Stock options are a major player when it comes to equity compensation, especially for those who work in the tech startup space. Not to be confused with their cousin, restricted stock units, they come in two flavors: nonqualified stock options (NQSOs) and incentive stock options (ISOs). We’ll focus on ISOs here!
Quick Tip!
The world of ISOs is filled with lots of fun terminology. To help make things easier, I’ve included a list of essential vocabulary at the bottom of this post.
I suggest glancing at that first! If you’ve only just been handed your first ISO award, the vocabulary alone will be well worth reviewing.
As far as milestones go, ISO grants and the cascade of decisions that need to be made after create quite a series of inflection points in your financial journey. Beyond helping you speak the language, we’ll take a comprehensive approach to understanding incentive stock options in the context of your life.
In an attempt to do it justice, I’m going to break up the topic into a series of 3 separate posts with their own general theme:
- In this post, we’ll explore exactly what ISOs are
- In Part 2, we’ll get into the various tax implications to anticipate and prepare for
- And in Part 3, we’ll cover a framework for decision-making – how to actually position ISOs as a tool to support your goals
So stay tuned for the follow-up pieces!
With that, let’s jump into the “what” of incentive stock options…
Overview
Put simply, an “incentive stock option” is an agreement between you and your employer that gives you the right to buy stock in your company at a pre-determined price, as long as certain conditions are met. They are commonly offered as part of an overall compensation package at early-stage, private startups (alternatively, RSUs are more typically offered at public companies). Note that options are merely that… an option. It is your choice to act on them, not a requirement.
ISO ≠ a stock
ISO ≠ an obligation
The greatest incentive stock option success stories have produced millionaires overnight thanks to the unique ability of ISOs (in a best case scenario) to amplify and speed up the most fundamental rule of investing: buy very low → sell for a lot higher.
Of course, sound planning (and, to be fair, in plenty of cases, a healthy dose of old-fashioned luck) goes a long way in leading to such positive results.
The Life Stages of an Incentive Stock Option
To help further understand how this type of equity compensation can generate such wealth, let’s lay out the basic mechanics of ISOs.
Grant
ISOs are given to employees in the form of a “grant” or award. This usually happens at the point of hire and/or later on when compensation is adjusted, or as part of a promotion. These grants are for batches of ISOs. For example, a grant might be in the form of 100 ISOs – which means that you receive the option to purchase up to 100 shares of your company at a future point.
Vesting
Enter the first component of the “incentive”. Your employer has said, “Here’s this potentially awesome benefit, but… you’ll need to stick around for a while if you want to actually reap the reward.”
You won’t be able to do anything with your ISOs right away (*unless your employer allows for early exercise – more on this later*). Instead, you’ll have to wait patiently for the ISOs to vest over time. Only after they vest are you then able to do “the something” that creates any real value for you. You’re likely to see a schedule that starts with a “cliff”. During this time, no ISOs will vest at all. But once that cliff ends, they’ll begin to vest according to the established schedule. For example, if the schedule is quarterly for 4 years with a 1-year cliff – the first set of options will vest 12 months from the date of grant and then each quarter thereafter for the next 3 years.
Exercise
We’ve arrived at another aspect of the “incentive”. As soon as the ISOs vest, you have the opportunity to convert them into shares of company stock. Put another way, you can now choose to exercise your option to buy the stock.
The perk is this: You get to purchase the underlying stock for the stated “strike price”, which is specified at the time of grant. The idea – and hope – is that the strike price (for which you buy the stock) is LESS THAN the current fair market value (amount you could immediately sell the stock for). If that’s the case, then you are able to produce tangible cash value from the incentive stock options if you exercise and sell them right away.
Alternatively, you may choose to exercise the ISOs and then hold onto the shares, hoping for even more growth in the stock price before eventually selling (plus a long enough holding period to create a “qualified disposition” – more below). Either way, exercising an option leads to ownership of the stock. Once you own the stock, it is then yours to sell when you like.
In terms of ISOs, this is the first big decision you’ll have to make. Note that you do NOT have to exercise your options at the moment of vesting. You can decide to do so later on, or not at all. Additionally, it’s up to you how many ISOs you exercise – it’s not an all-or-nothing deal.
Be aware that, if you don’t exercise, the options have an expiration date. In most cases, they will expire after 10 years.
Sell
Upon taking ownership of the underlying stock, the next major question becomes… When do you sell? Of course, you don’t derive any true value from a stock until it is sold for more money than you bought it for.
Let’s take a look at an example that illustrates how this could play out…
Virginia works for a hot new tech startup called Sovereign AI.
After Virginia’s grant, Sovereign AI experienced a liquidity event and went public. As a result, the stock is currently trading on the open market at $25 per share.
Let’s say today is February 2nd, 2025, and Virginia has not done anything with her ISOs yet.
