How Does a Pre-IPO Company Pay Stock to Employees?

Working at a startup or a company preparing for an IPO often comes with a big question: how does a pre-IPO company pay stock to employees? Unlike a regular salary that shows up in your bank account, stock compensation is a promise of future value.

Pre-IPO companies usually offer stock options or restricted stock units (RSUs) as part of their pay package, giving employees a chance to benefit if the company grows and eventually goes public.

Understanding how this works—vesting schedules, exercising options, and liquidity—can help employees see the real worth of their equity.

Also Read: What is IPO Cycle? A Complete Guide for Investors

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What Types of Stock Do Pre-IPO Companies Offer?

Pre-IPO companies don’t simply hand out tradable shares like public companies. Instead, they use specific forms of equity compensation designed to balance employee rewards with the company’s early-stage limitations.

1. Stock Options

Stock options give employees the right—but not the obligation—to purchase company shares at a fixed price (called the strike price). There are two main types:

• Incentive Stock Options (ISOs): Usually offered to employees, these may qualify for favorable tax treatment if certain conditions are met.
• Non-qualified Stock Options (NSOs): More flexible, but they don’t carry the same tax benefits as ISOs.

2. Restricted Stock Units (RSUs)

RSUs are promises to grant company stock in the future, once specific conditions are satisfied (like staying with the company for a set period). Employees don’t have to pay to receive RSUs—they simply gain ownership when they vest.

3. Restricted Stock Awards (RSAs)

RSAs are actual shares given to employees upfront, but with restrictions such as forfeiture if the employee leaves before a certain time. They are more common in very early-stage startups where valuations are still low.

4. Employee Stock Purchase Plans (ESPPs)

Some companies allow employees to buy shares at a discounted price through payroll deductions. While ESPPs are more common in public companies, some late-stage pre-IPO startups may offer them as well.

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How Stock Compensation Works in a Pre-IPO Company

Understanding how stock pay works is key to knowing its true value. Here’s the typical process:

1. Granting the Stock

When you join a pre-IPO company, part of your compensation package may include stock options or RSUs. These are granted on paper, outlining how many shares you’re eligible for and the conditions attached.

2. Vesting Schedule

Equity isn’t given all at once. Companies use a vesting schedule—commonly 4 years with a 1-year “cliff.” This means you earn the right to 25% of your stock after the first year, and the rest vests gradually over the remaining period. Vesting encourages employees to stay with the company longer.

3. Exercising Options

If you have stock options (not RSUs), you need to exercise them—meaning you buy the shares at the agreed strike price. For example, if your strike price is ₹100 per share and the company later IPOs at ₹500 per share, you stand to make a significant profit.

4. Fair Market Value (FMV)

The price of your stock is determined by the company’s 409A valuation (in the US) or similar valuation methods elsewhere. This sets the fair market value for your shares and affects how much you pay when exercising options.

5. Tax Implications

Equity compensation has tax consequences that employees should understand:

• ISOs: May receive favorable tax treatment, but could trigger Alternative Minimum Tax (AMT).
• NSOs: Taxed as ordinary income when exercised.
• RSUs: Taxed as regular income when they vest.

Since taxes can get complicated, many employees consult a financial advisor before exercising or selling their shares.

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Liquidity Before the IPO

One of the biggest challenges with pre-IPO stock is liquidity—your shares exist on paper, but you can’t easily sell them for cash. Unlike public companies, pre-IPO stock isn’t listed on an exchange, which means employees have to wait for a major event (like an IPO or acquisition) to turn equity into money.

That said, there are a few scenarios where employees might get access to liquidity:

• Secondary Markets: In some cases, private equity investors or specialized platforms allow employees to sell a portion of their vested shares to third-party buyers. These transactions depend on company approval and may come with restrictions.
• Tender Offers: Sometimes, the company itself or existing investors buy back employee shares during fundraising rounds, giving staff an opportunity to convert a portion of their equity into cash.
• Patience Until Exit: For many employees, the most realistic option is to hold onto the stock until the company either goes public or gets acquired.

Understanding these limitations is crucial, because while stock options can be valuable, they don’t provide immediate financial relief like a salary does.

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What Happens After the IPO

Once the company goes public, the situation changes completely. Employee equity typically converts into publicly tradable shares, which means employees can finally see the value of their stock in real terms.

Here’s what usually happens:

• Shares Convert to Public Stock: Any stock options or RSUs you hold are transformed into common shares that trade on the stock exchange.
• Lock-Up Periods: Most employees face a lock-up restriction—usually 6 months—during which they cannot sell their shares immediately after the IPO. This prevents a mass sell-off that could affect the stock price.
• Selling and Realizing Gains: Once the lock-up expires, employees can sell their shares on the open market. If the company has performed well, this can translate into significant financial gains.

The IPO is often the moment employees have been waiting for, but timing matters. Stock prices can fluctuate heavily in the early months, so deciding when to sell requires both financial planning and awareness of market conditions.

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Benefits for Employees

Equity compensation in a pre-IPO company can be a game-changer for employees, especially if the company grows successfully. Some of the key benefits include:

• Potential for Significant Wealth Creation: If the company’s valuation increases after the IPO or acquisition, employees may see their stock multiply in value. Early employees at companies like Google or Flipkart turned their stock options into life-changing wealth.
• Sense of Ownership and Loyalty: Receiving equity makes employees feel invested in the company’s future. This shared stake often boosts motivation and alignment with company goals.
• Preferential Tax Treatment (in some cases): Depending on the type of equity (for example, Incentive Stock Options), employees may qualify for lower tax rates on long-term capital gains compared to regular income tax.

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Risks and Considerations

While the upside can be huge, employees should also understand the risks that come with pre-IPO stock:

• Illiquidity Risk Before IPO: Shares cannot be easily sold before the company goes public, which means you may have paper wealth without cash in hand.
• Possibility of Company Valuation Drop: If the company doesn’t perform well or its IPO falls short, the stock’s value could decline sharply.
• Tax Liabilities Even Before Liquidity: Exercising stock options may trigger taxes, sometimes before you can sell the shares to cover them.
• Not All Stock Options Lead to Profit: In some cases, the strike price might end up being higher than the eventual market price, leaving employees with little or no gain.

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Conclusion

So, how does a pre-IPO company pay stock to employees? The answer lies in equity compensation—through stock options, RSUs, RSAs, or purchase plans. For employees, this can be a powerful incentive, offering the chance to share in the company’s future success.

At the same time, it’s important to understand the full picture—vesting schedules, strike prices, fair market value, and tax implications all play a role in determining the real benefit. Pre-IPO stock is not guaranteed wealth, but with the right knowledge and planning, it can be one of the most rewarding parts of your compensation package.

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