ISO Stock Option
Introduction to Incentive Stock Options (ISOs)
What Are Incentive Stock Options (ISOs)?
ISOs are a one of the most common type of equity compensation granted to employees. They are most commonly granted to private companies earlier in their life (seed-stage through series A/B/C).
ISOs grant employees the right to purchase company stock at a fixed price for a specified period of time. Although the options give the employee the choice to buy stock, they do not obligate them to do so. The ability to purchase shares usually becomes available over time through a vesting schedule. As employees vest in more of their grant, they earn the right to buy a greater portion of the shares (usually monthly or quarterly).
Relative to NSO stock options, ISOs have preferential tax treatment. But because of that, they also have some special rules and extra complexity (as detailed in sections below).
How ISOs Work/Key Components
Number of Shares
The number of shares stated in the option grant determines how many shares employees may purchase. Additional options must be earned through new grants to buy more shares.
Exercise Price
The exercise price is the fixed price per share at which the stock can be purchased when options are exercised. The exercise price is set at the time of grant and does not change over the life of the option.
Vesting Start Date
The vesting start date is exactly as it sounds -> the date the vesting begins.
For new-hire grants, vesting typically starts on the employee's start date.
For existing employees (getting new/additional grants), the vesting start date can vary, but is usually somewhat close to the grant date.
Vesting Schedule
The vesting schedule determines when an employee receives ownership of a portion of the shares. The key sub-parts of this are:
Vesting Start Date
Total Length (e.g. 4 years)
Vesting Frequency (e.g. Monthly, Quarterly, Yearly)
Cliff or No Cliff
And in less common cases -- other items like staggered schedules or acceleration may apply
IMPORTANT: Vesting schedules can (and frequently do) vary in many ways. See 🔗 Vesting Schedules for more info and examples.
Cliff Vesting ("Cliff")
Cliff's are a common feature of ISO grants, especially for new hires. A cliff is built into the vesting schedule, functionally modifying it so that no shares will vest until a minimum amount of time is met (i.e. the cliff time period). For new hires, a 1-year cliff is very common.
Why do companies use cliffs? Stock-comp is intended to incentivize employees to add value to a company. Cliff's help ensure a long enough tenure to add such value.
For example, let's say a new employee gets a 4yr, monthly vesting ISOs -- and then leaves the company after 3 months. Their value-add to the company is likely minimal, perhaps even negative (given they were being trained in the first 1-3 months):
With no cliff. The employee would have vested into 3 of 48 months.
With a 1-year cliff. The employee would not have vested into any shares.
Expiration Date
The date after which any unexercised vested options expire and can no longer be exercised. The expiration date is typically 7-10 years from the grant date. Any options not exercised before the expiration date are forfeited.
Are Shares Eligible to Be Exercised Early?
Some companies allow individuals to early exercise ISOs. If your company (and your specific ISO grant) allow early exercise, that means you have the option to exercise/purchase unvested shares before they vest.
If you choose to early exercise shares, you elect to be taxed on the difference (if any) between the strike price and fair market value now -- instead of waiting for the shares to vest and exercising those shares at the future vesting date.
This can benefit you if the company's stock price increases substantially.
But the return on investment could be materially negative in many scenarios, such as (i) the company performing poorly, or even average, and (ii) paying taxes upfront for shares you could forfeit if you leave the company before you vest into the shares.
See this strategy page for more info and examples: ISO Planning/Strategy
Early exercising requires you to file paperwork with your company and the IRS. If you early exercise, you must file an 83(b) election with the IRS within 30 days of exercising the options.
How ISOs Provide an Employee With Value
Companies grant stock options to give employees (or other individuals) the opportunity to financially participate in the company’s success. For ISOs, an individual has the right (but not obligation) to purchase company shares at a fixed price for a specified period of time.
If the company’s share price appreciates, the ISO (via its fixed purchase price) provides a financial benefit -> the ISO grantee could exercise/buy shares at a the (lower) fixed price detailed in their ISO and then sell those shares at a (higher) market price.