If she were to exercise all the shares that have vested so far (200), she would pay a total of $100 (200 x 0.50). She could then sell them immediately for $25/share. Doing so would result in proceeds of $4,900 ([200 x 25] – 100), before taxes.
* We have not accounted for any taxes in this example *
Admittedly, this is a pretty straightforward example. Nonetheless, it shows us the basic lifecycle of an ISO…
Grant → Vest → Exercise → Sell
Oftentimes, an employee will see their options vest before a liquidity event occurs. While the value of their private company stock at the time of vest may be higher than the strike price, it might not be by much. Still, it can be wise to exercise even at that point and hold onto the stock until a later date. Or maybe there’s a scenario where the current value of the company stock is less than the strike price – meaning the options are worthless. If that’s the case, the best thing could be to hold off on exercising until the value hopefully goes back up.
What to Expect if You Leave Your Employer
There are some important things to be aware of in the event your employment comes to an end, whether by choice or otherwise. It all comes down to the life stage of the stock option…
Those unvested ISOs...
They go away.
Vested ISOs that you haven’t yet exercised...
You can still exercise after leaving, but only up to a certain point. Your company will give you a set window within which you can exercise any remaining vested options before they expire – oftentimes this is as short as 90 days. If you have more time, know that the options will lose their more tax-beneficial ISO status after 3 months and automatically convert to nonqualified stock options.
Options that you’ve already exercised...
That’s now stock you own outright, so nothing changes there.
If you’re planning a departure from your current employer, be sure to factor in the ISO-related decisions and the associated timeline that will come with the transition.
A Couple of Special Rules
Early Exercise
Some companies will allow for employees to exercise their options early – even before the vest date. This can be a wonderful opportunity to consider since it creates additional tax benefits, but it does carry additional risk. It also requires filing paperwork with the IRS, called an 83(b) election, within 30 days of exercising.
$100k Limit
While many recipients of option grants won’t have to worry about this, it is necessary to know the total annual value of your ISOs, based on the fair market value of the stock at the time of grant. The IRS doesn’t want people benefiting too much from ISOs (classic), so they have put this limit in place. Simply put… If the value of the shares scheduled to vest in a given calendar year, multiplied by the FMV of the company stock at the time of grant, is greater than $100,000 → any options beyond that threshold are treated as nonqualified stock options instead of ISOs.
Tax Essentials
Ok ok… I know I said taxes will be in a separate post, but some elements are crucial to know from the jump. I’ll expand on these and include more in the follow-up piece. After all, what REALLY sets “incentive” stock options apart from their nonqualified counterpart comes down to the tax treatment.
First off, let’s address when there is a taxable event…
You can easily see how taxes may not come into play at all until it’s time to sell the shares.
Exercising and Taxes
For many people, there will be no taxes owed when they exercise ISOs – creating an impactful tax advantage over nonqualified stock options. However, for some, exercising could mean paying Alternative Minimum Tax – thus making it critical for everyone to be mindful of what this is.
AMT is a totally separate tax “system” (Form 6251) than the one most of us are accustomed to (Form 1040). In other words, it is an entirely different method for calculating tax liability for the year. Certain conditions require someone to figure out their tax liability under “ordinary” income tax rules and then run the calculation for the alternative minimum tax. They then have to pay whichever amount is higher for that year. If someone exercises ISOs and does NOT sell them within the same year – this is a condition that requires them to run the AMT calculation. More specifically, the difference between the strike price and fair market value of the stock at exercise (spread) is included as income when figuring AMT liability.
Tax Treatment at the Time of Sale
To recap where we are: Many people will pay zero taxes on ISOs at the time of grant, vest, and exercise (assuming AMT doesn’t apply). That means that taxes often don’t even enter the equation until the stock is eventually sold, at which point we will assess the impact in one of two ways: “Qualifying Disposition” or “Disqualifying Disposition”.
Qualifying Disposition...
A qualifying disposition means that the shares were held at least two years beyond the date the ISOs were granted AND at least one year past the exercise date. If these conditions are met, then the difference between the sale price and strike price (amount you paid at exercise) will be taxed at the more favorable long-term capital gains rates.
Disqualifying Disposition...
If you fall short of those two conditions, then the sale is considered a disqualifying disposition. In this situation, the tax treatment is less beneficial. The difference between the strike price and the FMV on the date of exercise is taxed at ordinary income rates. Then, the difference between the FMV at exercise and the eventual sale price is taxed at either short-term capital gains (ordinary income) or long-term capital gains rates – depending on how long the shares were held after exercise (Did you hold for one year of less? STCG… Did you hold for more than one year? LTCG).
Wrapping It Up
If you are awarded incentive stock options as part of your compensation package, start with learning the lingo (below!). Then, make sure you understand the life stages of an ISO and the timing of each. This will create a powerful foundation from which you can start building out your strategy. To round it out, familiarize yourself with the tax implications of each possible decision and consider how a given scenario can support your personal financial goals – see Part 2 and 3!
