Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) are a type of employee compensation that grant the right, but not the obligation, to purchase shares of an employer's stock at a predetermined strike price after meeting certain criteria—typically a vesting period.  These options are "non-qualified" because they do not meet the requirements set forth by the IRS to be considered "qualified" (or "incentive") stock options.  NSOs differ from Incentive Stock Options (ISOs) in their tax treatment and regulatory requirements.

Key Terms:

• Grant Date: The date the NSOs are issued to an employee.

• Strike Price: The price at which the employee can purchase the company’s stock.

• Vesting Period: The period after which the employee can exercise the option to purchase the stock.

• Exercise Date: The date when the employee exercises the option to purchase the stock.

• Expiration Date: The date after which the option can no longer be exercised.

• Bargain Element: The difference between the strike price and the market value of the stock at the exercise date.

Companies typically issue NSOs as a component of employee compensation in order to attract talent and to align the interests of employees and shareholders.  NSOs offer employees the option to participate in the potential financial upside of a company liquidity event, such as an IPO or acquisition, without the need to make a near-term cash outlay or investment.  The potential value of vested NSOs can attract key employees to join the company and deter them from leaving, especially if they believe the company has a bright future.  NSOs can also be useful as equity compensation to reward non-employees such as contractors and service providers.

Tax Considerations:

• At Exercise: The difference between the market value of the stock when you exercise the NSO and the exercise price (the "bargain element") is considered taxable compensation and is subject to ordinary income tax.  Employers are generally required to withhold taxes on this amount.

• At Sale: The sale of stock acquired through NSOs can result in a capital gain or loss.  The tax treatment is favorable if the stock is sold at least one year after the exercise date, qualifying for long-term capital gains.

• Alternative Minimum Tax (AMT): While Incentive Stock Options (ISOs) are more commonly associated with the AMT, there are scenarios in which NSOs could also trigger AMT considerations.  Consult with a tax advisor regarding your specific situation.

Financial Planning Considerations:

• Timing of Exercise:  The decision on whether and when to exercise NSOs should be based on a range of factors, including the current market value of the stock, the exercise price, potential for future appreciation, and individual financial goals.

• Liquidity Needs:  Exercising NSOs requires a cash outlay from the employee to pay the strike price and any taxes that are not withheld by the employer.  Plan your liquidity accordingly, especially if you intend to hold the stock long enough to qualify for long-term capital gains.

• Diversification: NSOs should be valued as a component of compensation and factored into overall portfolio diversification from an investment perspective.  Holding a significant portion of wealth in a single stock carries risk.

• Employment Changes: Leaving the company can affect NSOs. Typically, the NSO plan stipulates a limited time to exercise vested options after employment termination.

• Market Conditions & Company Performance: Stay informed about market conditions and the overall economic environment.  Understand the competitive landscape and industry trends that could impact your company’s stock price and the value of NSOs.

Potential Early Exercise:

Early exercise refers to the act of exercising stock options before they have vested.  Check the specific terms of your NSO plan to determine if this option is available to you.  In the context of NSOs, early exercise may have certain tax advantages by allowing the employee to start the clock on the holding period for long-term capital gains tax treatment prior to vesting.  Early exercise can also help minimize the amount subject to ordinary income tax by locking in a lower bargain element if the stock price is expected to appreciate.  However, if the stock’s value decreases after early exercise, the employee might incur a loss.  Also, if an employee leaves the company before the shares are fully vested, the unvested shares may be forfeited, depending on the company’s policy.

In conjunction with early exercise, employees may opt for an 83(b) election with the IRS, allowing them to pay taxes on the bargain element at the time of the early exercise, which can be beneficial if the stock is expected to appreciate significantly by the time it vests.  To make an 83(b) election, the employee must file with the IRS within 30 days of the purchase of the unvested stock, pay tax on the bargain element, and send a copy to their employer.  However, the risk is that if the shares decrease in value or if the employee leaves the company before the shares vest, the upfront tax paid cannot be recovered.

Conclusion:

Non-Qualified Stock Options are a valuable form of equity compensation that allow employees to participate in the financial benefits of company building.  However, NSOs require careful financial planning and consideration of tax implications, market conditions, and individual financial circumstances.  We recommend consulting financial and tax advisors with expertise in equity compensation planning.  If you need help finding one, do not hesitate to reach out.  We are here to help you find a trusted financial advisor that is right for you.