What is a NSO grant?

What is a non-qualified stock option (NSO)? Also known as a non-statutory stock option because we need more jargon in the legal world. Please note we’ll discuss the NSOs more famous cousin the incentive stock option (ISO) in next week’s Founder FOMO).

An NSO is a typical stock option, but is “non-qualified” because it does not provide the holder with the ISO’s favorable tax treatment. However, what an NSO lacks in favorable tax treatment, it partially makes up for with its flexibility.

We should first discuss the NSO’s tax treatment and why it’s considered less favorable than an ISO. For any option, there are 3 phases of an option when taxes may arise – at the time of grant, exercise, and sale of the underlying stock.

At grant, an NSO is typically not taxable unless it has no readily ascertainable fair market value at the time of grant (which it usually doesn’t).

At exercise, an NSO requires the holder recognizes ordinary income on the spread (ie. the difference between the fair market value of the shares received and the exercise price of those shares) and the issuer can also recognize a tax deduction for that ordinary income amount.

At sale of the stock, the holder also must recognize any capital gain or loss on the difference between the sale price and the sum of ordinary income that was previously recognized and the exercise price originally paid.

Consequently, NSOs aren’t considered tax favorable for startup companies because of the need to recognize ordinary income at the time of exercise even though the underlying stock is restricted and illiquid without a market to sell the shares.

So why do companies issue NSOs if they’re not tax favorable?

For one, a company may have no choice because it is issuing options to certain types of service providers such as consultants, advisors, and non-US taxpaying employees are ineligible for receiving ISOs. These types of service providers are still valuable to the startup, so an NSO at least gives them the opportunity to assume some of the inherent risks of the startup and potential higher rewards in owning equity. A company also can't issue ISOs if it is not taxed as a corporation.

Startups may also prefer NSOs because of the flexibility they offer. Unlike ISOs, NSOs can be exercised more than 3 months after a holder’s service to the company terminates, allowing workers to depart and wait to see if/when the startup will experience a liquidity event. Further, unlike ISOs, NSOs do not need to be exercised within 10 years of grant, so a holder has much more time to decide if/when to exercise. NSOs are also more freely transferable because ISOs are only transferable upon a service provider’s death.