Non-qualified stock options: how it works for startups

Stock options is a powerful currency in today's startup economy. If you're a startup founder, you know that offering stock options is important if you want to play the long game and attract skilled people who understand the importance of ownership.

Depending on your business requirements and your jurisdiction, there are different types of equity grants that a company can leverage to incentivize and motivate its team. Stock options are common among startups, of which there are two types: the non-qualified stock options (NSO or NQSO) and the incentive stock options (ISO).

Non-qualified stock options are the most flexible type of stock options,

according to Matt Secrist, Employee Benefits Partner at Taft Law.

And this guide will flesh out why!

If you prefer to watch or listen, Matt Secrist talked about stock options in this episode of Startup Equity Matters.

In this guide, we will deep dive specifically into the nuts and bolts of NSOs, how it works, what makes it different from incentive stock options, and how NSOs can benefit both employer and employees. Let's begin!

NSO, explained

What are non-qualified stock options

Non-qualified stock options, also known as NSOs, are a type of stock options commonly used in startups. Like any type of stock options, NSO gives the recipient the opportunity to purchase shares at an predetermined price (known as the "exercise price" or "strike price"), within a specific vesting period.

They are referred to as "non-qualified stock options" because they don't meet all the requirements of the Internal Revenue Service and the preferential tax treatment of incentive stock options (ISO). Although ISOs have its tax benefits, NSOs are more common and straightforward than ISO.

NSOs are by far the most flexible type of stock options. You can grant it to an employee and non-employee, like an independent contractor. An ISO can only be granted to an employee, so there's like one restriction. An NSO has a lot more flexibility for startups when cash might not always be available to pay your bills.
^{—Matt Secrist, Partner at Taft Law}

Aside from the ability to offer stock options to employees and non-employees alike, NSO offers more flexibility in terms of the entity structure of the company that offers them. Unlike ISOs that can only be offered by corporations, NSOs can be offered by any entity (corporations, LLCs, partnerships.) This flexibility is very important for startups.

NSO vs ISO

Between these two main types of stock options, NSO and ISO, you want to know which one to use for your startup's requirements.

Some important distinctions between NSO and ISO:

• NSO may be granted to employees and non-employees (advisors, consultants, board members), whereas ISOs can only be granted to employees.
• NSO may be granted by any entity Corporations, LLCs, Partnerships, whereas ISO can only be granted by Corporations.
• Exercise periods for NSO is more flexible than ISO. For example, ISOs have to be exercised 90 days after an employee leaves before they forfeit their incentive, whereas with NSOs, employees can hold on to their options as long as the option rules allow them too.

You don't see ISO too much in the startup world. The reason I say you don't see it that much is because it's a little more complicated. There's a lot more bells, there's a lot more regulation versus NSOs.
^{—Matt Secrist, Taft Law}

To know more about incentive stock options, read this article on ISO vs NSO.

How does non-qualified stock options work

When a startup grants NSOs to recipients, it gives them the right to purchase a specific number of company shares at a predetermined exercise price or strike price. These options typically have a vesting period, during which a recipient needs to fulfil certain conditions, such as remaining with the company for a specific duration or achieving a certain performance metric. Once the vesting conditions are satisfied and the stock options vest, the recipients can exercise their options.

There are four stages in the lifecycle of non-qualified stock options: (1) Grant, (2) Vesting, (3) Exercising, and (4) Exit.

Let's break that down:

1. Grant

Initiating the journey

When NSOs are granted by employers as part of a compensation package, the recipient receives a stock option offer letter or an equity agreement. This document contains all the important details of the grant. The number of options granted, vesting schedule, and expiration date are all predetermined at the time of grant.

Just like any legal document, the equity agreement serves as a binding contract between the company and the recipient and a rule book for the entire lifecycle of the stock option.

In the Cake app, setting up stock option grants is simple. Equity agreement templates are ready for use or to be customized depending on your requirements. You can also upload your own NSO agreement if you already have one. Sign up to get started.

