Suppose you’ve finally turned your groundbreaking idea into a flourishing startup. You've attracted a talented team of go-getters who believe in your vision. Now comes the challenging part: deciding how to equitably compensate them. You've heard of Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs), but the decision is far from easy. Which one should you pick to ensure that you're incentivizing your team the right way, while also considering the financial implications for your company?
To provide a comprehensive comparison of ISOs and NSOs, here’s a guide to examining the benefits, drawbacks, and eligibility criteria of each. Eventually, you'll have a clearer understanding of these two forms of employee equity compensation, enabling you to make informed decisions that best serve your startup's goals and your employees' interests.
Stock options grant employees the right to buy a specific number of shares in a company at a pre-determined price, known as the exercise price. Stock options trace their origins back to the late 1950s, with a primary goal of incentivizing employees to work towards increasing the company’s share value. The rationale behind stock options is simple: employees who own a piece of the company are more likely to be invested in its success.
When considering equity compensation for your employees, two major types of stock options are likely to cross your path: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). These two options, while similar in their overarching goal of incentivizing employees, possess unique qualities that can influence their utility and appeal to both employers and employees.
ISOs receive preferential tax treatment and are often seen as a lucrative perk for employees, while NSOs provide greater flexibility and can be granted to a wider range of beneficiaries. Understanding the distinct characteristics of these options is imperative when designing an effective compensation strategy. Here are some key differences:
ISOs receive favorable tax treatment under the Internal Revenue Code. The key benefit here is the ability to defer tax until the sale of the stock. This means your employees do not have to pay tax when they exercise their options, but only when they sell the stock, which can be significantly later. If the necessary holding period requirements are met, the profits could be treated as long-term capital gains, which usually have lower tax rates compared to ordinary income tax rates.
Conversely, NSOs do not offer the same deferral benefits. Tax is due at the time of exercise based on the difference between the exercise price and the fair market value of the stock. This difference referred to as the 'bargain element', is treated as ordinary income and subject to income tax, and potentially employment tax as well.
ISOs are reserved for employees, giving you a powerful tool to incentivize and reward your team members. NSOs, on the other hand, can be granted to employees, consultants, advisors, and even external directors. This broad eligibility makes NSOs a more flexible choice if you want to extend equity-based benefits beyond your full-time workforce.
For both ISOs and NSOs, the exercise price is typically set at the fair market value of the stock at the time of grant. However, there is an exception for ISOs granted to owners of more than 10% of the company’s voting stock. In such cases, the exercise price must be at least 110% of the fair market value at the time of grant.
ISOs are subject to an annual limit, which restricts the aggregate fair market value (as determined at the time of grant) of stock that becomes exercisable for the first time during a calendar year under all of the company’s ISO plans to $100,000. Any grants exceeding this limit are treated as NSOs. NSOs, however, do not have such limitations.
To qualify for tax benefits, ISOs have a required holding period. The employee must hold the shares for at least one year after the exercise date and two years from the date of the grant. NSOs, on the other hand, do not have any such holding period requirements.
Being able to identify their distinctive qualities can help you to better assess which type of stock option aligns with your company's goals, your financial strategies, and the needs of your team.
As an employer contemplating the type of stock options to offer, the potential advantages of ISOs are worth serious consideration. Beyond the tax advantages that ISOs provide to your employees, they also confer several strategic benefits for your company. Understanding these benefits can guide you in your decision-making process.
Offering ISOs to your employees can serve as a powerful retention tool. Because ISOs require a minimum holding period (two years from the grant date and one year from the exercise date) to receive the favorable tax treatment, employees may be more likely to stay with your company longer.
ISOs are often seen as a valuable perk due to their potential tax benefits. Therefore, offering ISOs in your compensation package can make your company more attractive to highly skilled professionals, giving you an edge in competitive job markets.
When employees own a piece of the company via stock options, their interests are more likely to be aligned with the company's success. This may encourage greater productivity and engagement, as employees can directly benefit from the company's growth.
Unlike NSOs, granting or exercising ISOs does not create a tax event for the company. This can help manage your company's tax burden more effectively.
ISOs are typically associated with established, successful companies. By offering ISOs, your company may be perceived more favorably by potential investors and stakeholders, which could bring in additional funding and support.
Each of these benefits can contribute to your company’s overall growth and success, so it’s vital to weigh them carefully against the limitations and potential drawbacks of ISOs when deciding on your employee equity compensation strategy.
Despite the advantages, ISOs also present certain drawbacks. They have stringent restrictions, requiring a holding period of at least two years from the date of the grant and one year from the exercise date. Moreover, ISOs can only be granted to employees, not to consultants or advisors. These factors limit the flexibility of ISOs as a compensation tool.
