NSO stock options and notable differences between ISO and RSU

Understanding NSO Stock Options

Getting employee stock options can be both exhilarating and confusing. On one hand, stock options can sometimes hold tremendous upside. On the other hand, employees often don’t fully understand what they’ve been granted or what the value of their stock options might be. Here, we’ll examine one of the more common types of stock options — non-qualified stock options (NSOs), also known as nonstatutory stock options.

What Are NSO Stock Options?

The names nonstatutory or non-qualified stock options might sound negative, but the “non” essentially just refers to meeting certain IRS criteria related to income tax.1

NSOs might not be as tax-friendly as statutory stock options — such as incentive stock options (ISOs) — but they can still be lucrative under the right circumstances. Some of the notable differences between NSOs and other types of equity-related compensation include the following:

NSOs vs. ISOs

On the surface, NSOs and ISOs might seem interchangeable, as they both can give you the option to buy company stock, but they differ in a few main areas. For one, ISOs are only for employees, whereas NSOs can be for employees along with others that companies might want to grant stock options to, like advisors. ISOs also generally cannot be transferred2 and most often have to be exercised within 90 days of leaving a company,3 whereas NSOs have more flexibility in these areas. But perhaps the biggest difference comes down to taxes.4 NSOs can incur income tax when granted if you can readily determine the fair market value. If not, they can count toward income when exercised, based on the difference between the value

at the time of exercise and what you paid for them. Then, once you own the actual stock shares, you could be responsible for capital gains tax if you eventually sell for a profit. ISOs, however, do not necessarily incur income taxes when granted or exercised, although exercising ISOs could trigger the alternative minimum tax (AMT). Overall, ISOs are generally considered to be more tax-friendly, while NSOs are more flexible. The rules around stock options can be complex, so you should consult with a tax professional or financial advisor to make sure you handle everything correctly.

NSOs vs. RSUs NSOs give you the option to buy stock, but you might decide to never exercise them if the company’s valuation falls below your strike price. In comparison, restricted stock units (RSUs) are actual shares that you acquire as they vest. You don’t have to pay to exercise RSUs; you simply receive the shares. So, unless a company goes to $0, RSUs always retain some value, whereas stock options like NSOs can be more of a gamble.

RSUs are taxed when you receive the actual shares, with the value counting as income. Then, when you sell the shares, you could pay capital gains taxes on additional profits.5 So, while NSOs might not be as profitable as RSUs, the initial tax bill might be smaller when comparing equal amounts of NSOs to RSUs.

It’s also much more common for RSUs to be used by public companies (and occasionally late stage unicorns), as opposed to startups which prefer to use stock options to compensate early stage employees.

How Do NSOs Work? Basically, if you own NSOs, like with other stock options, you have the right to buy an equivalent number of shares of company stock at a given price, known as the strike price or exercise price. This amount is generally set at or above the fair market value of the company at the time of the NSO grant. Then, if your company goes through several funding rounds and eventually has an IPO, for example, the price per share might be far above your strike price. By exercising those options and then selling your shares, you could profit based on the gap between the current price and your strike price. Stock options also generally have a vesting period of around four years with a one year cliff where you would vest 25% of the options. For the first year after receiving NSOs, for example, you might not be able to exercise any options, but as time goes on, you can exercise progressively more until you become 100% vested.

If you’re not sure what type of stock options you have, consult your employer or a trusted professional like a financial advisor. Some of the differences can be subtle, but you’ll want to know what type you have to make the best tax and overall financial decisions.

How to Value NSOs

In some cases, a startup’s stock might trade on a secondary marketplace like Forge, which could make it relatively easy to see the current value of your NSOs. To see what they might be worth in the future, you could analyze trading activity for similar types of companies.

Also, you can look at funding round valuations for your current company as well as similar ones to get a better sense of the stock’s trajectory. That said, valuing stock options can still be tricky, so you might want to consult with a financial advisor to better understand what yours could be worth.

The good news is that because NSOs generally have more flexibility than ISOs, you might have an easier time exercising and then selling your stock options through a secondary marketplace like Forge, rather than needing to wait for a liquidity event like an IPO.

Key Takeaways

Want a quick refresher on NSOs? Take a look at these key takeaways

  • What are NSO stock options?

    NSOs are nonstatutory or non-qualified stock options, meaning they don’t meet certain IRS rules that can lead to more favorable tax treatment, compared with other stock options like ISOs. However, NSOs can still be profitable, as they still give you the right to buy company stock at a given price set at the time of the grant. If the company grows by the time you exercise the options, that could lead to significant gains.

  • How are NSO stock options taxed?

    NSOs are not taxed at the time of the grant. Income is recognized upon exercise based on the option spread, or the difference between the grant price andfair market value on the exercise date. Although not commonly seen, some companies may offer early exercises in which the employee can exercise shares prior to vesting while submitting a timely 83(b) election to the IRS. An 83(b) election requests that your NSOs be taxed on the date the NSOs were granted rather than the date on which they become fully vested. Shares received from the NSO exercise upon sale are subject to capital gains, long or short depending on the holding period.

  • When should you exercise NSO stock options?

    Exercising NSOs depends on several factors, such as whether the company’s valuation is above your strike price and your potential tax consequences at the time of exercising. You’ll also generally want to be confident that you can then sell exercised shares at some point for a profit, whether that’s through a private marketplace or via public markets after an IPO. Speaking with a financial advisor can help you better determine if and when to exercise.

  • Who can sell private shares on a secondary marketplace?

    There are no accreditation requirements for sellers but you must provide proof of holding the shares you are seeking to sell.

1 IRS

2 FindLaw

3 DLA Piper

4 IRS

5 Charles Schwab

About the Author

Jake Safane specializes in financial reporting and is a former thought leadership editor for The Economist with articles appearing in Business Insider and The Washington Post among other media outlets.

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