Startup Employee Compensation: ISO vs. NSO

How to work out startup employee compensation is a critical question that most entrepreneurs face. Startups often have fewer funds at their disposal than their incumbent counterparts. This means that they have to look for alternative ways to compensate their employees instead of relying on traditional monetary compensation, and benefits. That is where employee stock options come in, and they are beneficial for both the employees and the company.

Employee stock options give employees a chance to capitalize on the success of the startup they work for. However, employee stock options offer two separate types called Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO) and both types of stock options are very different from one another.

Granting stock options to employees has become a popular trend among startups. Not to mention, employees often expect this form of compensation when they join a startup today. So startups need to know what ISO and NSO are before they choose either type of stock option to offer.

If you are a startup that plans on issuing stock options or an employee who has been offered stock options, then keep reading. This article will explain the key features of ISO and NSO, as well as equip you with all the knowledge you need to choose between the two options.

What Are Stock Options, And Why Do Companies Offer Them?

Before we move on to the key differences between ISO and NSO it is important to explain what stock options are and why they are offered. Employee stock options or ESO are a form of equity compensation that both startups and larger businesses offer to their employees and executives.
Companies offer employee stock options to attract great talent and ensure employee retention. Employees on the other hand have a chance to receive significant returns once the company grows or goes public and its stock becomes more valuable.

With that said, a lot of employees and startup owners think that employees receive a certain amount of stock when they get ESO. However, employee stock options merely give employees a choice to buy a certain amount of stock at a discounted price once they have stayed in the company for the required amount of time.

Since employees have to stay in the company for the required number of years before becoming eligible to exercise the stock options they are less likely to leave. Not to mention when employees know that they have a direct stake in the company they will feel more motivated to work towards its growth.

Recruiting and employee retention are challenges for startups. However, employee stock options help overcome this challenge. Combine the employee retention with little to no initial cost of offering stock options and it is not difficult to understand why ESO has become a popular form of startup employee compensation option.

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What Are Incentive Stock Options?

Incentive stock options are more popular among employees compared to their counterparts. Not to mention they are simpler for startups to offer because they have lesser tax liability associated with them. ISO is meant to be given specifically to employees. They usually have a 10-year expiry duration so they should be exercised within this time frame.

There is a predetermined vesting schedule associated with incentive stock options. Once employees stay in the organization and fulfill their vesting schedule they can exercise their options in full.

Here are some important points about incentive stock options that you should know about.

ISO has a lower tax liability

ISO is more favorable for employees because employees only have to pay taxes once when they exercise stock options and buy stock.

Companies don’t require valuation when issuing ISO

Another distinct feature of incentive stock options is that they don’t have to comply with the regulation of section 409A. The 409A is a regulation by the IRS that requires companies to get a valuation for their company when issuing stock. Since the valuation process can be tricky and comes with separate costs of hiring a professional, ISO is the preferred option for startups with limited resources.

Important things to know about ISO

While ISO comes with its set of advantages for both employees and startups, they also have certain restrictions that need to be honored when issuing them. Here are some key points about ISO that both employees and startups should know about:

• Incentive stock options can not be transferred from one person to another unless in case of the death of the holder.
• ISO comes with a yearly limit which is set at $100,000. Any stock options that are worth more than the limit will no longer be treated as ISO but instead, be treated as NSO. So when you are using ISO, make sure that the share values of each employee don’t exceed $100,000.
• If an employee owns more than 10% of the company’s shares in the form of ISO, then the exercise price will be set at least 110% of the fair market value of the company stock.
• ISOs are restricted to a company’s employees and have a more advantageous tax status than other forms of employee stock purchase schemes.

What Are Nonqualified Stock Options?

The reason why non-qualified stock options of NSO are called nonqualified is that they don’t qualify for special ISO treatment. If a company doesn’t qualify for ISO, then NSO are issued as a substitute.

However, non-qualified stock options are actually simpler compared to ISO. NSOs are taxed on the difference between the discounted strike price the employee gets with stock options and the market value of shares when the employee sells them. In short, any proceeds generated from NSO are treated as personal income, and they are taxed as regular income as well.

With that said, NSO does require the startups to complete valuation requirements under 409A. So for this reason, non-qualified stock options may not be the best option for startups who are simply trying to issue stock options to retain their workforce and are running very lean.

