ISOs vs. NSOs: How Startup Stock Options Actually Work

Stock options are one of the strongest tools a startup has for attracting talent without spending cash. The tax rules reward planning and punish improvisation, so setting them up correctly at the start is imperative. This is the sort of thing you should work with a professional on. Don’t wing it.

A stock option is the right to buy a set number of shares at a fixed price, called the strike price or exercise price, for a defined period. The strike is locked in when the option is granted. If the company grows and the shares become worth more, the holder can buy at the old price and keep the difference. Options are how most startups pay early employees, advisors, and sometimes contractors, because they conserve cash and align the person’s interests with value of the company.

Startup grants typically come in two types: incentive stock options (ISOs) and non-qualified stock options (NSOs, sometimes NQSOs). The mechanics of buying the shares are identical. What differs is the tax treatment and who is allowed to receive them. Getting the classification right, and setting the strike price correctly, is where founders most often need counsel.

The vocabulary

Grant: the company awards the option. Nothing is bought yet.

Vesting: the schedule on which the option becomes exercisable, often its four years with a one-year cliff, but this can vary.

Exercise: the holder pays the strike price and receives actual shares.

Spread: the difference between the fair market value of the shares at exercise and the strike price. This is where the tax lives.

Who qualifies for each

ISOs are creatures of the Internal Revenue Code and come with conditions. They can go only to employees, not to independent contractors, advisors, or non-employee directors. They must be issued under a written plan, carry a strike price no lower than fair market value at grant, and be exercised within ten years. There is also a ceiling: to the extent the value of stock, measured at grant, that first becomes exercisable in a single calendar year exceeds $100,000, the excess is treated as NSOs.

NSOs carry none of those restrictions. Anyone can receive them, including employees, contractors, advisors, and board members. The tradeoff is less favorable tax treatment.

How each is taxed

NSOs. No tax at grant. At exercise, the spread is ordinary income. For an employee that means income and payroll tax withholding on the spread, even though no cash came in beyond paying the strike. When the shares are later sold, any gain above the exercise-date value is capital gain, long term if the shares were held more than a year after exercise.

ISOs. No regular income tax at grant or at exercise. Meet both holding periods, more than two years from grant and more than one year from exercise, and the entire gain at sale is long-term capital gain. That is the advantage. Sell before meeting those periods and it is a disqualifying disposition, which pulls the spread back into ordinary income and looks much like an NSO.

The catch with ISOs is the alternative minimum tax. The spread at exercise, while free of regular tax, is an AMT adjustment. In other words: exercising ISOs can trigger a tax bill on money you have not actually made yet, for stock you may not be able to sell.

State treatment varies, so confirm the consequences for each specific holder. For example, California imposes its own AMT, so a California resident can take the hit at both the federal and state level.

The strike price and 409A

An ISO strike must be at least fair market value at grant. An NSO priced below fair market value creates its own problem under Section 409A, including immediate income inclusion plus a penalty. Because startup common stock has no public market, the company needs a defensible number to set the price. That is the 409A valuation, usually an independent appraisal that, done properly, gives the board a safe harbor. Guessing at the number, or skipping the valuation, is a common and expensive mistake.

Exercise windows and the 90-day trap

Most plans give a departing holder a short window, often 90 days, to exercise vested options or forfeit them. Separately, ISO status itself requires exercise within three months of leaving employment; miss that and the option is treated as an NSO. An employee who leaves with valuable but unexercised options then faces a choice: pay the strike price, plus any tax, inside the window, or walk away. Some companies extend the window to keep people whole, but extending an ISO past three months converts it to an NSO. Explain this in the offer, not after someone quits.

Early exercise and 83(b)

Some plans let holders exercise before vesting. Paired with an 83(b) election filed with the IRS within 30 days of exercise, this can start the capital gains clock early and cap ordinary income and AMT exposure while the stock is cheap. The risk is real cash: you pay for shares that may never vest, in a company that may fail. Early exercise is a planning tool, not a default.

The option pool

Options come out of a pool the company sets aside, often 10 to 20 percent of the fully diluted shares. That pool is dilution. Investors usually require it to be created or topped up before their money goes in, which pushes the dilution onto the founders rather than the incoming investor. Size the pool against an actual hiring plan, because an oversized pool dilutes you now for hires you may never make.

TL/DR

This is the kind of stuff you should be hiring counsel and/or an accountant to assist with. Confirm eligibility before promising ISOs, since contractors and advisors cannot receive them. Consider getting a 409A valuation before granting. Spell out the post-termination exercise window in the offer. Flag AMT exposure to anyone exercising a meaningful ISO. And size the option pool against real hiring needs so the dilution matches the plan. Shares are typically set aside for the exercise of options, so that dilution doesn’t come as a surprise later.

This post is general information, not legal advice, and does not create an attorney-client relationship. Tax rules are fact-specific and change. Talk to counsel about your situation.