While ISOs offer several key advantages, Non-qualified Stock Options (NSOs) are not to be overlooked. They offer a different set of benefits that could make them a more fitting choice, depending on your company’s circumstances.
NSOs offer unparalleled flexibility in terms of who can receive them. They can be granted not only to employees, but also to consultants, advisors, and even external board members. This can be a great way to extend equity-based incentives to a larger pool of contributors to your business.
Unlike ISOs, NSOs are not subject to the $100,000 limit on the aggregate fair market value that can be exercisable for the first time in any calendar year. This provides flexibility when granting substantial equity to key employees or other stakeholders.
When an employee exercises an NSO, your company can take a tax deduction equal to the difference between the exercise price and the fair market value of the stock. This can provide a valuable offset to some of the compensation costs.
NSOs do not require a specific holding period to receive preferential tax treatment (as they don't receive such treatment). This can provide a more immediate financial benefit to recipients, making NSOs attractive in certain situations.
NSOs can be simpler to administer than ISOs. They don’t require tracking of holding periods or annual limits, which can reduce administrative complexity.
These benefits make NSOs a powerful tool in your compensation arsenal. Depending on your company's goals, employee structure, and business strategies, NSOs may provide the advantages you need to drive growth and success.
The downside of NSOs lies in their tax treatment. As NSOs are taxed at ordinary income rates upon exercise, they might seem less attractive to employees, especially those in higher tax brackets. This may affect your ability to attract and retain key talent.
When deciding between ISOs and NSOs, understanding who is eligible for each type of option is vital. Each type of stock option comes with its own set of eligibility criteria, which can significantly impact your decision-making process.
ISOs are strictly for employees. This means you can only grant them to people who work for your company, which includes both full-time and part-time employees. This includes officers and directors who are also employees of the company but excludes contractors, consultants, advisors, and external directors.
The aggregate fair market value (as determined at the grant date) of ISOs that can become exercisable for the first time during any calendar year is limited to $100,000. Any excess over the $100,000 limit is treated as an NSO.
ISOs granted to owners of more than 10% of the company’s voting stock must have an exercise price of at least 110% of the fair market value at the time of grant, and the term of the ISO cannot exceed five years.
NSOs are more flexible in their eligibility criteria. They can be granted to a wide range of individuals, including employees, gig workers or contractors, consultants, advisors, and even external directors.
Moreover, NSOs can be issued to anyone associated with the company, making them an effective tool to incentivize and reward a broader spectrum of individuals who contribute to your company's success.
Unlike ISOs, NSOs do not have an annual limit on the fair market value of the stock that can be exercisable for the first time in any calendar year.
Interestingly, NSOs do not have special requirements for major shareholders, unlike ISOs. The exercise price for NSOs can be set at any amount, although it is typically set at the fair market value of the stock at the time of grant.
These eligibility criteria should be considered alongside the strategic benefits and potential drawbacks of each type of stock option. By doing so, you can make the most informed decision on which type of option best aligns with your company's objectives and the interests of your employees or other stakeholders.
Choosing between ISOs and NSOs is not a decision to be taken lightly. The choice will significantly impact both your company and the recipients of these options. Below are some factors you should consider when deciding which type of stock option to use:
Tax considerations, both for the company and the recipients, are a primary factor. ISOs offer potential tax advantages for employees but do not provide the company with a tax deduction. NSOs, conversely, result in ordinary income tax for the employee upon exercise, but the company can claim a corresponding tax deduction.
If employee retention is a major concern, the required holding period of ISOs might serve as a powerful incentive for employees to stay with the company. NSOs, however, do not have this holding period and may not serve the same retention purpose.
NSOs are taxed upon exercise, which could provide cash to the company if employees pay the exercise price in cash. ISOs, on the other hand, are usually not taxable upon exercise, so the company would not receive cash at that time.
If you want to provide equity incentives to a broader group that includes non-employees like consultants or external board members, NSOs are the more fitting choice due to their flexible eligibility criteria.
NSOs may offer simpler administration compared to ISOs because they don’t require tracking of holding periods or annual limits.
If you plan to grant a significant amount of stock options that exceed the ISO annual limit ($100,000), NSOs might be a more fitting choice.
If there are plans to sell the company in the near future, you might consider NSOs. With no required holding period for favorable tax treatment, NSOs could allow recipients to exercise and sell their shares more quickly.
Restricted Stock Units (RSUs) are another form of equity compensation. Unlike stock options, RSUs give employees an ownership interest in the company right away, without needing to exercise any options. They vest over time, generally tied to the duration of employment or performance milestones. RSUs can be simpler to manage than stock options and may be better suited to certain situations, especially in larger, more established companies. To know more about RSUs and how they’re changing the equity game for startups, book a demo with Upstock today.