Non-Qualified Stock Option - NSO

Qualified: Think qualified for favorable, long-term gains tax treatment. If you have qualified stock options, aka incentive stock options, or ISOs - and they are relatively rare, they are generally only given to the very first, i.e. single-digit number of employees joining a company then those employees get the benefit of being able to buy out their stock options, and having them become fully owned common stock shares.

This ability is a huge benefit, not just for the meaningful vibe of being able to feel like and actually be a co-owner of the company, but because it usually means that the employee-investors will qualify for much cheaper tax rates when they eventually do sell. If the employee does not buy out the options, there is no difference in tax treatment. That is, these options are treated just like the less qualified non-stock options, or NSOs.

The number which can be granted to a company are limited, and if a company violates this number by granting too many, the company is taxed heavily, as it is viewed by the IRS as having used "falsely" cheap stock to pay key employees. Catchily, that's called the Cheap Stock Rule.

The granting of these kinds of compensatory stock options can only be given to employees-slash-insiders of the company. They have to be granted at a fair market value strike price, i.e. whatever the 409a valuation calculated by lawyers and bean counters said that the company was worth, that’s the valuation the strike price has to reflect for the common stock.

These types of stock options carry a maximum life of 10 years. And then there are the 10% rules. That is, for at least 10% of the shareholders, the exercise price of these options has to be 10% greater or more than the fair market value of the company at the time. Because these options receive such favorable tax treatment, their strike price has to carry a premium.

And lastly, the maximum cap or value of these stock options, for any individual, cannot exceed $100,000 as exercised or bought out in any one year. In other words, they are designed only for very early employees with companies carrying very low valuations.

Okay, so that’s qualified stock options. The other end of the world? Non-qualified stock options. Those options can, in fact, also be bought out, but upon that transaction, employees are taxed as if they are direct compensation, and those taxes are levied as ordinary income, i.e. the very high tax rates.

So in practice, most employees getting qualified stock options buy them out immediately... and usually there is a negotiation before that employee is hired, such that their commitment to the company is made clear by their tacit agreement to buy out their qualified options.

For employees with non-qualified stock options, the buyout usually doesn’t happen, and those options are viewed as gentle lottery ticket potential big wins way down the line, should the company do well.

Example time.

OK, so you and your roommate both joined Shmoopflix early. You both received the same grant of 100,000 options at a $1 a share strike price.

How was this dollar calculated? Lawyers and bean counters were hired, for a small fee, to make their own valuation assessment of the company, and when they completed that review, they determined that, if the company were sold today, its common shares would command a dollar each on the open market, or eBay, wherever the company was sold.

That number is called the 409a valuation, and the strike price of those options applies to both qualified or ISOs, and non-qualified stock options. Unfortunately, because you only majored in econ, your package gave you non-qualified stock options, whereas your roommate was an engineer, so she received qualifieds.

Not a big deal at the time. You didn't really care.

Other than the one little thing, which was that your roommate borrowed $100,000 to buy out all of her options at the time. A risky move, because if the company had gone bankrupt or done poorly, that hundred grand would have been zero…fast. However, because they were ISOs, she did not pay any tax on the exercise.

So then along comes an IPO, and the stock rocks, and the 4 years pass, and Shmoopflix is, conveniently for this example problem, hovering around $31 a share. It is 30 bucks in the money. And then you both go to sell.

Your roommate pays a 25-ish% long-term gains tax on the 30 dollars times 100,000...or 3 million bucks. That is, she pays 750 grand in taxes, to net 2.25 million. You, however, pay 50% ordinary income tax on the 3 million bucks in gains to net 1.5 million.

You paid a lot of tax - so it's a good problem to have … but wow - the little word NON on your non-qualified options plan cost you 750 thousand bucks of winnings. Ouch.

So this sounds like Silicon Valley magic, where everyone gets rich and becomes a millionaire by the time they finish their bar mitzvah. Oh so not the case. In fact, most startup companies in Silicon Valley go fully bankrupt. So, had a tax-avoiding, more greedy-than-fearful employee bought out all of their options, qualified or not, and then the company was sold for ⅔ of the value of its preferred stock investment, the common stock would be wiped out. Worthless. And all of the money the employees spent buying out their options would be gone.

So the business of betting big on startups is not one for the faint of heart, but going in, the presumption is that you’ve carefully watched this video, and others on Shmoop finance, and you know the witch and warlock dance between risk and reward.

Make sense? Make dollars.