Disclosure: I'm not a lawyer or an accountant. Just sharing my knowledge so that you don't have to suffer through figuring it all our as I did. — Chet
When a startup hires you, they often compensate you with stock options. These grant you the option to purchase the company's stock at a specific strike price (the price for you to buy the stock). Usually, these stock options have a vesting schedule where by you accumulate stock options over time, usually monthly over four years with a 1 year cliff (i.e. you don't get any stock for the first year, then you get the first years worth of stock options at once at the end of the first year).
When you are granted the stock options, the strike price for the stock is the fair market value for the stock. Every year (or whenever there's a financial "event"), the IRS requires private companies that issue stock to hire a 3rd party agency to value the company, also known as a 409a valuation. This valuation is usually as conservative as possible (for reasons I'll explain later) and determines a new strike price / fair market value for the companies stock.
Another thing to know is that there are two types of stock — NSO and ISO stock. ISOs are usually for early employees and have better tax treatment. NSO are for later employees and contractors. I will explain more on this soon.
When you choose to purchase your stock options (also known as exercising your stock options), you get to purchase the stock at the strike price stated on your stock grant. Sometimes, if the company's value has gone up, the fair market value of the stock may be higher than the strike price. When you purchase the stock, the IRS will consider the difference between the value you paid for the stock and the fair market value of the stock as income. If you purchase NSO shares, you need to pay income tax on this difference, and if you purchase ISO shares, you need to pay the alternative minimum tax (AMT) which is less than income tax (~20% I think?).
If you plan on buying your stock, its best to do it before the stock price goes up to minimize your tax burden.
Example
strikePrice = $1.13
fairMarketStockPrice = $4.50
numberOfShares = 1000
costToPurchase = $1130
fairMarketValueOfStock = $4500
taxableIncome = $4500 - $1130 = $3370
Note: it's OK if you can't purchase your stock options right away, you'll just have to pay more taxes later...
Because of this tax benefit, companies sometimes let employees purchase their stock options before they have vested. This is called early exercise or an 83(b) election and lets you get the tax benefit of purchasing the stock before the strike price goes up so you can pay less tax. If you early exercise your stock but leave the company before the stock you've purchased has vested, the company will pay you back the amount you've paid for unvested stock.
When it comes to liquidating (a.k.a selling your stock for cash), there are some other tax incentives. If you hold onto NSO shares for one year or ISO shares for 2 years after purchase, then when you sell your stock you are subject to long term capital gains tax instead of income tax which is about 20% less. Thus purchasing your stock sooner will allow you to sell it sooner without paying the extra tax.
If you hold onto your stock for 5 years, you can benefit from Section 1202 Qualified Small Business Tax which allows you to potentially pay 0% tax on the first $10M. There's some legal stuff involved here as far as whether Notion qualifies and some states (such as California) don't respect this federal law and still tax you, but you can deal with this later when you want to sell you stock. It's just something to know about so you can talk to a lawyer and an accountant when the time comes. And again, the sooner you purchase your stock options, the sooner the 5 year waiting period starts.
There are several ways in which you can sell your stock to get cash.
The company can go public which means it will engage in a deal with a large investment bank to issue a initial public offering (IPO) to list the stock on a public stock exchange. This allows anyone to buy and sell the companies stock. When this happens, there is usually a holding period when employees are not allowed to trade their stocks to wait for the market to stabilize.
These days, tech companies try to avoid going public because public companies are regulated by the SEC and are subject to the irrational ebbs-and-flows of the stock market. The whole point of an IPO is to raise a large sum of money for the company, but these days, private investors are able to offer a comparable amount of money. There was a really good A16Z presentation about this called "Tech IPOs are Dead" but I can't find it anymore.
The company can get acquired. Usually as part of the acquisition, you can sell some or all of you stock to the acquiring company. But the acquiring company doesn't want all of the employees to leave so they usually offer a package where you have to continue working for the company for another two years before you can reap all of the financial benefits, a.k.a golden handcuffs.
The company can raise money from outside investors and extend a tender offer to stockholders allowing them to sell their stock to the investors. This is becoming more and more common. My last company (Affirm) does this every year. They don't need to raise more money, but it allows their employees the opportunity to liquidate some of their stock should they choose.
You can sell your stock on a secondary market. Most companies have a "right of first refusal" clause in their stock option agreement which means that if you're about to sell your stock to a random investor, the company can pay the same price to buy your stock and keep a random person out of their finances. Most stock option agreements these days have a "limited transferability" clause which means that you can't sell your stock at all on the secondary market without the company allowing you.