Important things to know about NSO:

Similar to ISO, there are pros and cons of NSO as well. While they do come with a valuation requirement, they are less restrictive compared to ISO in terms of other requirements. With that said, here are some important points to know about NSO. Understand them carefully to figure out the best startup employee compensation to choose.

• NSO allows companies to get tax deductions. Because NSO earnings are viewed as the personal income of the employee by the IRS. Because of the way NSOs are structured, they allow companies to benefit from tax deductions.
• As explained in the previous section, both employees and companies have to comply with certain regulations in order to maintain ISO status. However, that is not the case with NSOs, and companies and employees don’t have to adhere to such strict requirements to maintain their NSO status.
• If an organization fails to fulfill all its ISO requirements, its status changes to NSO. This may occur as a result of a holding duration, among other things. Companies have to ensure the following if they want to avoid reverting to NSO status:

1. Make sure their employee holds the stock for at least 2 years after it is granted to them.
2. Make sure the employee holds the stock for at least one year after they exercise their options.

What Are The Key Differences Between ISOs and NSOs?

Now that you know what ISO and NSO are about and their key features, you can understand the key differences between the two easily. So without further ado, here are the key differences between ISOs and NSOs:

• ISOs can only be issued to an employee, and they can not be issued to a non-employee. NSO can be issued to consultants, advertisers, directors as well as the company’s employees.
• ISO is not taxable under income tax or employment tax, on the other hand, NSO is taxable under income and employment tax.
• ISOs have to be exercised within three months after the employee leaves the organization. On the other hand, NSO can be exercised at any time before the expiry date of the options.
• ISOs normally have a term of 10 years for regular issuance and a 5-year term for incentive stock options issued to employees that hold more than 10% shares. On the other hand, NSOs don’t have a term, however, for convenience, their term is set to 10 years.

These are the major differences between ISOs and NSOs which can help both employees and employers in choosing either type of employee stock option. However, keep in mind that the actual decision of picking between ISOs or NSOs should be made after consulting a lawyer or advisor to make sure you have picked the right form of employee stock options.

When Should You Pick ISOs And NSOs?

Knowing the differences between ISOs and NSOs helps you in selecting the right type of startup employee compensation option. However, no two startups and their employees are going to have the same circumstances or needs. So in order to help startups in picking the right type of employee stock options, we are listing down some cases where each of them is applicable.

ISO application scenarios

By now, you would have probably guessed that ISOs are highly favorable for employees because of the tax savings they get from them. So if you are an employee, you will obviously prefer incentive stock options over NSO. However, ISOs have some application scenarios where they prove beneficial for companies as well. Here is a list of scenarios where ISO makes more sense for companies:

1. When the company is only trying to issue stock options for employees and doesn’t want to incentivize other stakeholders, offering ISO makes more sense. Since incentive stock options are specifically meant to be issued to employees, they are a better choice when startup employee compensation is the only goal.
2. ISO is also the preferred choice when companies are trying to retain a key employee or executive. Since ISO is a desirable form of stock option for employees, offering it to key employees increases their chance of staying with the company for longer.
3. When a company is able to fulfill the requirements for offering ISO, they normally go for ISO to make the employee stock options more attractive for employees.

NSO application scenario

While NSOs may not seem desirable for employees at first glance, they are used by most startups. NSOs align with the most equity compensation scenarios, here is a list of some common situations when NSO is applicable:

1. When companies are trying to offer stock options to entities instead of employees, then NSO is the right form of stock option to choose.
2. NSO is the preferred type of employee stock option when a company is looking for a simpler form of stock option to offer to their employees.
3. When companies want to benefit from tax deductions at the time when employees exercise their stock options, then NSO is the right choice for them.

You can probably understand by now that companies can’t ignore ISO or NSO completely as both types of stock options are a good fit for different scenarios. At the end of the day, it all boils down to whether you are able to meet the ISO requirements or not. Because unless your organization is able to meet ISO regulations, you have no choice but to go towards NSOs. When deciding between ISO and NSO, companies have to choose whether they want to benefit from tax deductions or want to transfer the benefits to employees in the form of special tax treatment.

Conclusion

This breakdown of ISO and NSO stock options will help both employees and employers get a better understanding of these options and their differences. As well as which may be preferable given your specific situation and needs. So, take the time to explore how startup employee compensation works.

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