Incentivizing With Stock Options: What Your Startup Needs To Know About ISOs, NSOs And Other Parts Of The Alphabet Soup

One of the most common questions executives of emerging companies face when issuing stock options is what type of option to issue.

By Louis Lehot, the founder of L2 Counsel, P.C. and the video blog series #askasiliconvalleylawyer

At formation stage, a startup should adopt an equity incentive plan to pay service providers with equity and position itself to be able to recruit and retain talent. The most ubiquitous form of equity compensation in the startup world is the stock option. At the point of formation when cash is scarce, startups use stock options as the currency of remuneration. If you don’t know the difference between the tools available, and most importantly, how they are taxed at the corporate and individual level, you will be leaving money on the table and fail to optimize value.

While minimum wage laws still apply in most jurisdictions, with cash compensation required to comply with such regimes), the stock option is the bridge from what a startup is able to pay and what is required to recruit and retain talent.

There are two types of stock option that exist under U.S. tax rules: incentive stock options (ISOs), which qualify for special tax treatment under the U.S. Internal Revenue Code, and non-qualified stock options (NSOs or “non-quals”), which do not. Both ISOs and NSOs still give the option holder a right to purchase shares of stock at a defined exercise price upon vesting that will have value if the underlying shares subject to the options increase in value. While it is typical for an equity incentive or stock option plan to allow both types of grants, there are essential differences.

So, as an entrepreneur, how do you know whether to offer ISOs or offer NSOs? Well, ISOs can result in lower taxes for the optionee, and are not taxed until the optionee sells or disposes of their shares. NSOs are taxed when exercised in amounts equal to the difference between the exercise value and the fair market value (FMV) on the date of exercise.

For example, think of a new startup that grants stock options to an employee at an exercise price of $0.10 per share. As the company grows over time, the share value grows. So, when the option fully vests, the shares underlying the option are worth $1.00 each, and the employee exercises the option or pays $0.10 for each. If the grant happens to be an NSO, the employee will pay income taxes at $0.90 of income per share at the exercise point, even though they have not sold any shares. However, if the grant is an ISO, there is no federal income tax due at exercise. Fast forward to three years later — if the employee sells the shares, they will then owe federal income taxes, which will be at the long-term capital gains rate on the difference between the value at the point of exercise and the value at sale for an NSO, or the difference between the point of the exercise price and the value at sale for an ISO.

So, then why wouldn’t you always grant ISOs? Well, the tax treatment for ISOs does provide some limitations:

  • only employees of a startup are eligible to receive ISOs
  • NSOs may be given to any kind of service provider, whether or not an employee
  • ISOs must be exercised within three months after termination of employment
  • ISOs must be held for more than two years after grant.
  • The shares procured upon exercise of an ISO after exercise must be held for more than one year
  • ISOs must be exercised in 10 years of the grant date
  • The FMV of ISOs exercisable for the first time in a given year may not exceed $100,000 based on the FMV at the time of grant
  • Early exercise provisions can have an impact on the number of shares eligible for ISO treatment
  • ISOs are only transferable upon the death of the recipient
  • ISOs granted to shareholders must have an exercise price of at least 110% FMV and must be exercised in five years after the grant date
  • ISOs can only be granted by an entity which is taxed as a corporation (e.g., a “C” corp, and not an LLC, LLP, LP or S corp)

Maybe you tried to grant ISOs, but you didn’t meet all requirements — what next? If your ISOs don’t meet the criteria, the option grant itself is still valid and will automatically be treated as an NSO. Options granted as ISOs often don’t qualify for the preferential tax because the required holding period is not met or the ISO is not exercised and is cashed out in connection with an acquisition of the company. Further, an ISO that is canceled for a cash payment is subject to ordinary income taxes for federal purposes.

Louis Lehot

Louis Lehot is the founder of L2 Counsel, an elite boutique law firm based in Silicon Valley designed to serve entrepreneurs, innovative companies, and investors with sound legal strategies and solutions. Louis is a corporate, securities, and M & A lawyer. He helps his clients, whether they be public or private companies, financial sponsors, venture capitalists, investors, or investment banks, in forming, financing, governing, buying, and selling companies. Formerly the co-managing partner of DLA Piper’s Silicon Valley office and co-chair of its leading venture capital and emerging growth company team, Louis is praised by clients, colleagues and industry guides for his business acumen, legal expertise and leadership in Silicon Valley.