What is the difference between incentive stock options and non-qualified stock options?

Incentive stock options, or “ISOs”, are options that are entitled to potentially favorable federal tax treatment.  Stock options that are not ISOs are usually referred to as nonqualified stock options or “NQOs”.  The acronym “NSO” is also used.   These do not qualify for special tax treatment.  The primary benefit of ISOs to employees is the favorable tax treatment — no recognition of income at the time of exercise, and long-term capital gains versus ordinary income at the time the stock is sold.  But in the typical exit by acquisition scenario, employees exercise their stock options and are cashed out at the time of the acquisition.  In that scenario, since they sell immediately, they do not qualify for the special tax rates, and their stock options default to NQOs.  So in practice, there tends not to be a material difference in the end between NQOs and ISOs.  If emplyees are in a situation where it makes sense to exercise and hold (for example, if the company goes public), then the benefits of ISOs may be realized.

The discussion below is not comprehensive.  Please consult your own tax adviser for application to your situation. 

Primary differences between ISOs and NQOs 
  Incentive Stock Options Non-Qualified Stock Options
Who can receive? Employees only. Anyone.
 Requirements: Must be issued pursuant to a shareholder- and board-approved stock option plan. Should be approved by the board of directors and pursuant to a written agreement.
  The exercise price must be no lower than fair market value at the time of grant. If the exercise price is less than the fair market value of the stock at the time of grant, the employee may be subject to significant penalties  under Section 409A, including taxation on vesting.
  The option must be nontransferable, and the exercise period (from date of grant) must be no more than 10 years.  
  Options must be exercised within three months of termination of employment (extended to one year for disability, no time limit for death).  
  For 10% (or more) shareholders, the exercise price must equal 110% or more of the fair market value at time of grant.  
  For 10% (or more) shareholders, the value of options received in any one year,  cannot yield stock valued at more than $100,000 if exercised (value is determined at the time of the grant).  Any amount in excess of the limit will be treated as an NQO. No limit on value of granted options.
Tax effect to Company:

The company is generally not entitled to a deduction for federal income tax purposes with respect to the grant unless the employee sells the stock before the end of the requisite holding periods.

Company receives deduction in year recipient recognizes income, as long as, in the case of an employee, the company satisfies withholding obligations.

Tax effect to Employee: No tax at the time of grant or at exercise. Long term capital gain (or loss) recognized only upon sale of stock if employee holds stock acquired by exercise a year or more from exercise and at least two years from date of grant. The recipient receives ordinary income (or loss) upon exercise equal to the difference between the exercise price and the fair market value of the stock at date of exercise.
  But the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax. The income recognized on exercise is subject to income tax withholding and to employment taxes.
  Gain or loss when the stock is sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). When the stock is sold, the gain is long term capital gain if held more than one year from exercise. The gain will be the difference between the sales price and tax basis, which is equal to exercise price plus the income recognized at exercise.

What is IR Code Section 409A?

Caution: The discussion below is not comprehensive.  You need to consult your own attorney as to the specifics of Section 409A and as it applies to your situation.

These days anyone involved with equity compensation will hear a reference to “Section 409A”.   It is a reference to Section 409A of the Internal Revenue Code, part of the American Jobs Creation Act of 2004.

Employees and independent contractors participating in a nonqualified deferred compensation arrangement which fails to comply with Section 409A will be subject to:

  • income tax on vesting
  • an additional excise tax equal to 20% of the amount deferred
  • interest on the underpayments if the tax on the deferred amounts is not paid when first includible in income at a rate equal to the underpayment rate at the time of vesting plus 1%.

 Incentive stock options (“ISOs”) are exempt from Section 409A.  However, one requirement of ISOs is that the exercise price at the time of grant is no higher than the market value of the common stock.   So, if it is determined that the fair market value of common stock is greater than the exercise price at the date of grant, the option will not be exempted from 409A.  Therefore, the steps necessary for valuing a nonqualified stock option are also applicable to incentive stock options.

The company may protect itself and its option recipients from the negative consequences of Section 409A by doing the following: (1) make sure that the exercise price is no less than fair market value on the date of grant, and (2) insure that the option does not include any other feature for the deferral of compensation other than deferral of recognition until the exercise or disposition of the option or, if the stock received on exercise is restricted, until the vesting of that stock.    An example of a deferred compensation feature would be an option that allowed the employee at the time of exercise to elect to take cash amount equal to the option spread as deferred compensation over time.   This would render the option subject to Section 409A. 

With respect to setting the exercise price at fair market value, it is important to keep in mind that the board’s  determination of fair market value must be defendable to the IRS (and in the event the company goes public, to the SEC, as discussed below).   A simple board resolution stating the fair market value of the company is insufficient.  The fair market value of private company stock or equity unit must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.

The factors to be considered under a reasonable valuation method:

  • the value of tangible and intangible assets;
  • the present value of future cash-flows;
  • market value of similar entities engaged in a substantially similar business; and
  • other relevant factors such as control premiums or discounts for lack of marketability.
There is a presumption that the valuation is reasonable if it is based on (a)  an independent appraisal prepared no more than 12 months before the transaction date, or (b) a written report by a person “with significant knowledge and experience or training in performing similar valuations”.  To rebut the presumption, the IRS must show that either the valuation method, or the application of the method, was “grossly unreasonable.”

