ISOs vs. NSOs: Employee Stock Options and Exercise Windows Explained

Stock options are one of the main ways startups attract and reward talent. But not all options are the same. In the US, options come in two main types, incentive stock options (ISOs) and non-qualified stock options (NSOs), with very different tax consequences for the people who hold them.

Understanding the difference, and how exercise windows work, helps founders design better equity plans and helps employees avoid costly surprises. This guide explains both.

1. How Stock Options Work

• An option gives the holder the right to buy shares at a fixed price, called the strike or exercise price.
• The strike price is usually set at the fair market value of common stock on the grant date, supported by a 409A valuation. See choosing a 409A valuation provider.
• Options typically vest over time, often four years with a one-year cliff.
• The holder profits if the company's share value rises above the strike price.

2. Incentive Stock Options (ISOs)

• Only for employees, not contractors, advisers or non-employee directors.
• No regular income tax at exercise, but the difference between the share value and strike price can trigger the alternative minimum tax (AMT).
• Potential long-term capital gains treatment on the full gain if shares are held for at least two years from grant and one year from exercise, a "qualifying disposition".
• Selling earlier creates a "disqualifying disposition", with part of the gain taxed as ordinary income.
• Annual limit: only up to $100,000 of options, measured by grant-date value, can first become exercisable as ISOs in a year; the excess is treated as NSOs.
• Maximum term of ten years, with stricter rules for holders of more than 10% of the company.

3. Non-Qualified Stock Options (NSOs)

• Can be granted to anyone, including contractors, advisers and directors.
• Taxed as ordinary income at exercise on the difference between the share value and the strike price, with withholding for employees.
• Later gains or losses are taxed as capital gains or losses.
• More flexible, with no annual limit or holding requirements.

4. Comparing the Two

• For employees, ISOs can be more tax-efficient, especially if shares are held long enough, but AMT can create a large bill at exercise.
• For companies, NSOs can create a tax deduction when exercised, while ISOs in qualifying dispositions generally do not.
• For non-employees, NSOs are the only option.

5. Exercise Windows After Leaving

When an employee leaves, they usually have a limited time to exercise vested options before they expire. The traditional window is 90 days.

• Why 90 days? ISOs generally must be exercised within three months of leaving employment to keep ISO tax treatment.
• The problem: exercising can require significant cash for the strike price and taxes, often before shares can be sold.
• Extended windows: some companies offer longer post-termination windows, sometimes several years. Options exercised after three months are generally treated as NSOs.

Longer windows are more employee-friendly but can keep more shares outstanding and affect the option pool. See the option pool shuffle.

6. Early Exercise

Some companies let employees exercise options before they vest. Combined with a timely 83(b) election, this can start capital gains holding periods early and reduce tax, though it requires paying the strike price upfront and risks losing money if the company fails. See the 83(b) election.

7. Tips for Founders and Employees

• Founders: decide on a post-termination exercise policy deliberately, communicate it clearly and keep a current 409A valuation.
• Employees: understand which type of options you hold, model AMT before exercising ISOs, and plan for exercise costs before leaving a company.
• Both: consider liquidity options such as tender offers. See secondaries and tender offers.

Frequently Asked Questions

Which is better, ISOs or NSOs?

ISOs can be more tax-efficient for employees who meet holding requirements, but AMT and liquidity needs can complicate that. NSOs are simpler and available to non-employees.

What happens to my options if I leave?

Unvested options are usually forfeited. Vested options must typically be exercised within the post-termination window, often 90 days, or they expire.

What is AMT?

The alternative minimum tax, a parallel tax calculation that can apply when exercising ISOs, based on the spread between share value and strike price.

Can a company change ISOs to NSOs?

ISOs can become NSOs in certain situations, such as when exercised more than three months after employment ends or when they exceed annual limits.

The Bottom Line

ISOs and NSOs both give employees a stake in the company's success, but their tax treatment differs sharply. Founders who design thoughtful plans and exercise windows, and employees who understand their options and plan ahead, can avoid surprises and make equity work as intended.

Global Capital Network connects founders with investors and advisers through our events and investor network. Get in touch to learn more.

This article is general information, not tax or legal advice. Option tax rules are complex; consult a qualified adviser.