Stock Options (ISO vs NSO)

Stock options give someone the right to purchase shares of your company at a predetermined price (the exercise or strike price) within a certain time window. They're the primary tool startups use to attract talent they can't afford to pay market-rate salaries. There are two types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), and the difference is mostly about taxes.

ISOs are available only to W-2 employees (not contractors or board members) and receive favorable tax treatment. When an employee exercises ISOs and holds the shares for at least one year after exercise and two years after the grant date, any profit is taxed as long-term capital gains (typically 15-20%) rather than ordinary income (up to 37%). However, the difference between the exercise price and the FMV at exercise can trigger the Alternative Minimum Tax (AMT), which catches many employees off guard.

NSOs can be granted to anyone — employees, contractors, advisors, board members. They're more flexible but less tax-advantaged. When you exercise NSOs, the spread between the exercise price and the current FMV is immediately taxed as ordinary income. No special holding period requirements, but no capital gains benefit on the initial spread either. Most startups grant ISOs to employees (for the tax benefit) and NSOs to non-employees (who aren't eligible for ISOs).

As a founder, you'll be granting options to almost every early employee. Understanding ISO vs NSO helps you structure compensation packages that are genuinely valuable to your team — and helps you explain the tax implications so employees can make informed exercise decisions. Missteps here can lead to employees facing unexpected tax bills or missing out on favorable tax treatment. Your legal and tax advisors should guide the specifics, but you need to understand the basics.