ISO Vocabulary
Incentive Stock option
An option or right to purchase stock in your company at a pre-determined price.
Grant
The award of a set of incentive stock options. A “grant” is typically given to an employee at hire, and/or as comp is adjusted up based on positive performance. Grants usually come in “sets” of ISOs (for example, 100 ISOs).
Exercise
The act of executing your right to buy shares in your company under the rules of your incentive stock option plan. This is the point at which you take ownership of the stock.
Vest
The moment at which you can first exercise your options. ISOs come with a “vesting schedule” – a period of time you must wait before you can exercise. You do NOT have to exercise as soon as the options vest. It is your choice whether or not you exercise and when. However, they will expire at some point, typically after 10 years.
Cliff
Sometimes included at the front end of a vesting schedule. This is a duration of time – immediately after a grant is awarded – during which no options vest. Once this period has passed, the options will begin to vest according to the terms of the grant. A common cliff is one year.
Fair Market Value
The underlying value of a stock. For publicly-traded companies, this is simply the stock price at any given point of time.
409A Valuation
In the context of ISOs, this is the current assessed fair market value of a private company’s stock. With private companies, you can’t simply google the stock symbol to find the price. Instead, you must check with your employer to learn the current 409A.
Strike Price
Also referred to as the “exercise price”. This is the “pre-determined” price at which an employee is able to purchase the stock in their company – under the rules of the incentive stock option grant. The hope is that – at the time of exercise – the strike price is lower than the current fair market value of the stock, meaning there is immediate value in taking advantage of the option to exercise.
Spread
Also referred to as the “bargain element”. This is the difference between the strike price and the fair market value of the company stock on the day of exercise.
Holding Period
The amount of time that passes from the point of exercising (purchasing) your company stock until you sell the stock. In other words, this refers to how long you own (or hold) the stock.
Qualifying Disposition
Refers to the process of selling your company stock (purchased through an incentive stock option plan) that receives more favorable tax treatment on the bargain element at sale. In order to meet the required thresholds, you must hold the stock up until at least 2 years from the date of grant and at least 1 year from the date of exercise. If these thresholds are met (and assuming there is a gain), then any sale from that point forward qualifies for “long-term capital gains” tax treatment (a lower tax rate than ordinary income tax rates). This preferential tax rate is applied to the entire gain – the value between the exercise price and sale price.
Disqualifying Disposition
Refers to the sale of company stock (acquired through an incentive stock option plan) that does NOT receive preferential tax treatment, at long-term capital gains rates, on the bargain element. In this case, the stock is sold before meeting the thresholds outlined above for a “qualifying” disposition. Therefore, the spread (difference between the exercise price and FMV on the date of exercise) is taxed at the individual’s ordinary income tax rate. Any additional gain beyond the spread will still be taxed based on the holding period from exercise. If the stock was sold in one year or less, those additional gains are also taxed at ordinary income tax rates. If the stock was sold more than one year after exercise, then just those additional gains will be taxed at long-term capital gains rates.
In the Money
Means that your incentive stock option is worth something! Put another way, it’s the scenario when your exercise price is lower than the current FMV – meaning that if you were to exercise and then sell right away, you’d make money.
Out of the Money
Means that your incentive stock option is worthless… In this scenario, your exercise price is higher than the current FMV – meaning if you were to exercise, you would be paying more for the stock than it’s actually worth. Subsequently selling it would lose you money.
Alternative Minimum Tax
A totally separate tax “system” (Form 6251) than the one most of us are accustomed to (Form 1040). In other words, it is an entirely different method for calculating tax liability for the year. There are certain conditions that require someone to figure out their tax liability under “ordinary” income tax rules and then run the calculation for the alternative minimum tax. They then have to pay whichever amount is higher for that year. If someone exercises ISOs and does NOT sell them within the same year – this is a condition that requires them to run the AMT calculation.
83(b) Election
Allows for early exercise of options, even before the set vesting schedule, with the potential for more beneficial tax implications. This election simply locks in the “spread” at the date of the early exercise. The hope is that this results in a lower spread, thus reducing or eliminating AMT liability, and starts the holding period clock earlier than would otherwise be possible. The election must be filed with the IRS within 30 days of exercise.
Liquidity Event
A major transition event for a company that creates significant potential value for an employee holding company stock or incentive stock options. Common examples include an Initial Public Offering (IPO) or acquisition. This event creates an opportunity for the stockholder to easily sell their stock for greater value than what it was purchased for – or for an option holder to simultaneously exercise the options and sell the underlying stock for more than the strike price.
Eddy Jurgielewicz, CFP® is a Partner and Lead Financial Planner at Upbeat Wealth, a fee-only firm based in New Orleans and serving clients virtually across the country. He specializes in providing straightforward financial guidance to ambitious young families as they navigate life’s many milestones.
Do you have questions about what we shared in this post, or anything else in general? Feel free to schedule a free consultation or drop us a line!
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