The second part in our tour of equity based compensation. There are two types of options we'll discuss, Non-qualified Stock Options [NSO] and Incentive Stock Options [ISO].

If you happen to have RSUs take a look at our tour of RSUs here.

Note that this post will be using the following common terms.

Terms

  • Cashless Exercise - When you sell a portion of your exercise equity to pay for the exercise itself.
  • Cost Basis - How much you paid to acquire the equity (Price * Quantity at the point of ownership).
  • Cliff - a period that an employee must work before any of their equity or stock options vest.
  • Dispose - To sell
  • Long Term Capital Gains - If you hold on to an equity for over a year you are taxed as long term capital gains and taxed at a flat 15%.
  • Proceeds - How much you got when you sold the equity.
  • Sell to Cover - selling a portion of the equity to cover taxes.
  • Spread - The difference between how much you sold something for vs. how much you bought it for. (i.e: Proceeds - CostBasis).
  • Long Term Capital Gains - If you hold on to an equity for less than a you are taxed as short term capital gains and taxed at your income tax rate.
  • Strike Price - The price per share of the underlying in an option
  • Vest - vesting is a process used by companies to grant ownership stakes or stock options to employees or partners over a set period of time.

Summary of How Options Work

As the name implies an "option" gives you a choice. If that choice is not profitable (known as "out the money") you can choose to just ignore it and it costs you nothing. If the option is profitable (known as "in the money") then you probably don't want to ignore it.

The "choice" that options give you is the ability to buy a certain number of shares at a certain price (known as the "strike" price). If the price on the option is lower than the current price then you're basically able to buy the stock for cheaper than anyone else, instant profit.

🧠
The strike price is determined by the company share price when the option is granted.

For an early employee at a successful start up their option's strike price could mean huge profit if the underlying stock is worth much more.

Lifecycle of an option

  1. Grant
    This usually happens as a part of your employee offer letter. This tell you the number of options you get, as well as strike price
  2. Vest
    Similar to RSUs over time you "acquire" the options over some period of time. Unlike RSUs with options you acquire the option to buy equity not the equity itself. There is no tax event on vesting for options.
  3. Exercising
    "Exercising" is when you exercise your right to the option. In other words the options are being converted into the underlying company stock. For certain types of options this is a taxable event (see NSO below for more details).

    To exercise you need to buy the shares at the given strike price.
  4. Sale
    Now that you have shares you can sell them at any time just like any other stock.

    How much you need to pay taxes on is determined by the value of those shares at exercise, and the value when you sell. (e.g. If they were worth $100k on exercise and $500k on sale then you would owe taxes on $400k ($500k-$100k)

    Similar to RSUs This is a tax event where:
      1. If you held on to the shares (not the option but shares) for longer than a year the tax rate is 15%
      2. If you held on to the shares for less than a year then the tax rate will be your income tax bracket.

Incentive Stock Options [ISOs]

Incentive Stock Options (ISOs) are a type of stock option granted to employees that offer favorable tax treatment under the U.S. Internal Revenue Code if certain conditions are met. If they don't meet those conditions they become Non-Qualified Stock Options.

🧠
ISOs can only be granted to employees (including executives and directors if they are also employees). They cannot be issued to contractors or board members who are not employed by the company.


One of the primary advantages of ISOs is that exercising the options does not result in a taxable event if you meet certain criteria.

To qualify ISO options need to meet two criteria:
1. Must be held for at least two years after a grant.
2. The shares must be held for at least a year after exercise.

If those two conditions are when you sell it's known as a "qualifying disposition" and any gain will be taxed as long term capital gains (a flat tax of 15%).

Golden Handcuffs
Golden handcuffs is a scenario as some startups where employees can't afford to quit.

This happens with ISO grants because:

  1. ISO grants can only be held by employees. If you quit or are fired you have three months to exercise the options or lose them.
  2. To exercise an option you need to be able to buy the underlying at the provided strike price.

Example:
If you have an ISO grant with 1000 shares at a $10 strike price you would need to come up with $100,000 to fully exercise that option.

This scenario is known as a "golden handcuff" because an employee that wishes to leave but has "in the money" options can't because they don't have the funds to exercise the grant before they leave. This is something known as a "cashless exercise" but some inscrutable companies don't allow for this.

Alternative Minimum Tax [AMT]

It's important to note that while exercising ISOs is not a tax event it can trigger if the amount is large enough. This is known as the Alternative Minimum Tax [AMT] tax.

🧠
ISO options have a number of special tax considerations and often require years of planning before sale to optimize taxes.

It's often best to consult a tax professional and come up with a plan that matches your specific needs.

Common Disqualifying Dispositions

A disqualifying disposition is when ISOs turn into NSOs.

These can lead to nasty tax surprises.

Common sources of disqualifying dispositions:

  1. Tender Offers
    A tender offer is when someone offers to buy out your portion of a company at a certain price. A recent example of that is when Elon Musk bought twitter.

    In the case of a tender offer you're exercising then selling your shares. Because the shares aren't held for a year it's considered a disqualifying disposition.
  2. Cashless Exercise
    A cashless exercise is when you use the sale of some shares to pay for the exercise of an option. Because shares are being sold to pay for an exercise those shares sold aren't being held for a year and hence are disqualified from ISO status.
  3. Acquisition
    In an acquisition ISOs are cashed out and are no longer qualified.

Non-Qualified Stock Options [NSOs]

Non-Qualified Stock Options (NSOs) are called "Non-Qualified" because they don't qualify for special tax treatment like ISOs.

Any one can potentially receive NSO options (contractors, advisors, etc.). It's not limited to employees.

Taxes:

  • At Exercise: Unlike ISOs NSOs do need to pay taxes on exercise. The amount of taxes owed is determined by the value of the shares after exercise minus value of the option (number of shares times exercise price).

    For example:
    If an NSO grant has a strike price of $5 and 1000 shares vested.
    And on exercise let's say the current company share price is $30

    The amount of money taxes would be owed on would then be:
    The value of the shares after exercise - the value of the option
    The value of the shares after exercise = $30 * 1000 shares = $30,000
    The value of the option = $5 * 1000 shares = $5,000
    What you need to pay taxes on = $30,000 - $5,000 = $25,000
  • At Sale: Just like with ISOs or RSUs; whenever you sell a stock it is a capital event. You'll need to pay taxes on the amount of profit you made.