These days, boards of directors of many venture-backed companies are relying on periodic formal valuations done by financial firms.   That may not be a realistic solution for an early stage company.  In such cases, the company can minimize its risk under Section 409A if it can find an adviser, CFO, or someone else who can qualify as someone with “significant knowledge and experience or training in performing similar valuations”.  Often very early stage companies have developed some software code but have no sales, sales contracts, or significant value in their trademark.  In such cases the reasonable replacement cost of the software code is one metric that might form the primary basis for the valuation. 

What is a stock option?

A stock option is a commitment from the company to allow the grantee (usually an employee) to purchase a certain amount of stock from the company at a fixed price (called the “exercise price”) for a certain period (typically up to 10 years from the date of grant). Shareholders own a piece of the company.  Optionholders are not shareholders (yet).   They own the right to purchase the stock at a given price by a certain time.  Options are usually intended as an incentive to build the value of the company going forward.   The exercise price does not change as the value of the company increases.  So (hopefully) as the value of the company increases, the value to the employee will grow.  If the value of the company remains dormant while the employee holds the option, then there is no significant benefit to the employee.  Employee stock options are usually issued pursuant to a stock option plan approved by the board of directors and the shareholders.  This is primarily because “incentive stock options” — stock options that are eligible for certain favorable tax treatment, must be issued pursuant to a shareholder approved plan.   See What is the difference between incentive stock options and non-qualified stock options.

The grant and exercise of of stock options are subject United States and local laws, including tax and securities laws.  

What is restricted stock?

Restricted stock is stock that is subject to forfeiture to the company for no additional consideration or repurchase by the company at the original price paid, if any, until it vests.  The number of shares of stock that are subject to forfeiture or repurchase at the purchase price decreases over time in a way that is similar to the way that options vest over time.  Restricted stock is issued pursuant to a Restricted Stock Agreement with the company.  Restricted stock is a form of stock award preferable to some recipients for tax reasons usually when a company has only been formed a short time.  It is generally not available for most employees.  Founders frequently take restricted stock.    See Should founders take restricted stock?

What are the different types of equity?

Equity refers to an ownership interest such as shares of stock in a corporation, a membership interest in a limited liability company, or a partnership interest in a partnership.  Technically, an LLC member has only one membership interest.  So it is incorrect to refer in the plural to a member’s “membership interests”.  However, a member’s (single) membership interest can be represented by multiple “units”, just as a shareholder’s corporate ownership interest is represented by shares of stock.  If membership interests are to be represented by units, it will be provided for in the company’s LLC agreement.

Rights to buy or convert into stock, a membership interest, or a partnership interest are considered contingent equity interests.  The most common types of contingent equity are stock options, warrants, and convertible notes.  Preferred stock is a form of equity that converts into another class of stock (common) according to certain contingencies.  

A properly prepared capitalization table will show all contingent equity.  See this post explaining what a “fully-diluted capitalization table” is.  

Should founders take restricted stock?

First off, we need to distinguish two definitions of restricted stock.  The term restricted stock also refers to stock that is restricted from public transfers under the securities laws because it has not been registered with the SEC and state securities agencies.  This post is about founder stock that is restricted in the sense that the company has the right to buy the stock back if the founder leaves the company.  Founder restricted stock typically has the following characteristics:

  • It is issued pursuant to a Restricted Stock Agreement between the founder and the company.
  • At least part of the stock is subject to repurchase by the company at the original purchase price if the founder leaves.
  • The restrictions on the stock, or in other words, the company right of repurchase, usually lapses according to a vesting schedule over two to four years, similar to stock options.
  • For tax efficiency, stock is ideally issued at the earliest stage of the company, when the value of the stock is low.
  • The founder makes an election under Internal Revenue Code Section 83(b) to include the value of the stock (in excess of the price paid for it) in the founder’s gross income for that year, which allows the founder to have capital gains treatment on the appreciated stock when it is later sold.
  • Although the stock is not vested (it is still subject to the buy-back right) it has all the rights and privileges of issued stock, including voting and distributions.

Although it may be deemed burdensome, restricted stock serves at least three purposes that are mutually beneficial for founders:

  1. It motivates founders and other key employees to stay with the company and do their fair share.
  2. It establishes a pre-agreed protocol for easing out founders who have lost interest or underperform.  (If a founder is perceived to be at higher risk than average to be tempted away to other projects, it is also possible to impose on the vested stock a buy back right at fair market value – as opposed to original purchase price for unvested stock.)
  3. Investors appreciate 1 and 2.  In some cases, investors have required founders to accept buy-back restrictions on their stock

Restricted stock can be particularly useful in early stage companies where one or more founders are not working full time on the project.  In such cases, rather than termination of employment, it is failure to contribute the minimum amount of service to the company that triggers the buy-back right.  A clause like the following in the founders’ mutual restricted stock agreements seems to work well to keep founders doing their share of the work:

Service” means at least an average of 20 hours of weekly service to the Company if Founder is not otherwise compensated (e.g., as a full or part-time employee).  Founder will be assumed to be performing Service for the Company unless he receives a written notice from the other two Founding Shareholders that, in their view, Founder is not meeting the service requirement, in which case Founder will have 30 days to cure the failure.

If you decide to use restricted stock, it is wise to consult with an attorney or accountant, particularly with respect to the tax aspects and the 83(b) election.  The 83(b) election must be filed with the IRS within 30 days of when the stock is originally issued.