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As a founder, equity compensation is one of your most powerful tools. It lets you attract talent when cash is tight, retain key players as you grow, and align your team’s success with your company’s long-term vision.
One of the most common forms of equity compensation is employee stock options (ESOs). These come in two main types: incentive stock options (ISOs) and non-qualified stock options (NSOs).
But all this terminology can feel overwhelming.
In this article, we’ll explain the different options so you can be confident you’re making the right decision for your company.
What are employee stock options (ESOs)?
Employee stock options (ESOs) give employees the right to buy company stock at a fixed price (the strike price), typically after a vesting period.
For example, say you give a new hire options over 1,000 shares in the company. You agree this has a “four-year vesting period with a one-year cliff”, and a “strike price of $1”.
Let’s break down what this means.
At first, they don’t get anything. Because of the “cliff”, they have to stay at the company for at least a year before earning any shares (if they leave before that, they walk away with nothing). But once they hit the one-year mark, 25% of their options vest all at once. That means they now have the right to buy 250 shares at $1 each.
After that, the remaining 750 shares vest gradually over the next three years. If the company uses monthly vesting, the employee earns a small portion of their options each month. And after the full four years, they’ll have the right to buy all 1,000 shares at the original strike price of $1 per share.
The real value of these options depends on how the company performs. If the company grows and its its common stock becomes valued at $10 per share, the employee can buy their 1,000 shares for $1 each – a total cost of only $1,000 for shares worth $10,000.
That’s a $9,000 profit before taxes. But if the company doesn’t do well, or the stock price never rises above $1, those options might not be worth much at all.
This is why stock options align the incentives of the employee with the company. Put simply, if the company succeeds, the employee benefits.
Why should I grant stock options?
There are many reasons to grant stock options, especially for an early-stage startup.
Here are the main ones:
- Help recruit talent: Startups often can’t match the high salaries of larger companies, but offering equity gives candidates a chance to “bet on the upside.” For example, a senior engineer might accept a 20% pay cut in exchange for stock options, believing the company’s valuation could grow 10x.
- Help retain employees: Vesting schedules ensure that employees earn their equity over time, keeping them committed to the company. This rewards long-term commitment and reduces employee turnover.
- Incentivize performance: When employees have a stake in the company, they think like owners. Instead of just collecting a paycheck, they’re directly motivated to help the business succeed because their own financial upside depends on it.
Particularly for startups with limited cash and high growth potential, stock options are a powerful tool to attract, retain, and motivate the right people.
Can you only give stock options to employees?
No, stock options aren’t just for employees. You can also grant them to advisors, contractors, and even board members – basically, anyone you want to reward with equity for contributing services or deliverables to the company.
That said, there are some differences in how options are typically structured depending on who’s receiving them.
Employees typically get Incentive Stock Options (ISOs). But, if you’re granting options to advisors, contractors, or board members, those need to be Non-Qualified Stock Options (NSOs).
What’s the difference between ISOs and NSOs?
The main difference between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) comes down to who can receive them and how they’re taxed.
ISOs can only be granted to employees of a company (not independent contractors).
But NSOs can be given to anyone, including employees, contractors, advisors, and board members, making them much more flexible to grant.
But they are treated very differently when it comes to tax.
ISOs can qualify for favorable tax treatment if certain conditions are met.
To validly grant an ISO, the following conditions have to be met:
Must be granted to employees only: ISOs can only go to employees, not contractors, advisors, or board members.
Must be issued by a corporation: Only C-corps and S-corps can grant ISOs (not LLCs or partnerships).
Exercise price must be at least fair market value (FMV): The strike price cannot be lower than FMV at grant (if the employee owns 10%+ of the company, it must be 110% of FMV). Here's how to establish the FMV of your company's stock using a 409A valuation.
$100,000 annual exercisable limit: An employee can only have $100,000 worth of ISOs become exercisable per year in ISOs (based on the FMV at the grant date).
Must be granted under a shareholder-approved plan: ISOs must be issued under a formal stock option plan that shareholders approve within 12 months of adoption.
Must be exercised within 10 years: Employees have 10 years to exercise ISOs from the grant date (if the employee owns 10%+ of the company, they have 5 years).
Must be exercised within 3 months of termination: If an employee leaves, they must exercise their ISOs within 3 months.
If any of these rules aren’t met, the ISOs automatically convert to NSOs, losing their tax advantages.
Must be granted to employees only: ISOs can only go to employees, not contractors, advisors, or board members.
Must be issued by a corporation: Only C-corps and S-corps can grant ISOs (not LLCs or partnerships).
Exercise price must be at least fair market value (FMV): The strike price cannot be lower than FMV at grant (if the employee owns 10%+ of the company, it must be 110% of FMV). Here's how to establish the FMV of your company's stock using a 409A valuation.
$100,000 annual exercisable limit: An employee can only have $100,000 worth of ISOs become exercisable per year in ISOs (based on the FMV at the grant date).
Must be granted under a shareholder-approved plan: ISOs must be issued under a formal stock option plan that shareholders approve within 12 months of adoption.
Must be exercised within 10 years: Employees have 10 years to exercise ISOs from the grant date (if the employee owns 10%+ of the company, they have 5 years).
Must be exercised within 3 months of termination: If an employee leaves, they must exercise their ISOs within 3 months.
If any of these rules aren’t met, the ISOs automatically convert to NSOs, losing their tax advantages.
For example, if an employee holds their shares for the required period, they don’t pay income tax. They’d only have to pay long-term capital gains tax when they sell. That’s a big advantage because capital gains tax is lower than ordinary income tax.
NSOs don’t get the same tax break.
When someone exercises an NSO, they’d have to pay income tax when they exercise their options. Plus, any additional gains are taxed as capital gains too.
This table gives a quick overview of the main differences between ISOs and NSOs:
| Factor | ISOs | NSOs |
| Recipients | Employees only | Employees, contractors, advisors |
| Value cap | Up to $100,000 that vests in a single year (based on FMV at the time of the grant). For most startups, this won’t be a problem. | No cap |
| Tax at exercise | No ordinary income tax. If the stock price at exercise is higher than the grant price, the difference (the “spread”) may be taxed (under Alternative Minimum Tax). | Taxed as ordinary income |
| Tax at sale | If the holding period is met (2 years from grant, 1 year from exercise), gain is taxed as long-term capital gains (which is lower than income tax rate). If sold earlier, you’ll pay ordinary income tax on the spread, plus capital gains tax on additional gain. | Capital gains on profits made. If sold within a year of exercising, you’ll pay short-term capital gains. If sold after one year, you’ll pay long-term capital gains (which is lower). |
| Flexibility | More complex, strict IRS rules | Simpler, fewer restrictions |
When should I offer ISOs or NSOs?
If you’re offering stock options to employees, ISOs are better for them. But, as we covered above, there are a lot more rules around ISOs than NSOs.
So, you’ll have to make the decision on what you want to prioritise – simplicity or tax efficiency for your employees.
The flowchart below gives you an indication of which options might be right for you.
Equity compensation needn’t be complicated
Stock options can be a game-changer for attracting and retaining talent (especially when raising salaries isn’t an option).
So, if you want to put options in place for your company, book a call below so we can help you out.
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