Startup Stock Options: ISOs vs. NSOs

Startup Stock Options by on March 31, 2007 at 8:39 pm

An Employee’s Guide to Startup Stock Options

Even seasoned startup personnel frequently misunderstand the ins and outs of their options. I initially thought I could cram a full overview into one post, but quickly realized that it would take several posts to get into the detail that I wanted. So, this is the first post in the Startup Stock Options series. These posts are intended for employees and other people that own startup stock options. Brad Feld has a great series on Term Sheets which cover stock options (and plenty of other issues) that are more geared for company founders.

Over the course of this series, I’ll touch on (in no particular order):

  • How options are granted
  • Vesting schedules
  • Liquidation events
  • Buyback rights
  • Option prices & how they are set
  • Early Exercise
  • Multiple grants
  • Repricing & Dilution
  • Alternative Minimum Tax Impacts

This list isn’t complete and I expect that I’ll add more to it.

I’m going to assume that readers are familiar with options in general, and the concept of employee stock options in particular. Those two wikipedia links should provide enough of a foundation if you are unfamiliar with the concepts.

The two types of options:

The first aspect I’ll discuss is the two option types: Incentive Stock Options (ISOs, sometimes called Statutory or Qualified Options) and Nonqualified Stock Options (NSOs, NQSOs or sometimes called Nonquals). Many aspects of stock options are impacted by which type you hold so developing this familiarity early will help discussions later on. I’m not going to address Employee Stock Purchase Programs (ESPPs), as they are inappropriate for and rarely seen at startups.

Most option agreements will state which type of option you hold. All ISOs need to be issued under an ISO Agreement, which pretty much ensures that the agreement is named something like “Incentive Stock Option Agreement”. I’ve never seen an ISO Agreement that wasn’t named that way, but I’m not familiar enough with the legal aspects to guarantee this is always the case. The easiest way to find out if you hold ISOs or NSOs is to ask your employer.

Incentive Stock Options
Incentive Stock Options are a class of options created by the IRS that provide tax advantages over NSOs. These tax advantages are two-fold:

  • ISOs are taxed on the stock sale (not the grant or exercise). NSOs are taxed on the exercise of the option. You don’t make money until you sell the stock. There can often be gaps between the time you exercise the option (buy the stock), and sell the stock. There are plenty of scenarios where you may exercise the option, but never have the opportunity to sell it. This benefit prevents the worst-case NSO scenario from happening: your unsold, exercised stock becomes worthless. You’ve lost the money you paid to exercise the option, and you would also have to pay the IRS ordinary income taxes on the difference between the exercise price you paid and the market value of the option. So, if you paid $100 to exercise stock worth $1000, you could have to pay the IRS up to 35% of the $900 ‘gain’.
  • ISO shares may receive long-term capital gain tax treatment. If they have been held long enough to satisfy a special holding period ISO stocks can be taxed at lower long-term capital gains tax rates. Long-term capital gains are currently 15%. Ordinary income tax rates can go up to 35%.

It is also worth noting that the Alternative Minimum Tax is increasingly reducing the tax benefits of ISOs. But more on this in a later post.

There are multiple eligibility requirements for an ISO option. The notable requirements include (but aren’t limited to):

  • Employees only
  • Must be granted at fair market value (409A hell for companies)
  • Non-transferable (except through inheritance)
  • Must be granted within 10 years of shareholder/board approval
  • Must be exercised within 10 years of grant

Nonqualified Stock Options
Any option that does not ‘qualify’ to meet the requirements of an ISO or ESPP is an NSO (hence their nickname: ‘nonqual’). NSOs are far more flexible than ISOs, but several important differences include:

  • Can be given to anyone (partners, consultants, board members, gas station attendants, etc.)
  • Can be priced below (or above) current market value
  • Typically taxed on exercise at ordinary income tax rates. In some instances, they can be taxed at issuance.

ISOs offer tax advantages, but NSOs offer substantial flexibility. Consequently, many startups issue both ISO and NSO options depending on the situation. As an employee, in most cases you would prefer to receive ISO instead of NSO options.

Disclaimer: In one of the travesties of our legal system, discussing stock-option related financial decisions, gives corporate lawyers heartburn. Please take the discussions in this series as opinions only and not as advice, guidance or any actual suggestion. Consult a qualified financial or legal adviser before making any stock option related decisions. etc. etc. etc.


  1. […] post by davenaff and a wordpress plugin by Elliott […]

  2. PRoales — April 1, 2007 @ 8:16 am

    “So, if you paid $100 to exercise stock worth $1000, you could have to pay the IRS up to 35% of the $900 ‘gain’”

    Im not a tax lawyer, but most “cap gains” do not get taxed as normal income and so would never fall into the 35% bracket.

  3. davenaff — April 1, 2007 @ 9:32 am

    This examples refers to NSOs, and is unfortunately spot on – you owe taxes on the ‘bargain element’ of the NSO – in the example above, that is $900. This bargain element, or fictitious gain, is then taxed at ordinary income tax rates – not as capital gains.

  4. WTL — April 2, 2007 @ 8:43 am

    If an employee holds a NSO for say, two years, and exercises upon a company acquisition — that NSO is taxed at THAT time correct? And would it not qualify for the cap gains rate if held for that long?

  5. davenaff — April 2, 2007 @ 12:02 pm

    WTL, I think I understand your question, but to clarify I’ll answer with two scenarios:

    1. The employee exercises the NSO immediately after it was granted and then holds the stock for two years at which point the company is acquired. At exercise, the employee would owe taxes on the difference between the exercise price and the market value of the stock. If the NSO was issued at market value, the employee wouldn’t have to pay taxes at exercise. The gains between option exercise and stock sale would be taxed as capital gains because the stock was held long enough.

