What’s the difference between incentive stock options (ISOs), nonqualified stock options (NSOs), and Restricted Stock? May 27, 2010

Posted by hubtechinsider in Boston Executive Moves, Definitions, Investing, IPOs, Management, Staffing & Recruiting, Startups, Venture Capital.
Tags: Startups, stock options, Venture Capital
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What is the difference between the types of stock options? How many different kinds of stock options are there?

I am often asked questions about negociating stock options as part of a Boston high tech or IT job compensation package for an executive or management position. I am a successful entrepreneur and businessman who has handed out and received stock options. I have found to my surprise that prospective employees that I have spoken with regarding this topic leave me with the distinct impression that they have sat through job interviews listening to a company executive or recruiter talk about subjects such as “incentive and nonqualified stock options”, “vesting periods”, “strike price”, and “dilution”, nodding their heads in mute agreement, as if they understood everything.

First off, if you are serious about assessing equity incentives, and stock options in particular, you need to familiarize yourself with the lingo. I have included the Hub Tech Insider’s Glossary of Stock Options Terminology below, at the conclusion of this article. If you want to know the difference between incentive stock options (ISOs), nonqualified stock options (NSOs), and Restricted Stock, then I will attempt to shed some light on the confusion by writing about the different types of stock options.

Incentive Stock Options qualify for preferential tax treatment – the key preference being that the recipient can delay paying taxes on stock acquired by excercising the option until the stock is actually sold. If the recipient sells the stock right away, any gain is treated as ordinary income, which gets taxed at the same rate as your salary; but if the stock is held for a year, any gain qualifies as a capital gain, which is taxed at a maximum of 20%.

It is important to note that incentive stock options can only be granted to employees (as opposed to consultants or other contractors). Nonqualified options can be handed out to consultants, contractors, outside directors, and anyone else the company wants, but the recipient pays taxes on the difference between the excercise price of the option and the value of the shares as ordinary income as soon as the shares are acquired, rather than when the shares are sold. That means the recipient may wind up paying taxes before receiving any money.

Restricted stock can best be thought of as a mirror image of incentive stock options. Instead of being made available for purchase over a period of time, as incentive stock options are, restricted stock is given out all at once when an individual joins a company, usually with the restriction that it be sold or given back to the company if the employee leaves the company before a certain period of time has gone by. The reason more companies are making restricted stock available to certain senior executives is that it offers a potential tax advantage: because executives get their hands on the stock as soon as they join the company, they have a god shot at fulfilling the one-year holding period necessary to qualify for capital gains treatment on any profits from the eventual sale of the stock. Given how fast some companies are going public or are acquired, the capital gains treatment can result in significant tax savings.

The Hub Tech Insider Glossary of Stock Option Terminology:

Above Water – Options allowing the purchase of shares of stock for less than the market price are said to be “above water”.

Authorized Shares – The number of shares of stock available for a company to issue.

Bearish – Having a negative opinion about the future of the stock market.

Bullish – Having a positive opinion about the future of the stock market.

Capital Gains – The profit gained from the sale of an investment, such as stock, which is taxed at lower rates than ordinary income.

Cashless Exercise – Allows an individual to temporarily borrow the money needed to excercise options by selling some of his/her stock in order to cover the cost of the remaining shares.

Cliff Vesting – Allows option holders to excercise some or all of their options at once, such as after the first year of employment, instead of incrementally over a period of several quarters or years. (See Vesting Period)

Equity – Common stock in a company.

Exercise – The act of acquiring stock promised by an option.

Exercise Price – The price at which an option holder may buy shares of stock. Often referred to as the strike price.

Expire – Options are typically granted for a definite period of time. If individuals do not excercise the options before a specified date, they expire (meaning they are forfeited).

Forfeit – Employees forfeit or forego their right to exercise their options by leaving a company before all the options have vested – or by not exercising them before their date of expiration because they are “under water”.

Founders Stock – Shares in a company held by the initial founders, usually subject to certain restrictions as to their disposition.

Fully Diluted Capitalization – The total number of shares outstanding or set aside for issuance (such as shares in a stock option plan).

Immediate Vesting – When one company has been bought by another, all options that have been issued by the acquired company are automatically available for immediate excercising, or vesting.

Incentive Stock Options (ISOs) – ISOs can only be granted to employees, as opposed to outside consultants or contractors. Their advantage is in allowing holders to acquire stock without paying taxes on their gain in value until they sell the stock.

Incremental Vesting – Period of time during which options become vested gradually, such as quarterly, which is specified in an option agreement. Such vesting is also referred to as vesting on an incremental basis.

Initial Public Offering (IPO) – An IPO is a company’s first sale of stock to the public.

Insider – An insider is any officer, director, advisor, or investor of a company that is public or about to go public. Because of his or her inside knowledge of a company’s financial plans, an insider is restricted in trading the company’s stock based on information not disclosed to the public.

