Equity Incentive Plan: ISO Rules, Approvals and a Template

An equity incentive plan is the board-adopted document that lets a company grant stock options, restricted stock and other equity awards to employees, directors, advisors and consultants. It sets the share reserve, who can receive awards, and how awards vest and are priced. For incentive stock options to qualify, Section 422 of the tax code requires stockholders to approve the plan within 12 months before or after adoption.

Definition: An equity incentive plan (EIP), sometimes called a stock plan, is a formal program adopted by a company's board and approved by its stockholders that governs how equity-based compensation is granted and administered.

Most founders promise equity before they have a plan to grant it from. The trouble starts when promises pile up in offer letters and nobody turns them into board-approved grants until an investor's lawyer asks.

What an equity incentive plan does

The plan is the rulebook; individual grant agreements are the plays. Without a plan, every grant tends to become a one-off negotiation with its own legal and tax risk. With one, the board can approve grants quickly and consistently, and investors can see how much of the company is reserved for the team.

Most startup plans allow several award types:

The IRS explains in Topic 427 that ISO holders generally include nothing in income when they receive or exercise the option, but may owe alternative minimum tax (AMT) in the year of exercise; Carta notes the spread at exercise counts as income for AMT purposes. NSOs without a readily determinable value are taxed at exercise on the difference between fair market value and the price paid.

How an equity incentive plan works, step by step

1. Board adoption. The board adopts the plan by board resolution, sets the share reserve, and names the employees or class of employees eligible for ISOs, which Section 422 requires the plan to state.
2. Stockholder approval. Internal Revenue Code Section 422 requires stockholder approval within 12 months before or after adoption for options under the plan to qualify as ISOs.
3. 409A valuation. Before granting options, most companies get an independent 409A valuation so the exercise price equals fair market value. Carta describes a 409A as valid for up to 12 months, and for less time if a material event such as a financing occurs. See our 409A valuation guide.
4. Grants. The board approves each grant with the recipient, share count, exercise price, vesting schedule and vesting start date.
5. Vesting. Four years with a one-year cliff is the common default.
6. Exercise and ownership. Vested options can be exercised by paying the exercise price; restricted stock is already owned but subject to vesting.
7. Liquidity. On an acquisition or IPO, the plan and the deal documents determine whether awards are assumed, converted, cashed out or accelerated.

For the offer side of this process, see our employee equity offer letter template.

ISO rules worth knowing

Section 422 sets the requirements. The ones that tend to matter at a startup:

• Exercise price. At least fair market value on the grant date.
• Term. No more than 10 years from grant.
• 10 percent owners. For someone holding more than 10 percent of voting power, the statute requires a price of at least 110 percent of fair market value and a term of no more than 5 years.
• Plan life. Section 422 requires ISOs to be granted within 10 years of the earlier of plan adoption or stockholder approval.
• Employment. Section 422 requires the holder to be an employee from grant until 3 months before exercise. That's the source of the familiar 90-day post-termination window: Carta notes ISOs not exercised within three months of leaving lose ISO treatment and are taxed like NSOs.
• Holding periods. To get long-term capital gains treatment, Section 422 requires shares to be held more than 2 years from grant and more than 1 year from exercise. Selling earlier is a disqualifying disposition, taxed partly as ordinary income.
• The $100,000 limit. Under Section 422(d) and Treasury Regulation 1.422-4, only $100,000 of stock (valued on the grant date) that first becomes exercisable in a calendar year can be treated as ISOs. Options are counted in the order granted, and the excess is treated as NSOs.

Worked example: the $100,000 limit and holding periods

An employee receives 100,000 ISOs with a $3.00 exercise price, so the grant is worth $300,000 at grant-date value.

• Standard vesting (25 percent per year): about $75,000 first becomes exercisable each year, under the limit, so the whole grant can qualify as ISOs.
• Fully exercisable in year one (for example, an early-exercise feature): $300,000 becomes exercisable at once, so $100,000 qualifies as ISOs and $200,000 is treated as NSOs. Treasury Regulation 1.422-4 illustrates the same split with an immediately exercisable $150,000 grant.

Holding periods, in the same illustrative example: if the grant is dated January 15, 2026 and the employee exercises on March 1, 2027, the shares need to be held past January 15, 2028 (2 years from grant) and past March 1, 2028 (1 year from exercise). The later date controls, so the first qualifying sale is after March 1, 2028.

Should you offer a longer exercise window?

Here reasonable people genuinely disagree. The 90-day window means a departing employee has to find the cash to exercise, and pay any AMT, within three months or lose the options. Critics call that golden handcuffs; some companies now offer multi-year windows.

The other side has a point. Any exercise after the 3-month mark loses ISO treatment, so a longer window quietly converts those options to NSOs. It also leaves options outstanding for longer, which some investors see as dead weight on the cap table.

Our read: a longer window is a real benefit to employees, as long as you tell them plainly what it does to their taxes.

Setting the equity incentive plan share reserve

The plan states a share reserve, and Section 422 requires it to state the aggregate number of shares that may be issued as ISOs. Too small a reserve and you may run out of equity for key hires; too large and founders can absorb unnecessary dilution, often when investors ask for a pre-money top-up. Carta, citing HSBC Innovation Banking's UK-focused Venture Capital Term Sheet Guide 2026 (643 of its 711 term sheets were for UK-headquartered companies), reports that pools of 10 to 15 percent are most common in those deals, with 10 percent the most frequent, but recommends sizing the pool to the hires you need to reach your next milestone. Our option pool strategy guide walks through the sizing math and the separate U.S. figures, which run somewhat higher.

