordinary income treatment.

Vesting: The Most Important Protection Mechanism

Vesting prevents dead equity and misaligned incentives. Market standard includes:

  • 4-year vesting
  • 1-year cliff
  • Monthly or quarterly vesting thereafter

Common Option Grant Mistakes Startups Make

  • Granting too much equity too early
  • Forgetting to create an option pool
  • Promising options without board approval
  • Ignoring securities law limits
  • Misunderstanding tax consequences

Key Terms Every Founder Should Understand

  • Exercise price
  • Vesting schedule
  • Cliff
  • Acceleration
  • Expiration

Best Practices for Option Grants

  • Adopt a formal option plan early
  • Distinguish clearly between employees and service providers
  • Apply Section 102 / ISO only where legally allowed
  • Use Section 3(i) / NSO knowingly
  • Track all grants in your cap table

Equity compensation should be predictable — not emotional.

Conclusion: Options Are Powerful — Handle With Care

Options can build loyalty, attract talent, and fuel growth. They can also quietly damage your company if handled casually — especially across jurisdictions.

If your startup operates in Israel, the U.S., or both, your option strategy must align with tax law, securities law, and investor expectations.

If you’re planning an option plan, granting options, or preparing for investor review — feel free to reach out.

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