Incentive Stock Option (ISO): A Guide for Employers and Startups‍

Casey Fenton

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October 23, 2023

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Suppose you're sitting in a boardroom with your star employees. They're talented, dedicated, and pivotal to your company's growth. But they want more than just a salary. They're seeking a piece of the success they're helping to create. They want equity.

As the employer, you understand their sentiments. You want to share the success of the company with those who contribute to it. But you're also aware of the financial realities of running a business, especially if you're leading a startup. Cash flow is king, and you're not keen on reducing it by offering hefty raises or bonuses.

In the middle of this conundrum, you remember hearing about Incentive Stock Options (ISOs). Could ISOs be the answer to aligning your employees' ambition with the financial sustainability of your company? 

What is Incentive Stock Option (ISO)?

Incentive Stock Option (ISO) is a unique type of employee benefit that offers employees the chance to buy company stock at a pre-set, usually discounted, price. It's like an exclusive membership card that gives your employees the right—but not the obligation—to become shareholders in your company.

ISOs are essentially contracts, detailing the specific terms and conditions under which employees can exercise their right to purchase the company's stock. These contracts are usually laden with various clauses and conditions, but two key elements to understand are the 'grant date' and the 'strike price.'

The grant date is the day when the ISO is issued to the employee, marking the beginning of the contractual relationship. The strike price, on the other hand, is the predetermined price at which the employee can buy the company's stock. Typically, the strike price is equivalent to the fair market value of the stock at the time of granting, aligning with the U.S. tax code requirements.

However, the beauty of ISOs lies in their potential for wealth creation. If your company's stock price rises, employees can buy stock at the strike price—lower than the market price—and potentially make a profit. It's this promise of sharing in the company's growth and success that makes ISOs such a compelling form of compensation.

Yet, it's also important to note that ISOs come with a 'vesting' period, a predetermined length of time employees must wait before they can exercise their stock options. This vesting period, often ranging from a few years to several years, serves dual purposes. It encourages employees to stay with the company longer and rewards their sustained contribution to the company's success.

History of ISO as Equity Compensation

ISOs have a rich history as a cornerstone of employee compensation. Believe it or not, ISOs weren't always a part of the corporate world. They emerged in the 1950s as a result of increased competition for talent in industries experiencing growth. Companies needed a way to attract top talent and thought of sharing the company's success with the employees. The concept of giving employees an option to buy shares at a predetermined price was born.

However, ISOs really took center stage during the tech boom of the late 1980s and 1990s. Rapidly growing tech companies, many with limited cash resources, sought innovative ways to attract and retain top talent. ISOs, with their potential for significant financial gain, became a preferred tool. They allowed companies to offer competitive compensation packages without draining their cash reserves.

During the dot-com bubble, ISOs became even more popular. However, the subsequent burst brought a mixed bag for ISO holders. Some employees found themselves "underwater," meaning the market price of the stock fell below their strike price. On the other hand, those who held onto their ISOs until the market recovered reaped substantial gains, reinforcing ISOs as a high-reward, high-risk incentive.

After the financial crisis in 2008, companies started looking for less risky alternatives to ISOs. Restricted Stock Units (RSUs) started gaining popularity. Unlike ISOs, RSUs hold some value even if the stock price drops, making them a more stable, albeit less lucrative, equity compensation option.

Today, ISOs remain an important part of compensation packages, especially in tech startups and companies anticipating high growth. While they have somewhat been overshadowed by RSUs, particularly in larger, more stable companies, ISOs still serve as a compelling tool for businesses looking to align employees' interests with the company's success.

Benefits of ISO for the Business

Every tool in a business owner's toolkit has a purpose, and Incentive Stock Options (ISOs) are no exception. Designed to forge a bond between a company's success and its employees, ISOs offer unique advantages that can propel a business to new heights. Below are key components that make ISOs such a beneficial tool for your compensation strategies:

1. Attracting Top Talent

The competition for top talent in today's business landscape is intense. As an employer, you're continually seeking ways to differentiate your company and attract the best and brightest. Offering ISOs as part of your compensation package can make your company more attractive to ambitious individuals seeking to share in the success of the business they work for.

2. Employee Retention

But attracting top talent is only half the battle; retaining them is just as important. ISOs, with their vesting schedules, can be a powerful tool for employee retention. The potential for significant financial gain encourages employees to stay with the company for longer periods, increasing employee loyalty and reducing turnover.

3. Alignment of Interests

ISOs inherently align employees' interests with the company's success. When your employees own a piece of the company, they're more invested in its success. This sense of ownership can lead to increased motivation, productivity, and overall job satisfaction among your team.

4. Preserving Cash Flow

As a startup or a growing company, cash is a precious resource. ISOs allow you to offer a competitive compensation package without negatively impacting your cash flow. Because ISOs are not immediately realized as income by the employee, they can be a more affordable way for companies to incentivize their employees compared to immediate cash bonuses or significant salary increases.

5. Tax Advantages

Last but not least, ISOs can offer tax advantages. Unlike cash compensation, which is taxable to the employee and a tax deduction for the employer at the time of payment, ISOs do not create an immediate tax event. This can result in lower payroll taxes for both the company and the employee, although it's necessary to understand that specific tax implications can vary.

How ISO Works

The process of ISO begins with a grant. This is when the company offers the employee the option to buy a certain number of shares at a predetermined price, known as the strike price. The grant doesn’t mean instant ownership, but it provides the employee with the potential for ownership in the future. Remember, the strike price is typically equivalent to the fair market value of the stock on the grant date.