    2. The employee holds the option for two years and exercises the NSO (thereby acquiring stock) upon acquisition. I think this is the case you’re referring to. Unfortunately, the difference between the exercise price and the acquisition price is taxed as ordinary income.

    An option (NSO or ISO) cannot accrue time towards capital gains until it has been converted into stock.

  6. […] a catchy name. Anyway, what is a start-up stock option? Naffziger’s Net has a short but very insightful post. Oh, and the stock options that was promised? Didn’t get it. At least I learned a lesson or […]

  7. This looks like it will be a useful series. Another important tax difference with ISOs is that there is no withholding at exercise, whether you hold or sell the stock, and there is no employment tax on the spread (Social Security and Medicare). You will eventually owe income tax on the spread, so if you are selling the stock at exercise or holding it/triggering AMT, you want to put the money aside or pay estimated taxes. Employment taxes will not apply later with your tax return.

    Another important ISO rule is that you must exercise them within 90 days of leaving the company, or they convert to NQSOs. You have longer in situations of disablity and death.

    Bruce Brumberg, Editor,

  8. […] This is the second post in my series on Startup Stock Options. This post applies to first-time founders as well as employees. Although the concepts are straightforward, I’ve seen both groups of people be surprised by some of these issues. The points discussed below are independent of whether you own ISOs or NSOs. […]

  9. […] So far we’ve touched on the the two types of options and vesting schedules in this series. The type of option has an impact on some of the content in […]

  10. Claude — September 27, 2007 @ 5:30 am

    Well, a tax on normal stock gains will also be imposed if you surpass certain income levels. However, there is the strategy that you dont sell the stocks but still keep them in order to make them ineligible for taxation. And to keep the bulk of your capital gains you buy put options on your stocks.

    If you want to know more aboutStock Option Trading

  11. Craig G — October 30, 2007 @ 7:25 am

    i am in a unique situation. I will be leaving my company for personal reasons. I currently have ISO’s, but do not have the capital to exercise them. My employer has stated they are comfortable extending the period to exercise my ISO’s from 90 days to 2 years. I have learned this is not allowed under the ISO rules. Does my company need to issue me new Non-qual options at the current market valuation? This would affect me, as the current market valuation is much higher than it was when my ISO’s were issued. Any advice is appreciated.

  12. Dave Naffziger — October 30, 2007 @ 7:35 am

    This is definitely worth reviewing with a qualified tax person.

    My understanding of the law is that this extension simply changes how the IRS changes how they treat your options. Essentially, the ISO options become NSO options and the beneficial tax treatment afforded to ISO options is lost.

  13. […] This post depends heavily on understanding the difference between ISOs and NSOs. […]

  14. Harry — December 24, 2009 @ 9:12 pm

    If I exercise my NSO options when the fair market value has dropped below the exercise price, would I still need to pay taxes on the "spread" (which is actually negative) when I exercise?

  15. dan — June 5, 2010 @ 1:39 pm

    I have recently exercised my ISO at $0.33/share when the unofficial FMV for this common stock is around $2.00 (i.e. no document provided by the company stating this value, only verbal comment). The company is still private and thus my stocks are not salable. Am I still subjected to any tax? or shall I be paying taxes at selling time?

  16. Dave Naffziger — June 6, 2010 @ 4:30 pm

    Speak to a tax attorney. I don't believe you are subject to tax until
    you exercise the ISO options.

  17. Shar — June 12, 2010 @ 7:20 am

    My friend has a technical product in development and has very little cash. She will eventually be looking for investors to launch this product. In the interim she needs advice from attorneys and other professionals so she is offering deferred compensation. Can you offer advice on how to structure the deferred compensation? Are there laws that govern this?

    Thank so much for you advice.

  18. Dave Naffziger — June 13, 2010 @ 12:17 am

    Hmm, that sounds challenging. Usually attorneys will work on a
    financing and take their payment after the transaction closes.

    I generally think stock options should only be used for non-employees
    in exceptional circumstances and professional service providers rarely
    fall into that category.

  19. Gary — December 12, 2010 @ 7:06 am

    Dan posted that he exercised ISO options with a $0.33 strike price with a FMV of $2 (FMV I assume set by the Board for new hire options or the post money on a round of financing) at a privately held company so the stock is not salable. You replied that you do not believe that this is a taxable event. My experience in Start-Ups is that if you exercise your ISO options and hold (until the company is public), I've had to pay AMT on the "paper gain" between the strike price and the FMV (ie the verbal finger in the air FMV determined by the Board). This is very painful as you haven't realized any proceeds and you are at risk whether the stock will ever have any value (ie FMV drops or the company never has an exit). The benefit of exercising your non-public ISOs is to start the clock toward Long-term Capital Gains (vs being tax as ordinary income upon selling your stock). It's a big gamble and I've seen a lot people get burned. To avoid AMT, some stock plans allow you to exercise the moment your receive your ISO options (strike price = FMV) so you avoid realizing a gain. You're still put the money you used to exercise your options at risk but you don't pay tax until you sell the shares (and have the proceeds from the sale to use to pay your taxes).

  20. Daniel Galligan — February 2, 2011 @ 4:50 pm

    how did 409A impact ISO and NQO?

  21. Daniel Galligan — February 2, 2011 @ 4:52 pm

    How did 409A impact/change ISO and NQO?

  22. davenaff — February 5, 2011 @ 2:12 am

    A good writeup is here:

    Basically, 409A requires that you have a valuation of the company done
    for the purposes of issuing ISOs or NSOs…

  23. Ymehta — February 29, 2012 @ 8:19 pm

    Do ISO become NOS after you retire? 

  24. davenaff — February 29, 2012 @ 8:28 pm

    No. If ISOs are not exercised within a certain period (90 days I think) after you retire, you lose the options.

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