2. Vesting

Earning the right

Vesting schedules ensure that employees fulfil certain requirements, such as remaining with the company for a specific duration or hitting a certain milestone, before they can exercise their options. In other words, this is the period where the option holder earn the right to exercise and receive shares.

It's important to note that if an employee leaves (e.g. resignation, termination) before the options vested, then any options that have not vested will lapse, placed back to the option pool, or re-allocated to a new recipient. This is why stock options are great for incentivizing key employees to stay longer.

Startup founders have the flexibility to set vesting periods and exercise periods for NSOs.

3. Exercising

Seizing the opportunity

Exercise periods determine the timeframe within which employees can exercise their vested options. The exercise price is set at the fair market value and predetermined at the date of grant, and the stock price is the value of the stock at the date of exercise. When the exercise price is lower than the stock price, option holders are purchasing stocks at a discount, essentially leading to substantial financial returns.

When you're talking about exercise periods, generally, you can have a long exercise period with NSO. In comparison, ISOs have some restrictions when it comes to exercise periods. For example, you can't have longer than 10 years for an exercise period, and if someone quits and they're no longer an employee, they only have 90 days to exercise or they forfeit their ISOs.

With NSO, you'd be looking to have as long an exercise period as possible. There's no rules around exercise periods. Some founders want to have 1-3 year exercise periods, but I'm a huge advocate for having the longest possible exercise period when you grant an option.
^{—Jason Atkins, Cake Equity}

There's a lot more flexibility in terms of exercising with NSO. As long as the company sets up a long exercise period, recipients can keep their options even when they're no longer with the company, and wait for the best time to exercise them.

4. Exit or sale

Reaping the rewards

Option holders typically wait for a liquidity event to sell their shares. A liquidity or exit event could be an acquisition or an IPO, or as Secrist puts it, a "change of control".

In startup land, it's all about high growth exits, M&A (mergers and acquisitions), IPO, that kind of thing. It's all about the exit, the liquidity event. So you're much more trying to align the ownership structure of the incentive plan to this exit opportunity.
^{—Jason Atkins, Cake Equity}

In other words, this is the part where the option becomes shares and the recipient gets the cash.

It's important to note that the treatment of non-qualified stock options during a liquidity event is subject to various factors, including the company's policies, the terms of the option agreements, and any negotiations that may occur during the event. Option holders should refer to their NSO agreement, the company's stock option plan, and/or to consult legal or financial professionals to understand the specific impact of a liquidity event on their non-qualified stock options.

Tax implications of non-qualified stock options

With NSOs, there is no tax impact on the date of grant, or at any point during the vesting period. NSOs are subject to tax in two stages: upon exercise and upon sale.

NSO taxation upon exercise

When you decide to exercise NSO (non-qualified stock options), the taxation process involves the "Spread", which refers to the difference between the exercise price and the fair market value (FMV) at the time of exercise. This spread is considered as compensation and is subjected to ordinary income tax. Additionally, you will be responsible for paying federal, state, and local income taxes, along with payroll taxes.

It is important to note that the company will also be eligible for a tax deduction based on the compensation provided.

NSO taxation upon sale

Upon the sale of NSOs, you will need to pay capital gains tax (CGT) on the additional gains. The calculation of CGT involves deducting the cost basis (i.e., exercise price plus NSO spread) from the sale price.

There are two types of NSO sales to consider. The first type involves holding the shares for at least one year after exercising the options. The second type encompasses holding the shares for less than one year after exercising. The first type of sale generally receives a more favorable tax treatment due to the typically lower rate of long-term capital gains tax.

Example of non-qualified stock option

Here's an example scenario of non-qualified stock option provided to an employee, and the tax treatment on grant, exercise, and sale of options.

• Grant. In Year 1, an employee is granted NSO to acquire 10 shares at an strike price of $10/share (valued at $100). The option is not taxed on the grant date.
• Exercise. In Year 3, the service provider exercises the option and acquires all 10 shares when the share price is $50/share (valued at $500). When exercised, the service provider has income of $400 ( the ‘Spread’ i.e. $500 - $100) that is considered wages subject to income tax and employment tax. The employer may claim a tax deduction for the $400.
• Sale. In Year 5, the service provider sells the 10 shares for $100/share. When the shares are later sold, the service provider has made a capital gain of $500 (the ‘Gain’ i.e., $1,000 - $500). Because the 1-year holding period has been met here, the Gain is subject to the long-term capital gains tax rate.

