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Equity Compensation — NSO & ISO Basics

The two main types of stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs).

Many professions love to use acronyms, but especially finance. But as my English-major wife points out, NSO and ISO are initialisms, not acronyms. To make things even more confusing, some use the abbreviation of NQSO instead of NSO; they both mean the same, Non-Qualified Stock Option. NSO is just easier and kinda fun to say!

Companies often offer stock options as part of their employee compensation packages. This is done to attract and retain employees. Having equity, “skin in the game,” means employees are invested in the company’s success, and that can be a powerful incentive. Young companies short of cash can also “pay” their employees without immediately hurting their balance sheet and cash flow.

From the employee’s perspective, the NSO or ISO is only valuable if the right to purchase the company stock is lower than its market value, meaning they can buy low and sell high. Both can instill a sense of ownership and benefit both employee and employer, but there are some differences. NSOs can be offered to employees or independent contractors, ISOs just to employees. ISOs have much better potential tax benefits, but as you might guess, the preferential tax treatment comes with more rules and restrictions.

NSOs and ISOs go through five phases during their lifecycle:

  1. Grant Date = date when the company grants the stock option award package to a worker.
  2. Vesting Date (Vest) = date when a stock option becomes available to exercise.
  3. Exercise Date = when the worker uses the option to purchase (take ownership) stock at the strike price.
  4. Holding Period (Hold) = the period of time during which the worker owns the stock.
  5. Sale or Disposition = when the worker sells or otherwise disposes of the stock.
The life cycle of employee stock options

Other terms to know:

Strike (Exercise) Price = the price at which the employee can buy the stock.

Fair Market Value (FMV) = the value of a company’s stock at a particular point in time. For publicly traded stock, the fair market value is usually determined by the average of the stock’s highest and lowest selling prices on a particular day. For privately held businesses, the FMV would be determined by a formal appraisal.

Expiration Date = the latest date the options can be exercised. If not exercised by that date, they will expire, and the option to buy the stock will end.

Spread or Bargain Element = the difference between the Strike Price and FMV. (We will cover this in more detail in future posts)

An option is a right or obligation to do something. Owning an NSO or ISO gives the employee the right to purchase shares of stock at a predetermined price (exercise price) within a certain period of time through a process called a stock option grant.

After grant, the timing of when you can exercise and sell or exercise and hold your options is typically based on a “vesting schedule.” Shares cannot be sold until vested. Some vesting schedules are gradual and take place over a period of time; for example, 25% of the options can be exercised after year one, 25% year two, 25% year three, and the last 25% after year four. Even if you can exercise your shares, there may be a “blackout period,” and you may have to wait for an “open window” to sell your shares.

Even if you can sell your shares, if you believe your company’s value will increase, you may want to hold your shares and sell at a later date for even more gain.

The nice things about either NSOs or ISOs are that you have control and the potential to participate in the company’s upside. You don’t have to exercise or sell unless you want to. If you wish to exercise or sell, make sure it is done before the expiration date and that you are aware of the diversification and tax consequences. Our next blog post will focus on the tax consequences of each option type, along with some examples.

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