Liquidity – How easily an investment holding can be converted into cash. Shares of stock are liquid if there is a ready market for those shares, meaning that the shares are available to be bought and sold. If a company is privately held, the stock is sai to be illiquid.

Lockup Period – A period of time that insiders of a company are required by an underwriter to hold onto shares of stock gained from exercising options before being allowed to sell. Once individuals exercise options, they may not sell these shares for the entire lockup period, often one year.

Long-term capital gains – Profits from an investment held longer than one year. These gains are subject to tax rates that can be as high as 20%.

Nonqualified Stock Options (NSOs) – NSOs can be granted to anyone (employees, outside consultants, contractors, directors, and others). However, the receipient pays taxes on the difference between the price of the options and the value of the shares as soon as the shares are acquired, rather than when the shares are sold.

Offering Statement – A statement prepared by the underwriters and distributed to potential investors before a company goes public.

Option Agreement Letter – Document given by a company to an employee to legally grant options.

Option Grants – The number of shares a recipient can acquire via options.

Ordinary Income – Income subject to regular income tax rates, such as salary.

Par Value – The monetary value shown on a security.

Phantom Stock – Can be converted into real stock at some point in the future when certain predetermined events occur. Often referred to in the context of executive bonus plans tied to increases in a public company’s share price.

Preferred Stock – A class of stock that has advantages over common stock in the event of a sale or liquidation of the company.

Privately Held – A company that is owned by one or several individuals or institutions but not by the “public”. Shares of privately-held companies are said to be illiquid.

Publicly Held – A company is considered publicly held – or owned by the public – if its shares are traded on a public stock exchange (like the New York Stock Exchange or NASDAQ). A company can be publicly held even if the majority of its shares are still owned by the company’s original founders and investors.

Registration Statement – A statement required by the SEC in order for a company to conduct an IPO.

Repricing Options – When companies, usually publicly held, adjust the prices on stock options lower in consideration of a decline in their share prices that may place their employees’ stock options ‘under water’. Companies shy away from this practice because it means incurring an accounting charge against profits.

Restricted Stock – Stock available for purchase immediately upon joining a company, but subject to vesting and other conditions.

Securities and Exchange Commission (SEC) – The federal agency charged with ensuring that the investing public has access to all of the relevant and materail information about every public company traded on a US market.

Shares – Ownership in a company.  Usually referred to as shares of stock.

Shares Authorized – The number of shares of stock that a company is allowed to issue, whether they are outstanding or are held in treasury by the company.

Shares Outstanding – Stock held by investors, as opposed to shares held in the company treasury.

Short-term Capital Gains – Profits from an investment held less than one year. These gains are subject to taxes at regular income tax rates, which often exceed 20%.

Spread – When options are “above water”, the spread is the difference between the grant price and the stock’s market value.

Stock – Equity or ownership ina company commonly referred to as common
stock.

Stock Option Plan – An employee incentive plan that allows employees of a company the option to buy shares of stock in the company at a specified price at some point in the future.

Stock Options – These grant the right, but not the obligation, to buy shares of stock at a specified price within a particular time interval, and with a specific expiration date.

Stock Purchase Plan – A plan to encourage employees to take a personal financial stake in the company by offering shares of stock for purchase at a discount – usually in the range of 10-15% – over their “open market” purchase price.

Stock Split – Companies will often declare a split, often a 2-for-1 split, which will reduce by half the price per share and double the amount of shares outstanding.

Strike Price – The price at which an option holder may buy shares of stock. Often referred to as the exercise price.

Under Water – If an option does not allow the purchase of shares of stock for less than the market price of those shares, the option is said to be “under water”.

Underwriters – Investment bankers who in effect buy a stake in the company and then sell this stake to the public. The underwriter guarantees a minimum price for the sale of the company in return for a premium on the shares sold to the public if demand outstrips supply.

Venture Capital Firms – Investment vehicles funded by wealthy individuals looking to take risky stakes in promising new companies and technologies in return for both control and a share of future profits.

Vesting Period – Period of time during which the option holder is allowed to exercise incrementally more options that have already been granted. Vesting typically occurs over periods of three to five years in corresponding increments of 20% to 30% vested per year.

Warrants – An investment vehicle similar to options, allowing for purchase of stock at a specific price before a particular date or in the future.

Want to know more?

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About the author.

I’m Paul Seibert, Editor of Boston’s Hub Tech Insider, a Boston focused technology blog. You can connect with me on LinkedIn, follow me on Twitter, even friend me on Facebook if you’re cool. I own and am trying to sell a dual-zoned, residential & commercial Office Building in Natick, MA. I have a background in entrepreneurship, ecommerce, telecommunications and software development, I’m the Senior Technical Project Manager at eSpendWise, I’m a serial entrepreneur and the co-founder of Tshirtnow.net.

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