Equity Incentive Arrangements Types Intro--02 Incentive Stock Options (ISOs)
Updated: Aug 28, 2020
Stock options are the most common type of incentive awards granted to startup employees. Awards of stock options are usually subject to a vesting schedule. A typical vesting schedule consists of a 1-year cliff and 3-year vesting, meaning that no vesting occurs within the first year (the cliff) after which 25% become vested, the remaining 75% vesting occurs incrementally (monthly or quarterly etc.) over the next three years.
For startups, stock options are generally divided into two categories: Incentive stock options (ISOs, also known as statutory stock options) and Non-Qualified Stock Options (NSOs, also known as nonstatutory stock options). This post focuses on a brief intro of ISOs.
ISOs can only be granted to employees. Because of this, and because ISOs may have beneficial tax treatment for employees, startups often grant ISOs to select members of management or other important employees. At the same time, compare to NSOs, ISOs also tend to have more mandatory requirements and limits.
The major tax benefit of ISOs is that ISOs are taxed on a capital gains basis, rather than as ordinary income, so long as certain requirements are met (e.g. must hold the underlying stock for more than one year after exercise to receive favorable tax treatment). In brief, no tax at the exercise of ISOs, capital gain at the sale of underlying stocks (on [sale proceeds] – [exercise price]).
*However, employee gets capital gain treatment = startup employer gets no deduction
Some mandatory requirements and limits for ISO include:
ISOs can only be granted to employees.
Exercise price >= FMV on the date of grant (or 110% FMV for 10% shareholder)
Term (exercisable period after the date of grant) <= 10 years (or 5 years for 10% shareholder)
Must be granted within 10 years of Incentive Award Plan adoption
Value of underlying stock at the time of grant <= exercisability rate of $100,000 per year; options granted over this limit will be treated as NSOs
** This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.