If the company’s share price does not increase significantly, ISOs may provide little or no value to an individual.
Key Things to Consider:
ISOs are likely to be illiquid for an extended time period. The options themselves cannot be traded, and employees must wait for a liquidity event, such as an IPO or acquisition, to be able to sell their shares and generate value.
The company's share price must increase for an ISO to have value. If the company struggles or only achieves mediocre success, the share price may remain flat or decline. And in that case, an ISO would have no value (since the market price would be at or below the exercise price).
Exercising ISOs
To exercise your vested ISOs, there are a few steps you must take:
Notify your company of your intent to purchase shares. If your company is Pre-IPO, you will need to find the right internal person/team. If your company is publicly traded, this will likely be facilitated by a brokerage firm (e.g. Schwab, Fidelity, E*Trade).
Pay the purchase price. With ISOs you need to purchase shares. You will pay the strike price listed in your option grant multiplied by the number of shares you're purchasing.
Determine if you will owe AMT. If the fair market value of the shares the day you purchase is greater than your strike price, then there is a bargain element. With ISOs, the bargain element is not subject to ordinary income taxes, but it is considered income for AMT tax, and as such, your purchase may result in an AMT tax bill.
Upon payment of the purchase price + taxes (if any), your company will issue you the shares of stock.
Your company will not calculate or withhold for taxes on ISOs (if any)
If an ISO exercise will result in AMT tax being due, that's your responsibility. There is no corporate withholding requirement for AMT.
Further, if you sell the ISO-exercised shares in the same year (a disqualifying disposition), your company is not required to withhold taxes, even though the gains will be taxed as ordinary income.
ISO Qualifying vs. Disqualifying Dispositions
What primarily makes incentive stock options (ISOs) unique relative to NSOs is their beneficial (but complex) tax treatment upon exercise and sale. Depending on a number of factors, the sale can be classified as either a qualifying disposition or a disqualifying disposition.
Qualifying Disposition
A qualifying disposition must meet two criteria:
An ISO is granted at least 2 years prior to the sale of the shares.
An ISO is exercised at least 1 year prior to the sale of the shares.
Disqualifying Disposition
A disqualifying disposition occurs if you fail to meet either of the two criteria specified above.
Why It Matters = Lower Tax Rate
The profits on the sale of the shares in a qualifying disposition are taxed as a long-term capital instead of regular income. This can reduce the applicable tax rate by as much as a 13% in some situations!
ISO Benefits, Drawbacks, and Less Common Elements
ISOs provide the opportunity to share in a company’s success. If the company stock appreciates significantly, the value of employee's ISOs increases as well.
Employees have the right but not the obligation to exercise and purchase shares. Employees can decide if, and when, to exercise based on their own financial and tax situation. Employees have considerable control over certain timing elements.
Favorable tax treatment (vs NSOs) #1: long-term capital gains taxes with qualifying dispositions. In a qualifying disposition, the profits from selling the ISO shares are treated as long-term capital gains. Currently, the long-term capital gains tax rate maxes out at 20% (+ 3.8% for NIIT), significantly lower than the top ordinary income tax rate of 37% -> a difference of more than 13%.
Favorable tax treatment (vs NSOs) #2: No FICA taxes for disqualifying dispositions. In a disqualifying disposition, if the sale price is greater than the exercise price, the delta is treated as ordinary income. However, unlike most ordinary income, ISO disqualifying disposition income is not subject to FICA payroll taxes (i.e. Social Security and Medicare taxes).
ISO Taxation
ISOs are tax-complex; please see our ISO Taxation page for details
ISOs are the most tax-complex type of stock-based compensation. Due to this complexity, we don't believe we can adequately detail the nuances of ISO taxation in 1-2 paragraphs for this "Intro to ISO Stock Options" page.
If you own ISOs, we strongly suggest you also read: ISO Taxation
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