Non-qualified Stock Option Basics: What is an NSO stock option?
tl;dr: NSOs (non qualified stock options) are the right to purchase shares in a company at a fixed price, with the expectation that the price in the underlying shares would rise. They usually vest over time, meaning that small portions of the grant become usable (exercisable) over time. Unlike ISOs (Incentive Stock Options), they are not tax advantaged.
As the startup world has become larger, Stock options have become a common method for incentivizing employees, founders, board members, and even contractors. For all but the most senior employees, and those outside of the US, incentive stock options (or ISOs) are the most common vehicle for delivering this important incentive. ISOs have some potentially large tax benefits that make them very attractive, however there are restrictions on who can be granted ISOs. When a company wants to grant a stock option, but they can’t use an ISO (for various reasons I will describe below), they will issue an NSO, or non-qualified stock option.
The nice thing about NSOs is that they are a little simpler and easier to understand than ISOs, however stock options in general can be a confusing concept. This article will dive deep into what NSOs are, who gets them, how they are taxed, and how you can make the most of them. Keep in mind, I am not a tax attorney or a financial advisor, so you should research this for yourself as well.
What is an NSO stock option and how do they work?
NSOs are the simplest of the stock options to explain. The defining characteristics of an NSO are:
A) They can be granted to anyone
and…
B) They receive no specialized tax treatment
Otherwise, they function as a fairly typical stock option. All stock options (including ISOs and NSOs) have three components: quantity, price, and time. These components will change from startup to startup, and with each grant. Typically, a grant offer will look something like this:
Subject to the approval of the board, company XYZ grants [Your Name] 1200 shares of XYZ stock. ¼ of these shares will vest on 1/1/2018, with 1/48 to vest monthly thereafter.
You probably noticed that there isn’t an explicit mention of price in the above. There’s a reason for that. In closely held companies (like most startups), the price changes month to month or quarter to quarter, and it is usually set by the board with the assistance of external auditors and consultants. That means that you won’t know the exact strike price of your grant when it is offered to you, although you should try to determine the most recent price. If you’ve received a grant and you want to dig into the value, you can do so with my interactive calculator.
Let’s say for simplicity sake that the value for the grant in this example is $1.00 per share.
What is the difference between non qualified stock options and vs ISOs?
If you received NSOs, you may be wondering what the difference is between them and ISOs. The most important difference is the tax treatment. No matter which type of option you have, you will be subject to tax on the difference between the grant price and the fair market value of the stock at the time of Exercise (an exercise is when you purchase the underlying stock with the option). For instance, if your strike price -also referred to as the grant price- is $1, and you exercise when the stock has a fair market value of $10, then you will have a tax liability of $9 per share ($10-$1=$9).
The difference between NSOs and ISOs is how that spread is taxed.
With ISOs, the grant can be exercised without incurring ordinary income tax liability. ISOs are still subject to AMT (alternative minimum tax), but depending on circumstances it is possible that exercising the shares may generate no tax liability at all. It is important to note that any exercise or sale of ISOs must be qualified to ensure this special tax treatment, so do your homework.
NSOs are taxed at the higher ordinary income tax rate, and an exercise of an NSO will incur a tax liability no matter what. What’s more, NSOs are also subject to payroll taxes for both the employee and employer.
With either NSOs or ISOs, once you own the shares they are taxed according to typical capital gains tax rules. This generally means if you keep the shares for more than a year, you will pay the capital gains rate instead of the ordinary income tax rate on the difference between the price at purchase and the eventual sale price.
NSOs can also be granted to anyone.
Why did I get an NSO grant and not an ISO grant?
If you are wondering why you got an NSO there are a couple of potential reasons. ISOs have several restrictions that sometimes make it impossible to grant them:
They can only be given to people who are paying taxes in and employed in the US
They can only be given with a total exercise value in any given year of $100k or less
They can only be given to employees
This means if you are a foreign employee (or working for a foreign subsidiary), or if you don’t pay taxes in the US, you will probably get NSOs instead of ISOs. Big shot employees who are given massive stock grants are usually given NSOs as well, since the favorable tax treatment of ISOs can only be utilized on grants that have an exercise value of $100k or less per year. If a company grants 100k shares at a $5 per share strike price, vesting over four years) that is going to have to be an NSO. Each year is $125k of exercisable value. If it was granted with a typical 1 year cliff, the second year would likely be $250k in exercise value, since that year would see two years worth of stock become exercisable in the same time calendar year.
Since ISOs can only be given to employees, NSOs are also often used for contractors, consultants, board members, “friends of the company”, and whoever else needs to be incentivized but isn’t on the payroll.
Exercising non qualified stock options: How do you make money on NSOs?
Note: in this example, I am going to use the same grant mentioned earlier in this post.
1200 shares
¼ of these shares will vest on 1/1/2018 with 1/48 to vest monthly thereafter
Let’s also say, for simplicity sake, that the strike price (or grant price) is $1
Basics of an NSO Exercise #1: Quantity
This is by far the simplest component to understand. You have been granted a fixed number of shares. In this example it’s 1200.
