Equity Incentive Arrangements Types Intro--03 Non-qualified Stock Options (NSOs)

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 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 NSOs.

Any Option that does not qualify as an Incentive Stock Option, shall be deemed a Non-Qualified Stock Option. Unlike ISOs, NSOs may be granted to anyone who provides services to the company, including employees, officers, directors, and independent contractors.

In general, the tax treatment of NSOs is less favorable than ISOs, as NSOs are taxed (on [FMV at the time of exercise] – [exercise price]) at ordinary income rates at the time of exercise (even if no sale of underlying stocks have happened), rather than at the capital gains rate.

*Hence 83(b) election is especially important for NSO grantees.

For the startup employer, employee NSOs exercises are subject to withholding for employment taxes, and the company can generally deduct, as a compensation expense, the ordinary income recognized by the option holder upon exercise of the NSOs.

Compare to ISOs, there tend to be fewer mandatory requirements and limits on NSOs.

Some of the mandatory requirements of NSOs include:

• Exercise price >= FMV on the date of grant (otherwise may be subject to IRC section 409A regulation)

• Cannot be granted on preferred stock (otherwise may be subject to IRC section 409A regulation)

** 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.