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Not So Obvious: Here's What To Know Between NSO and ISO Stock Options

Stock OptionEquityEmployee

Nat Disston   May 18, 2017

The world of startup stock options can be pretty opaque. To outsiders, its seems all one does is join a small company, and, if it works, everyone becomes millionaires. For new employees, they often don’t know what they don’t know and are faced with piles of new documents and more questions once they join their budding business. Core to our mission is to help educate employees, companies, and their founders about their stock options and what they can do with their resulting shares.

We’ve had the good fortune of an engaged community of readers and this post is a direct response to a reader request. If you have anything you’d like to see discussed on these pages, please let us know! Here, we dive into a common point of confusion around ISOs (Incentive Stock Options) and NSOs (Non-Qualified Stock Options). But first…

What the heck is a stock option?

A stock option is a right to purchase a share of stock at a specific price within a specified period. Stock options are often used as long term incentive compensation for management and employees at high-growth companies. Once an employee exercises (buys) their stock options, they become stock in the underlying company. More on that here.

So back to the ISOs and NSOs. What drives the main point of confusion? You may have heard some discussion at the watercooler/ping-pong table that “ISOs have better tax treatment.” But with the labyrinthine American tax code, let’s circle above this topic at a few thousand feet.

Do ISOs really have better tax treatment? Maybe, but it’s not so black and white. ISOs are complicated because they can only be issued to employees (and not to contractors, lawyers, or outside vendors), must be priced at Fair Market Value (FMV, which is the same as a 409A valuation), and there are limits on how they vest and how much can vest in a given year (up to $100K). NSOs can be granted to anyone with no limit on volume or exercise price.

But Nat…which ones do I want???

(Disclaimer: I’m no tax expert and must advise you to speak to an accountant or financial advisor regarding your own situation.) NSOs are straight forward in that you must pay ordinary income tax on any gains at the time of exercise. If the current FMV is now $5 and your exercise price is $1 (FMV at time of grant), you pay ordinary income on the $4 paper gain. Furthermore, this tax event is withheld by your employer and may be tax deductible for them: another win for your employer. ISOs, on the other hand, don’t have any required tax at the time of exercise, which sounds nice but can be misleading. The fact is that exercising ISOs may make you subject to the AMT (Alternative Minimum Tax), which for most startup employees will be the case, and can lead to quite a surprise come tax season. Kind of like a club that has no cover charge at the door, but sells you $20 beers.

Still with me? We’re almost done! Remember: taxes are boring, but your taxes are important.

A commonality between NSOs and ISOs is that you will owe taxes when you exercise either type of options. Once the options are exercised, however, they are perfectly equal – stock in your company. This is important to note for EquityZen’s business, because they are treated the same way on the secondary market.


NSOs and ISOs differ in how they are taxed. And while there may be instances that ISOs have better tax treatment, each case is a little bit different. Fun Fact: a large part of EquityZen’s business is helping employees cover their exercise cost and subsequent tax bill, regardless of whether they’ve exercised ISOs or NSOs.

Demystifying 409A Valuations

Stock OptionValuation409AIlliquidShareholder

Shriram Bhashyam   November 15, 2013

This is part 1 of a 2 part series.  Click here for part two.

Founders and management should familiarize themselves with 409A valuations early in the company’s life. Section 409A of the Internal Revenue Code will come into play once you start to think about hiring. We’re here to help and we’ve brought in the big guns. We’ve enlisted friend of EquityZen and business valuation guru Bo Brustkern to answer fundamental questions about 409A valuations. This is the first in a series of blog posts on 409A valuations, and future posts will address more nuanced topics.

Bo is Managing Director and founder of Arcstone Partners1, experience as an investment and valuation professional. He has been quoted in a variety of publications, including The New York Times and Financial Times. The format is Q&A—let’s get right into it…

EquityZen (EZ): What is a 409A valuation?

Finalized in April 2007, Internal Revenue Code section 409A applies to discounted stock options and stock appreciation rights (SARs) defined as deferred compensation.

Under section 409A, stock options that have an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges. In short, the consequences for noncompliance, which affect the individual who holds the options and not the issuing company, are significant.

To avoid these consequences, management teams can issue options with an exercise price at FMV, and section 409A provides clear approaches on how to develop compliant policies. These safe harbors shift the burden of proof of noncompliance to the IRS. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the FMV.

EZ: What are the key inputs in determining a 409A valuation?

It depends on the stage of the company and complexity of transactions, but factors considered include financial statements (historical and projections), capital structure/rights and preference of securities, market/industry outlook, business model/outlook, public comparable companies/comparable transactions, and expectation/probability of timing for exit and failure.

EZ: At what point is a company required to do a 409A valuation?

A company must do its first 409A valuation prior to the first issuance of stock options.

EZ: How often must a company do a 409A valuation?

A company must do a 409A valuation every 12 months at a minimum, and any time a major change has occurred that either reduces risk or materially changes forecasts. Practically speaking, this means after a new round of financing is raised), or after any transaction involving the company’s assets (e.g., the company has acquired another, or divested itself of material assets).

EZ: What is “fair market value”?

Fair Market Value (FMV) refers to the age-old standard of value to which the IRS adheres. Fair Market Value is defined in IRS Revenue Ruling 59-60 as:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
Revenue ruling 59-60 goes on to say that:
Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
There is also Fair Value (FV), or the GAAP valuation standard, which is defined by the Financial Accounting Standards Board (FASB). For 409A purposes, the FMV is the standard of relevance; but most 409A valuation reports these days comply with both FMV and FV standards.

Questions or comments? Please use the comments section below or contact us at hello@equityzen.com. Click here for part two.

1 Arcstone Partners is a business valuation specialist firm whose bread and butter is 409A valuation for tech companies. Clients include Instagram and Quora.