Issuing equity in a startup can be surprisingly complex. When discussing compensation, founders and employees often mention percentages, but they may not specify whether the equity is in the form of a stock grant or a stock option. Moreover, if it’s a stock option, they may not differentiate between an NSO and an ISO.
There are two forms of stock options for U.S. companies: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs qualify for special tax treatment under the United States Internal Revenue Code whereas NSOs do not.
The differences between NSO and ISO may seem subtle to most founders, but they can have a profound impact. This article explains the distinction between the two and which is best for your situation. However, keep in mind that every company’s situation is unique, and it’s important to seek legal counsel to determine how this decision will affect your company and employees. If you need counsel, feel free to contact us here.
Taxation of ISOs and NSOs
If the grant is an NSO, the recipient pays federal income taxes on the difference between the fair market value (FMV) of the shares at exercise and the original exercise price, even though the employee has not sold any shares. On the other hand, if the grant is an ISO, there is no federal income tax due at exercise, only when those shares are sold.
Let’s say you were issued a stock option for 1,000 shares at an exercise price of $0.01 / share, which was the FMV of the company’s stock on the date of the grant. The company is successful and, after subsequent rounds of funding, the stock price has increased to $1 / share. During the time you held the option, the value of the company has increased 100x. You feel pretty good about that, so you want to exercise your options and purchase shares in the company.
If your stock option was an NSO, then, at the point of exercise, you are taxed on the difference between the exercise price ($0.01) and the current fair market value ($1), sometimes called the “spread” or $0.99 / share. If you exercise all 1,000 shares, then you’re taxed on $99,000 of income just to exercise your option. So, even though you haven’t sold those shares and made any money, you are still paying taxes on $99,000 of ordinary income.
On the other hand, if your stock option was an ISO, then there is no taxation at exercise.
Eligibility Requirements for ISOs
ISOs offer significant tax benefits, but only domestic employees are eligible to receive them. To issue ISOs, strict eligibility requirements must be met, including:
- ISOs are only available to employees, not advisors or contractors.
- The employee must hold onto their shares for at least two years after the grant date and one year after exercising their options before selling them.
- The employee must not have a 10% or higher stake in the company at any time during the two-year period before or after the grant date.
- The exercise price of ISOs must be set at or above the fair market value of the stock on the date of grant.
- ISOs must be exercised within three months of termination as an employee from the company. (Please note: If the service provider continues to work for the company but changes roles from an employee to a contractor, they must exercise within three months from the termination of employment.)
- ISOs must be exercised within 10 years of the date they were granted.
- Only the first $100,000 of exercised stock options will be treated as an ISO; the remainder is treated as an NSO.
- Only entities taxed as a corporation can issue ISOs.
- ISOs cannot be freely transferred; the recipient can only transfer them upon death.
The Right Time for Startups to Issue NSOs
Startups should issue NSOs if the above eligibility requirements are not met. The most common reasons to issue NSOs are when the service provider is either not in the United States or when they are an advisor or contractor.
How to Structure an Equity Compensation Plan That Balances the Needs of Employees and the Company
Creating an equity compensation plan that benefits both employees and the company can be a delicate balancing act. On one hand, startups need to attract and retain top talent by offering competitive equity packages. On the other hand, they also need to ensure that these packages are structured in a way that doesn’t put undue financial strain on the business.
Here are some tips for structuring an equity compensation plan that balances the needs of both employees and the company:
Consider Using a Mix of NSOs and ISOs
While NSOs and ISOs have their own unique advantages and disadvantages, using a combination of both can help balance the needs of employees and the company. For example, NSOs can be used to offer more flexibility in terms of who can receive them while ISOs can be used to provide preferential tax treatment for employees.
By combining these two types of options, startups can create an equity compensation plan that offers both flexibility and tax benefits while minimizing any potential drawbacks.
Determine Vesting Schedules Carefully
Vesting schedules determine when employees are eligible to exercise their options or receive shares. When designing vesting schedules, it’s important to strike a balance between incentivizing long-term commitment from employees while still allowing them some liquidity when needed.
For example, you could structure vesting schedules so that employees become eligible for partial vesting after one year but don’t fully vest until three years have passed. This would give them some liquidity early on while still incentivizing them to stay with the company over the long term.
Communicate Clearly with Employees About Their Options
Finally, it’s crucial to communicate clearly with employees about their options under your equity compensation plan. This includes explaining how options work, outlining eligibility requirements for different types of options (such as NSOs vs ISOs), and providing guidance on how taxes will be calculated when exercising options or selling shares.
By communicating openly and transparently with employees about their options under your equity compensation plan, you’ll be able to build trust and confidence among your team members while ensuring that everyone is on the same page regarding their rewards.
Work with Legal Counsel
Solid legal counsel will help design a stock plan and stock options that meet the specific needs of your startup. This is definitely a point that you’ll want to consult counsel on. If you are looking for legal counsel, feel free to reach out to us here.
