Employee Stock Options: ISO vs NQO

Stock options for employees, advisors, directors and other third parties offer employees attractive incentives and serve as an additional form of compensation for the staff working hard to make your company a success. Typically, these ISOs and NQOs confer special benefits that cost the company essentially nothing in the short-term—a fact that makes them especially appealing for startups and early-stage small businesses. 

Still deciding what kind of stock options to issue can be a real challenge for many companies, especially the first time it is done. A top startup lawyer from the Priori network can help you not only set up the stock options with the correct paperwork, but also help you decide which choice is right.

What Are NQOs?

NQOs, short for non-qualified stock options, are the most common type of employee stock option. They allow you to purchase stock for a fixed price for a defined period of time, as the market value of the stock continues to rise, allowing employees to profit off the difference. NQOs are just as they sound—unqualified. This means that they are not restricted by waiting periods, profit, price, employee status or any other stipulation. When employees sell shares after they vest, they have the potential to receive immediate, unlimited profit.

What Are ISOs?

ISOs, short for incentive stock options, are a type of employee stock option only offered to key employees and top-tier management that can confer preferential tax treatment. Unlike NQOs, they are subject to many restrictions. They must be held for a much longer time period, and thus can carry more risk; however, they have a higher potential for better returns.

Incentive Stock Options vs Nonqualified Stock Options

While similar, ISOs and NQOs operate differently. The following are some key differences to consider when assessing ISOs vs NQOs.

Eligibility

NQOs are unrestricted. As such, they can be offered to anyone. That means that you can extend them to not just standard employees, but also directors, contractors, vendors, and even other third parties. ISOs, on the other hand, can only be issued to standard employees. Generally, this is limited to upper management and key employees.

Taxation

The main difference between ISOs and NQOs is the way that they are taxed. NSOs are generally taxed as a part of regular compensation under the ordinary federal income tax rate. Qualifying dispositions of ISOs are taxed as capital gains at a generally lower rate. A qualifying disposition for these purposes is defined as ISOs disposed at least two years after the grant date and one year after the exercise date, as long as the employee was continuously employed by the employer granting the ISO up to a time no more than three months prior to exercising the options.

Limitations

There are very few limitations on how NQOs can be exercised. ISOs are subject to the above holding period in order to be exercised as such. In addition, only up to $100,000 in stock underlying ISOs can be exercised each year. Finally, options available to greater than 10 percent of all shareholders must be priced at least at 110 percent of the fair market value on the grant date.

Complexity

Issuing ISOs is more complicated for companies, and more complicated to exercise for employees. That said, neither option should be considered too complex to issue if its benefits outweigh the costs.

Priori Pricing

Depending on your needs, the cost of creating a stock option plan can vary significantly. Priori attorneys typically work from approximately $150 per hour up to $450 per hour for this type of work. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and free price quote from one of our lawyers.

FAQs

Should my company issue ISOs or NQOs? 

Unfortunately, there is no clear answer to this. Both have their advantages and disadvantages. The answer will really depend on who you want to offer stock options and the limitations and returns you want from offering this benefit. Talk to a startup lawyer about your unique situation to get a better idea of what each could offer 

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