Non-Qualified Stock Option (NSO)

What is a Non‑Qualified Stock Option (NSO)?

A non‑qualified stock option (NSO) is a contract that gives an employee the right to buy a set number of company shares at a fixed price (the exercise or grant price) for a limited time. NSOs do not meet the IRS requirements for incentive stock options (ISOs), so they are taxed differently.

How NSOs are used

• Employers use NSOs to compensate and retain employees while conserving cash, especially in startups and smaller companies.
• Options typically vest over a schedule; unvested options are forfeited if the employee leaves before vesting.
• Each option has an expiration date. If not exercised before that date, the option is lost.
• The expectation is that the company’s share price will rise, allowing employees to buy shares below market value.

Vesting, forfeiture, and clawbacks

• Vesting: Options usually become exercisable only after meeting time- or performance-based conditions.
• Forfeiture: Leaving the company before vesting generally results in losing unvested options.
• Clawbacks: Companies may include provisions to reclaim options under certain circumstances (e.g., misconduct, insolvency, or a buyout).

When to exercise NSOs

• A common rule: exercise when the current market price exceeds the exercise price and before the option expires.
• Consider tax consequences, cash needed to exercise, your belief in the company’s future, and any holding‑period requirements for favorable tax treatment on later gains.
• You can exercise and immediately sell (to capture gains and cover tax/costs) or exercise and hold (to pursue additional upside but assume market risk).

Taxation of NSOs

• At exercise: The difference between the market price at exercise and the exercise price (the “spread”) is treated as ordinary income and is reported on your W‑2. Employers typically withhold income and payroll taxes and may be liable for employer payroll taxes.
• After exercise: Your cost basis in the shares is the market price at the time of exercise.
• On sale: Any gain or loss between your cost basis and the sale price is a capital gain or loss.
• If you sell within one year of exercise, gains are short‑term and taxed at ordinary income rates.
• If you sell after holding the shares more than one year, gains qualify for long‑term capital gains rates.
• Note: NSOs do not trigger the alternative minimum tax (AMT) in the way ISOs can.

Pros and cons

Pros:
– Potentially large upside if the company’s stock rises.
– Aligns employee incentives with company performance.
– Useful for companies that want to conserve cash.

Cons:
– Risk of options becoming worthless if the stock falls or never exceeds the exercise price.
– Exercising can create an immediate tax bill and cash outlay.
– Possible vesting, forfeiture, and clawback provisions may limit value.

Should you accept NSOs as part of compensation?

• Evaluate the company’s prospects, the size of the grant relative to total equity, and how much cash you’ll need to exercise and pay taxes.
• If the company is early‑stage, the risk is higher but potential reward can be greater. If growth prospects are uncertain or the optioned equity is a small slice, it may be preferable to negotiate higher salary or cash compensation.
• Consult a tax advisor or financial planner to model expected tax and cash flows around exercise and sale decisions.

Key takeaways

• NSOs let employees buy company shares at a preset price for a limited time.
• The spread at exercise is taxed as ordinary income and reported on your W‑2; subsequent gains or losses are capital gains/losses.
• Consider vesting schedules, expiration dates, tax impacts, and company prospects when deciding whether and when to exercise.