Participant Education and Communication: What’s the difference between incentive stock options (ISOs), nonqualified stock options (NSOs), and Restricted Stock? Hub Tech Insider

 

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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.

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