Basics of an NSO Exercise #2: Price
As you can see above, the STRIKE PRICE, or the price you pay for each share, is $1.00. It is also important to know the EXERCISE PRICE which is what each share is worth on the day you purchase it. The spread between the exercise price and the strike price is the amount you stand to make per share if you sold at exactly the same time that you exercised. For instance, if you exercise the stock when it’s value is $10 per share:
Exercise price: $10.00 per share - Strike price: $1.00 per share = $9 per share profit
Then, you can multiply the number of shares by $9 to figure out the total profit. If you sold the whole 1200 share grant, it would be 1200 x $9 = $10,800. But remember, you pay ordinary income tax on that!
This also shows one of the most important fundamental concepts of NSOs (and indeed all stock options): you want to strike price to be as low as possible. If another employee had joined the company two years later and got the same 1200 shares but at a $8 strike price, they would only make $2 per share ($10-$8=$2).
Stock options are meant to be an incentive to take the risk of joining an early stage company. The earlier you join, the more you stand to make.
Basics of an NSO Exercise #3: Time
What I outlined above is a fairly typical grant. You will VEST, or be able to buy, 300 shares (¼ or 25% of the total grant of 1200 shares) one year from the date of the grant. This is referred to as the VESTING CLIFF, which you can see illustrated visually below: on a chart it really does look like a cliff. After that, 1/48th of the grant vests each month (25 shares) until the whole 1200 have been vested, which will occur exactly 4 years from the date of your grant.
Sometimes it’s easier to see this stuff visually. Here's the same view from the top, but now you have some more context.
So, what does it all mean when you put it together?
Stock options are supposed to be an incentive to stay, work, and make the company successful. That is why they vest over time. The cliff is intended to ensure that you are putting in some time before you are able to see a financial benefit from your options. Once the cliff passes, you get a big chunk of shares followed by a little every month going forward.
Theoretically, the value of the company will rise over time and as the number of share you have vested is also rising, the total value of the grant can grow quite dramatically. In the example shown above, the stock price 10x within the four years of the grant. Although that is very, very good, it is not unheard of in the startup world. Regardless, it’s best to keep your expectations of any gains firmly rooted in reality.
However, this does illustrate the power of NSOs as a wealth generator and incentive. If the company does well, so will you.
Exercising, selling, and monetizing your NSO employee stock option shares
If you want to benefit from your NSOs, then eventually you will need to exercise and (eventually) sell your shares. You are able to exercise as many shares as you have vested at any given point. In the example above, you would be able to exercise 300 shares on 1/1/2018, 325 on 2/1/2018, 1075 on 8/1/2020, or the full 1200 on 1/1/2019. The time that you choose to exercise your shares is incredibly important, as is the time that you choose to sell your shares, and both can have a large degree of bearing on your tax liability (although luckily this is simpler with NSOs than ISOs).
After you exercise your employee stock options, you need to sell them to turn your ownership into money. In the past, if the company who issued the grant wasn’t publicly traded on a stock exchange like the NYSE or Nasdaq, it was almost impossible to sell shares from an ISO grant. This is why IPOs are glorified in technology circles: without one, no one can sell the shares that they own and realize their gains. Nowadays, and especially with the rise of the Unicorn companies (private tech companies who have not gone public), there are a host of private markets that make selling privately held stock easier. However, it’s still difficult and comes with it’s own set of challenges.
Assuming the company has gone public, then the process of exercising and selling your shares is actually extremely simple. There are two basic types of exercise:
Straight Exercise: You pay the strike price ($1.00 per share in the example above) from cash, and all of the shares you exercise are then deposited in a brokerage account.
Sell to cover: You pay the strike price for your entire exercise by exercising and selling a portion of the shares. For instance, if you want to exercise 1000 shares at $1 a share, as in the example above, and the stock price is currently $100, then 10 shares will be sold to cover the exercise cost ($1000=$100x10). After selling the shares needed to cover the exercise, 990 shares are deposited in your account.
With either option, and again assuming the stock is publicly traded, you can choose to sell or hold the stock you purchase.
Do you have a stock option grant? Keep track of it with Personal Capital
If you have been granted a stock option grant, it is imperative that you keep track of its value over time. You can sign up (and use) Personal Capital to create your own vesting schedule for free. You can also monitor your other investments, along with your home and any debts so that you have a complete picture of your financial situation and net worth at any given time. Here’s what a vesting schedule looks like in Personal Capital: if you don’t know what yours looks like, then you are flying blind with your stock options.
Want to learn more about stock options?
There are a multitude of things you need to understand in detail in order to take maximum advantage of your ISOs. In this series, I’ll be going into each one in detail:
Part I: Incentive Stock Options
Part II: Valuing a stock option grant in an offer
Part III: 3 ISO tax mistakes and how to avoid them
Part IV: Planning the exercise of your options
Part V: Planning the sale of your options
