Equity, tax and compliance
Stock Options 101 for Startups: ISO vs NSO, 409A Valuations and Early Exercise
The short answer
A stock option is the right to buy a set number of shares at a fixed exercise price, usually vesting over four years with a one-year cliff. Incentive stock options (ISOs) can go only to employees and are not taxed at exercise for regular tax purposes (though the spread counts for the alternative minimum tax); non-qualified options (NSOs) can go to anyone and are taxed as ordinary income on the spread at exercise. Every option must be priced at or above the fair market value of the common stock on the grant date, which startups support with an independent 409A valuation refreshed at least every 12 months and after each financing.
Key numbers
| Rule | Figure | Source |
|---|---|---|
| Standard employee vesting | 4 years, 1-year cliff, monthly | Market practice |
| Maximum option term | 10 years (5 years for ISOs to 10%+ holders) | IRC Section 422 |
| ISO exercise price for 10%+ holders | 110% of fair market value | IRC Section 422 |
| ISO annual limit | $100,000 of stock (valued at grant) first exercisable per year; excess is NSO | IRC Section 422(d) |
| Post-termination exercise window for ISO treatment | 3 months (12 months on disability) | IRC Section 422 |
| ISO qualifying disposition | More than 2 years after grant and 1 year after exercise | IRC Section 422 |
| 409A safe harbor validity | Up to 12 months, or until a material event | Treas. Reg. 1.409A-1(b)(5)(iv) |
| Penalty for discounted options | Income at vesting, plus 20% additional federal tax and interest | IRC Section 409A |
How a grant works
- The company adopts an equity incentive plan approved by the board and the stockholders and reserves a pool of shares.
- The board approves each grant: holder, number of shares, type (ISO or NSO), exercise price (at least the 409A fair market value), vesting schedule and vesting commencement date.
- The holder signs a notice of grant and option agreement.
- As options vest, the holder may exercise by paying the exercise price and signing an exercise agreement.
- After leaving the company, the holder usually has 90 days to exercise vested options.
Offer letters should say that a grant "will be recommended to the board", not promise a number of options at a specific price.
ISO vs NSO
| Feature | ISO | NSO |
|---|---|---|
| Who can receive | Employees only | Employees, directors, advisors, contractors |
| Tax at grant | None | None (if priced at fair market value) |
| Tax at exercise | No regular tax; spread is an AMT adjustment | Ordinary income on the spread; withholding for employees |
| Tax at sale | Long-term capital gain if holding periods met | Capital gain on growth after exercise |
| Company deduction | None (unless disqualifying disposition) | Yes, equal to the employee's income |
| Limits | $100,000 per year rule; 3-month post-termination window | None |
Worked example: exercising 40,000 options
An engineer holds 40,000 vested options with a $0.50 exercise price. The current 409A value is $3.00. Exercise cost: $20,000. Spread: (3.00 - 0.50) x 40,000 = $100,000.
- NSO: $100,000 of ordinary income at exercise (subject to income and payroll tax withholding), even though the shares cannot be sold. At a combined 35% marginal rate, about $35,000 of tax on top of the $20,000 exercise cost.
- ISO: no regular income tax at exercise. The $100,000 spread is an adjustment for the alternative minimum tax (AMT); depending on the engineer's other income, AMT may or may not be due. If the shares are held more than 2 years from grant and 1 year from exercise, the whole gain on sale is long-term capital gain.
- Risk: if the company's value later falls, ISO holders may have paid AMT on paper gains (partly recoverable later through the AMT credit) and NSO holders may have paid income tax on value that disappeared.
The $100,000 limit
Only $100,000 worth of ISO shares (valued at the grant-date exercise price) can first become exercisable in any calendar year; the excess is automatically treated as NSOs. A grant of 400,000 options at $1.00 with a one-year cliff makes 100,000 shares ($100,000) exercisable at the cliff, exactly at the limit; any extra vesting in the same calendar year becomes NSO. Early exercise rights can cause all options to be "exercisable" at once, so they usually push most of a large grant into NSO territory.
409A valuations
Section 409A treats an option priced below fair market value as deferred compensation, which can tax the holder at vesting and add a 20% federal penalty plus interest (some states add more). To avoid this, startups obtain an independent appraisal of the common stock, which provides a safe harbor: the IRS must show the valuation was grossly unreasonable.
- When: before the first grant, at least every 12 months, and after any material event (a priced round, a term sheet, a major contract or acquisition offer).
- What it reflects: the preferred stock's liquidation preferences and rights, so common is usually valued well below the latest preferred price.
- Cost: commonly a few thousand dollars at early stages, sometimes bundled with cap table software.
- Mistake to avoid: granting options after signing a term sheet using the old, lower 409A value.
The post-termination exercise window
Most plans give departing employees 90 days to exercise vested options. Because the exercise price plus taxes can be large, many employees cannot afford to exercise and lose their options. Some companies extend the window (for example to 5 or 10 years) for employees with a minimum tenure. Note that ISOs exercised more than 3 months after employment ends are taxed as NSOs.
Early exercise
An early exercise provision lets holders exercise unvested options and receive restricted stock that vests on the original schedule, with the company able to repurchase unvested shares at cost if they leave. If exercised when the exercise price equals fair market value and the holder files an 83(b) election within 30 days, there is no tax at exercise, the capital gain holding period starts, and the QSBS clock starts for the shares. The trade-off: the holder pays cash up front for shares that might never be worth anything.
A first employee receives 100,000 options at $0.10 right after the 409A. Early exercise cost: $10,000. With a timely 83(b) and FMV equal to the exercise price, no tax is due. If the company is acquired five years later at $8.00 per share, the gain of $790,000 may be long-term capital gain and possibly eligible for the QSBS exclusion, instead of ordinary income or AMT on exercise.
Securities law for option grants
Option grants to employees and consultants are securities offerings. Most private companies rely on Rule 701, which allows compensatory grants up to the greater of $1M, 15% of total assets or 15% of the outstanding class in any 12 months, and requires additional disclosure (including financial statements) if more than $10M is granted in 12 months. Some states, including California, have their own requirements.
Frequently asked questions
What is the difference between ISOs and NSOs?
ISOs are available only to employees and receive favorable tax treatment if holding periods are met, with possible AMT at exercise. NSOs can be granted to anyone and are taxed as ordinary income on the spread at exercise.
Why do startups need a 409A valuation?
To set the exercise price at fair market value and avoid Section 409A penalties for discounted options. An independent appraisal provides a safe harbor.
How long is a 409A valuation valid?
Up to 12 months, unless a material event such as a financing occurs earlier.
Can advisors receive ISOs?
No. ISOs can only be granted to employees. Advisors, directors who are not employees and contractors receive NSOs or restricted stock.
What happens to my options if I leave?
Unvested options are forfeited. Vested options can usually be exercised within 90 days after you leave, or as your agreement provides.
Should I early exercise my options?
It can make sense when the exercise price is low and you file an 83(b) within 30 days, because it starts capital gain and QSBS clocks. You risk losing the money if the company fails.