More on NSO taxation and compliance

NSO for employees

As discussed earlier, when employees exercise their options, the 'Spead' is considered wages that are subject to ordinary income tax and employment taxes. These wages are reported on the employees' Form W-2 (Wage and Tax Statement), and the employer will withhold it and pay the Social Security and Medicare taxes.

Both the employer will pay its share and the employee will have its share withheld during the exercise.

NSO for non-employees

For non-employees, (such as advisors or board members), they will need a 1099 form and be responsible for all of their employment taxes and income tax withholding.

In the US, generally speaking, employers only withhold for employees, they don't withhold for 1099 consultants like board members.

409A valuation for NSOs

Determining the fair market value of NSOs is crucial for setting the exercise price. It's important to ensure that the exercise price reflects the company's current value. This is where the 409A valuation comes in.

The Internal Revenue Code Section 409A governs non-qualified deferred compensation programs. The IRS and the Treasury Regulations have a set of rules as far as the factors that you need to consider when determining the exercise price.

Under 409A, the exercise price of an option has to be equal to or greater than the fair market value of a share on the date of grant.

The important thing to know with 409A is, it can be costly for the stock option holders if you get this wrong.

The tricky thing with 409A is, unlike a lot of US and other countries' tax code provisions, the penalties are actually on the employee, the participant, not the company or the employer. Under 409A, if you violate those rules, it's actually a 20% excise tax penalty payable by the employee.
—Matt Secrist

This can be sort of the messy situation. You're well intended to incentivize employees, but if you don't follow these rules, not only are they including money amounts in their income before the wage piece, they're also having an extra tax bill on top of it. So it's kind of a double whammy that they wanna avoid.

The good news is, while it used to be that these 409As are extremely expensive and complicated, most of the good cap table providers and law firms will have a nice, simpler, and much more affordable solution, including Cake. We have that built in, so it's not that hard anymore.
—Jason Atkins

Cake offers fast, audit-proof 409A valuation which we have developed with our legal partners, giving you one less thing to worry about when setting up your stock option plans. Read more about Cake's fast 409A valuation.

Communicating stock option plans to employees

Effective communication of NSO plans is vital for fostering employee understanding, engagement, and motivation. Startup founders should clearly articulate the benefits, risks, and requirements of NSOs, providing employees with comprehensive information to make informed decisions regarding their participation.

One of the worst potential things I could do in granting equity to an employee is by giving them a portion of the company, also give them a tax bill where they have to take cash out of their bank account and pay it to the IRS. So that's one of the most disincentivizing things I could do. I need to be careful that what I'm doing is incentivizing my employee and not disincentivizing them or causing a negative action against them.
^{—Leah Brownlee, President & General Counsel of Lazurite}

When done right, NSOs can be truly rewarding for both employees and employers. Communicating and educating your team is an important aspect of offering equity compensations.

Frequently asked questions on NSOs

Can NSOs be granted to non-employees, such as consultants or advisors?

Yes, NSOs can be granted to non-employees, but additional considerations may apply.

What happens to NSOs if an employee leaves the company?

Generally, NSOs have a specified exercise period after an employee leaves the company, typically within a limited timeframe.

Can the strike price of NSOs be lower than the fair market value of the shares?

The strike price of NSOs must be equal to or higher than the fair market value of the shares on the grant date to avoid negative tax consequences.

Are there any limitations on the number of NSOs that can be granted to an employee?

There are no specific limitations on the number of NSOs that can be granted, but the overall equity plan should be structured reasonably and in line with industry norms.

Can NSOs be transferred or sold to another party?

NSOs are typically not transferable or saleable, except under specific circumstances outlined in the stock option agreement.