After the grant, there's usually a waiting period known as the vesting period. This is a predefined time frame during which the employee must remain with the company to be able to exercise their ISOs. Vesting schedules can vary, but a common approach is "four years with a one-year cliff," meaning that 25% of the options vest after the first year, and the remaining options vest monthly over the next three years.

Once the options vest, the employee can choose to exercise them, that is, buy the company stock at the strike price. The decision to exercise often depends on the current market price of the stock. If the market price is higher than the strike price, exercising the option can yield a profit.

Finally, ISO stocks end up being sold. This is when the employee can realize a financial gain. The profit from the sale of stocks is the difference between the market price at the time of sale and the strike price.

However, it's important to note that the timing of the sale can significantly impact the tax implications. If the employee sells the stocks at least two years from the grant date and one year from the exercise date, the profit is treated as long-term capital gains, which typically have a lower tax rate than ordinary income.

Tax Implications of ISOs

The tax journey of ISOs is a two-step process, each with its unique tax implications:

  1. Exercising the Options: Under the U.S. tax code, the exercise of ISOs does not trigger an ordinary income tax event. Instead, the difference between the fair market value at the time of exercise and the strike price—often referred to as the 'bargain element'—is subject to the Alternative Minimum Tax (AMT). Depending on the size of the bargain element and the individual's tax situation, the AMT can significantly affect the employee's tax liability for the year.

  1. Selling the Stocks: If the employee sells the stock at least one year after exercising the options and at least two years after receiving the grant, the profits are treated as long-term capital gains, taxed at a typically lower rate than ordinary income. If these holding periods are not met, the profits are considered a 'disqualifying disposition,' and a portion of the gains may be taxed as ordinary income, with the remaining portion as capital gains.

Tax Benefits for ISOs Revealed

Although the tax implications of ISOs can seem complex, they also bring significant tax advantages when managed correctly.

Unlike Non-qualified Stock Options (NSOs), exercising ISOs does not create an ordinary income tax event, provided the employee continues to hold the stocks. This can defer the tax liability to a future date and possibly reduce the tax rate.

If the stocks are sold after the specified holding periods, the gains are subject to the long-term capital gains tax, which is generally lower than the ordinary income tax rate. This tax treatment can significantly increase the net benefit the employee receives from their ISOs.

ISOs are not subject to Social Security, Medicare, or unemployment taxes, unlike cash compensation. This can provide both the company and the employee with payroll tax savings.

Although the tax implications of ISOs can be intricate, they also offer potential tax advantages. It's important for both employers and employees to understand these aspects, as they can significantly impact the financial benefit of ISOs. 

Common Challenges and Pitfalls with ISOs

While Incentive Stock Options (ISOs) present a myriad of benefits and tax advantages, they are not without their challenges and potential pitfalls. Being aware of these common challenges can help you navigate safely and make the most of your ISO plan.

1. Over Concentration in Company Stock

One potential pitfall of ISOs is the risk of employees becoming over-concentrated in company stock. If a significant portion of an employee's net worth is tied up in the company's stock, they could face substantial financial loss if the stock price declines. Diversification is a fundamental principle of financial planning, and it's important to remind employees not to put all their eggs in one basket.

2. Alternative Minimum Tax (AMT) Liability

While the exercise of ISOs does not trigger an ordinary income tax event, it can trigger the Alternative Minimum Tax (AMT). Depending on the size of the bargain element and the individual's tax situation, the AMT can significantly increase the employee's tax liability for the year, potentially resulting in an unexpected tax bill.

3. Timing of Exercise and Sale

The timing of when options are exercised and when stocks are sold can significantly impact the financial benefit and tax liability. Employees may be tempted to exercise their options and sell their stocks too soon, triggering a disqualifying disposition and potentially increasing their tax liability. Educating employees about the importance of timing can help them maximize their benefits and minimize their tax liability.

4. Market Volatility

The value of ISOs is inherently linked to the company's stock price, which can be volatile. Market fluctuations can cause the stock price to drop below the strike price, rendering the options "underwater." In such situations, the options lose their incentivizing power as employees are less likely to exercise them.

5. Complexity and Lack of Understanding

Perhaps the most significant challenge of ISOs is their complexity. Many employees struggle to understand how ISOs work, the associated tax implications, and how to make informed decisions about exercising and selling options. This lack of understanding can lead to poor financial decisions and reduced employee satisfaction. Employers can help mitigate this challenge by providing education and resources to help employees understand and manage their options effectively.

Best Practices for Implementing an ISO Plan

To navigate these potential pitfalls and create a win-win situation, consider these best practices when implementing an ISO plan:

  1. Education: Ensure your employees understand how ISOs work. Provide resources and perhaps even access to financial advisors.

  1. Clear Communication: Be transparent about the terms of the ISO plan, including the strike price, number of shares, vesting period, and tax implications.

  1. Regular Reviews: Regularly review and update the plan as needed. As your company grows and evolves, so too might your ISO plan.

RSUs as a Good Alternative to ISO

While ISOs can be a great tool, there are situations where Restricted Stock Units (RSUs) might be a better fit. For example, RSUs might be more attractive for employees in a company where the stock price is highly volatile or where the company doesn't plan to go public in the near future. Unlike ISOs, RSUs have value even if the stock price drops, and they're less complex from a tax perspective.

Fortunately, you don’t need to look further for the best RSU plan management. Upstock can handle all RSU-related functions necessary for your employee equity so all you have to do is focus on growing your business. To know more about how RSUs are changing the equity landscape, talk to us today.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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