NSO Stock Option
Introduction to Non-qualified Stock Options (NSOs)
What Are Non-Qualified Stock Options (NSOs)?
NSOs are a popular form of equity compensation given by private companies to employees. They are most commonly granted to private earlier in their lives (seed stage through series A, B, and C).
NSOs grant employees the right to purchase company stock at a fixed price for a specified period of time. Although the option gives the employee the choice to buy stock, it does 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).
How NSOs 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. For more info and examples see: Vesting Schedules
Cliff Vesting ("Cliff")
Cliffs are a common feature of NSO 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 NSOs -- 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 NSOs. If your company (and your specific NSO grant) allows 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.
For more info and examples see: NSO Planning/Strategy
Early exercising requires you to file paperwork with your company and the IRS. If you exercise early, you must file an 83(b) election with the IRS within 30 days of exercising the options.
How NSOs Provide Employees With Value
Companies grant stock options to give employees (or other individuals) the opportunity to financially participate in the company’s success. For NSOs, 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 NSO (via its fixed purchase price) provides a financial benefit -> the NSO grantee could exercise/buy shares at the (lower) fixed price detailed in their NSO and then sell those shares at a (higher) market price.
If the company’s share price does not increase significantly, NSOs may provide little or no value to an individual.
Key Things to Consider:
NSOs 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 NSO 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 NSO would have no value (since the market price would be at or below the exercise price).
Exercising NSOs
To exercise your vested NSOs, 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 NSOs, 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.
Pay applicable income taxes (if any). If the fair market value of the shares on the day you purchase them is greater than your strike price, then there is a bargain element and you will owe income taxes on that. The tax must be paid when you purchase the shares (your company is required to collect and withhold them).
Upon payment of the purchase price and taxes (if any), your company will issue you the shares of stock.
NSO Benefits, Drawbacks, and Less Common Elements
NSOs provide the opportunity to share in a company’s success. If the company stock appreciates significantly, the value of employees' NSOs 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.
NSO Taxation
NSOs are options, and thus the owner of the NSO has a reasonable degree of control over the timing of taxation on their shares (i.e. when they choose to exercise). Otherwise, taxation is relatively straightforward.
Not taxed at grant or vesting. NSOs do not trigger any tax implications when they are granted to an employee or when they vest.
Ordinary income tax treatment on bargain element when exercised. When an employee exercises their NSOs, if the fair market value of the shares is greater than the NSO strike price, a bargain element exists and the individual will owe ordinary income taxes.
Capital gains tax applies after exercising. After exercising, you own shares. And just like any other investment in stock/equity, the value can increase or decrease. If the value increases, it results in a capital gain; if it decreases, it results in a capital loss.
Beyond this simplistic overview, there's a lot to consider and strategize on. For more details see: NSO Taxation
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