Securities compliance: Rule 701

Private companies usually issue plan awards under SEC Rule 701. The SEC says Rule 701 covers compensatory grants to employees, consultants and advisors of non-reporting companies. Under the rule text (17 CFR 230.701), 12-month sales cannot exceed the greatest of $1 million, 15 percent of total assets, or 15 percent of the outstanding class, and the rule requires consultants to be natural persons whose services are unrelated to capital raising. If sales exceed $10 million in 12 months, Rule 701 requires the company to give recipients additional financial and other disclosure. State securities rules may also apply, so ask counsel.

Equity incentive plan outline (template)

[Startup Name] [Year] Equity Incentive Plan

1. Purpose: attract, motivate and retain employees, directors, advisors and consultants.
2. Administration: the Board or a committee it designates.
3. Eligibility: employees, directors, officers, advisors and consultants; ISOs for employees only.
4. Types of awards: ISOs, NSOs, restricted stock awards, RSUs.
5. Shares reserved: [X] shares of Common Stock, adjusted for splits and similar events, with an ISO limit stated.
6. Vesting: set per grant; a common default is 4 years with a 1-year cliff.
7. Exercise price: not less than fair market value on the grant date (110 percent for 10 percent holders receiving ISOs).
8. Term: no more than 10 years (5 years for 10 percent holders receiving ISOs).
9. Termination of service: treatment of vested and unvested awards and the post-termination exercise period (ISO treatment requires exercise within 3 months of leaving employment).
10. Corporate transactions: assumption, substitution, cash-out and any acceleration.
11. Amendment and termination: Board authority, with stockholder approval where required.
12. Compliance: Section 409A, Rule 701, state securities laws and tax withholding.

Common mistakes with equity incentive plans

• Granting before a 409A. Pricing options without a current valuation can expose employees to 409A penalties.
• Missing stockholder approval. Under Section 422, without it inside the 12-month window, options cannot be ISOs.
• Ignoring the $100,000 limit. Large or early-exercisable grants can quietly become part NSOs.
• Unrecorded grants. Promises in offer letters that don't reach board minutes tend to surface as diligence problems. Handshake equity is one of the red flags we look for when we read a cap table.
• Poor communication. Employees should understand vesting, exercise cost, taxes and the fact that value depends on a liquidity event.

Building the team that scales revenue

A good plan helps you hire people who think like owners. 1752vc's Accelerate program invests $100K at a valuation cap of up to $3.5M in early-stage startups ready to grow and pairs it with founder-led sales training and access to 850+ investors, which is often the stage when the first wave of equity grants happens.

The bottom line

An equity incentive plan is dull paperwork with sharp edges. Adopt it early, get stockholder approval inside the window, price grants off a current 409A, and put every promise through the board.

The offer letter makes the promise.

The plan is what makes it count.

Key takeaways

• An equity incentive plan is the board and stockholder approved rulebook for every equity grant a startup makes.
• Under Section 422, ISOs require stockholder approval within 12 months, an exercise price at or above fair market value and a term of 10 years or less.
• Only $100,000 of ISO stock first becoming exercisable per calendar year keeps ISO treatment; the rest is taxed as NSOs.
• Section 422 requires ISO shares to be held more than 2 years from grant and 1 year from exercise to get capital gains treatment.
• ISOs exercised more than 3 months after employment ends are taxed as NSOs, which is why 90-day exercise windows are common.

Frequently asked questions

What is an equity incentive plan?

An equity incentive plan is a formal document, adopted by a company's board and approved by its stockholders, that authorizes stock options, restricted stock and other equity awards for employees and other service providers. It sets the share reserve, eligibility, vesting, pricing and what happens to awards when someone leaves or the company is sold.

What is the $100,000 limit on incentive stock options?

Section 422(d) limits ISO treatment to $100,000 of stock, measured at grant-date fair market value, that first becomes exercisable for an employee in any calendar year. Options are counted in the order they were granted, and any amount above the limit is treated as a non-qualified stock option, even though the grant agreement calls it an ISO.

What are the ISO holding period requirements?

To receive long-term capital gains treatment, Section 422 requires ISO shares to be held more than 2 years after the grant date and more than 1 year after exercise. A sale before both periods end is a disqualifying disposition, and the IRS treats part of the gain as ordinary income. Exercising ISOs can also trigger alternative minimum tax in the year of exercise.

What happens to ISOs when an employee leaves the company?

Section 422 requires the holder to be an employee until 3 months before exercise, so ISOs exercised more than 3 months (roughly 90 days) after employment ends are taxed as non-qualified options. Unvested options are usually forfeited. Some companies offer longer exercise windows, but any exercise after the 3-month mark loses ISO tax treatment.

Does an equity incentive plan need stockholder approval?

Yes, if you want to grant ISOs. Section 422 requires stockholder approval within 12 months before or after the board adopts the plan, or options granted under it cannot qualify as ISOs. State corporate law, your charter and investor agreements may add their own approval requirements, so confirm the full list with counsel.

Sources

• Cornell LII: 26 U.S. Code Section 422, Incentive stock options
• eCFR: 26 CFR 1.422-4, $100,000 limitation for incentive stock options
• IRS: Topic no. 427, Stock options
• Carta: Incentive Stock Options, How ISOs Work and Tax Treatment
• Carta: Option Pools Guide
• Carta: What is a 409A Valuation?
• SEC: Employee Benefit Plans, Rule 701
• Cornell LII: 17 CFR 230.701, Exemption for offers and sales of securities pursuant to certain compensatory benefit plans