NSO vs ISO Stock Options for Startups

When it comes to compensating employees beyond their salary, equity in the company can be a powerful motivator. This means that employees, and sometimes advisors or contractors, get to participate in the company's growth and potential upside in the event that the company goes public or gets acquired—what's often called the "Big Exit."

There are two main categories of equity typically used by startups: stock options and restricted stock . This article focuses on stock options. There are two types of stock options: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). 

Differences in Tax Treatment

NSOs and ISOs differ significantly in tax treatment, which can impact both the company and the recipient. Generally, ISOs are more favorable for the employee due to better tax treatment. Specifically, when NSOs are exercised, the spread between the exercise price and the then-current fair market value is taxed as ordinary income to the option holder (and can result in a corresponding withholding obligation for the company). By contrast, when ISOs are exercised, the spread is not taxed as ordinary income and in most cases results in no tax, but it can result in an adjustment to the alternative minimum tax (AMT) if the option holder is subject to AMT.

However, not everyone can receive ISOs. They're only available to employees, not contractors or advisors, and must be granted under a formal equity incentive plan. Moreover, ISOs must be granted at a strike price equal to or greater than the fair market value of the stock at the time of the grant (although NSOs also generally need to be issued at fair market value for a different reason). The rules for ISOs are strict, including a requirement that options be exercised within three months of leaving the company, otherwise, they convert to NSOs. 

Ultimately, while ISOs offer better tax benefits due to potential long-term capital gains treatment, they come with more rules. NSOs are more flexible but can result in higher taxes for the recipient. The most common approach taken by startups is to use ISOs for employees and use NSOs for everyone else. This is not overly complex as long as the company properly sets up its equity incentive plan and keeps track of the requirements for ISOs.

Key ISO Rules:

• Eligible Recipients: Only employees can receive ISOs, not contractors or advisors.
• Tax Treatment upon Exercise: Typically no tax on the difference between the exercise price and market value at the time of exercise, but can result in AMT adjustment for some recipients.
• Granting Requirements: ISOs must be granted under a company plan and within ten years of the plan's adoption.
• Exercise Price: The exercise price, also known as the strike price, must be at least the fair market value at the time of grant.
• Post-Termination Exercise Period: ISOs must be exercised within three months of the end of employment to maintain favorable tax treatment.
• Holding Periods: Shares acquired through ISOs must be held for the later of two years from the grant date or one year from the exercise date to qualify for favorable tax treatment.

Key NSO Rules:

• Eligible Recipients: Can be granted to employees, contractors, advisors, and board members.
• Tax Treatment upon Exercise: Subject to ordinary income tax on the difference between the exercise price and market value at the time of exercise.
• Exercise Price: Typically must be at least the fair market value at the time of grant to comply with applicable tax laws (with some limited exceptions).
• Post-Termination Exercise Period: More flexible, can be longer than the standard three months for ISOs.

Special Considerations for Significant Shareholders:

For those owning 10% or more of the company, ISOs have stricter rules, including a required exercise price of 110% of fair market value and a maximum exercisable period of five years from the grant date.

The $100K Rule:

Additionally, there's the $100k rule: only the first $100k of ISOs that become exercisable in a calendar year can be treated as ISOs; the rest become NSOs. 

This can complicate things, especially when the fair market value of a company goes up over time, and/or when options are granted in a manner to permit early exercise, which allow employees to exercise options before they vest. 

Extended Exercise Periods and Early Exercise:

While most startups use a three-month post-termination exercise period for all stock options (both ISOs and NSOs), some extend this period, which can affect the option's classification as an ISO. 

Allowing early exercise can enable employees to start the holding period earlier for favorable tax treatment, but it comes with administrative complexities and potential tax implications. For those considering early exercise, it's crucial to file an 83(b) election to avoid negative tax consequences. I general, if the goal of the company and the recipient are for the recipient to early exercise options right away after being granted, then it is typically more straightforward to just issue restricted stock to the recipient and not use options.

Changes to Option Grants:

Amendments to ISOs, such as extending the post-termination exercise period, often result in reclassification to NSOs, necessitating careful consultation with legal advisors.

ISOs generally offer better tax advantages for employees, making them a preferred choice for incentivizing staff. However, they come with stringent requirements and limitations. NSOs, while less tax-advantageous, are more flexible and can be granted to a broader group, including non-employees.

Understanding the nuances of these options is vital. It's always recommended to consult with a legal professional when navigating these waters. And for those interested, check out our previous discussions on Employee Incentive Plans and other equity compensation forms.

For startups, understanding the nuances of these options is crucial in designing effective compensation plans that align with their goals and compliance requirements. SPZ Legal can help you weigh your options and guide you in developing the right compensation plans for your startup. Contact us today to find out how we can help.