Nonqualified Stock Options (abbreviated NSOs, NQSOs, sometimes NQOs, and often referred to as Nonquals) are a very common way for companies to compensate employees. They probably fall right behind Restricted Stock Units (RSUs) on the list of the most common equity compensation types.

The purpose of this article is to provide a quick reference that you can skim to quickly learn or do a memory refresh about important terms relating to Nonqualified Stock Options/NSOs. We’ve numbered the terms, but they aren’t necessarily sorted by order of importance.

NSO Term #1 - Grant Agreement

This is the agreement between you and your company that provides details about your NSOs. It will include many of the terms explained below, so we’ll be sure to specify which ones are typically called out in the grant agreement.

NSO Term #2 - Vesting Schedule

This is the agreed-upon timeframe in which your NSOs become yours and become available to exercise. A common vesting schedule is a 4-year vesting schedule. Under this vesting schedule, each year 25% of your total grant of NSOs becomes available for you to exercise. This is illustrated in the graphic below:

The vesting schedule within each grant is important to review because it can vary based on the grant you’ve received. For example, you could have received a grant of NSOs a few years ago that vests over three years, but your most recent grant may vest over four.

NSO Term #3 - Exercise Price

This is the price you must pay per NSO to obtain a share of company stock.

Say you work at Chime and received a grant of 10 NSOs. Detailed in that grant agreement, there will be a set price for which you can buy company shares. If that price was $25, you would pay $25 per NSO, $250 total, to exercise all 10 NSOs and receive 10 shares of Chime.

NSO Term #4 - Market Price

This is the price that your company is currently trading for. Most people look up values on Yahoo Finance, but you can look up the price at whatever brokerage company you use. 

If your company is not publicly traded, the value of your company is determined during a 409a valuation (probably another term you should know if your company is private).. In this valuation, the company publishes its market value per share to its employees. If you ask your compensation team, “What was [Your Company’s] latest 409a valuation per share?,” they will give you the market price.

There are at least two important reasons why you should regularly compare your exercise price with the current market price. One, because if the market price is less than the exercise price, you won’t want to exercise your NSOs because you could just buy the same shares for cheaper in the stock market. And two, there are tax consequences for exercising NSOs and the market value minus the exercise price will be taxable to you at exercise.

NSO Term #5 - The Spread

This is a term that refers to the difference between the Market Value and your Exercise Price. It’s also commonly referred to as the “bargain element.”

Being aware of the current spread of your NSOs will help you make decisions about whether you should exercise, and allow you to estimate your tax liability after exercising.

NSO Term #6 - Expiration Date

This is the date on which you will no longer be able to exercise your NSOs to purchase company shares. We cannot stress the importance of this term enough.

If you don’t exercise your NSOs by this date, you lose them. Sometimes your stock plan administrators will send you a reminder about upcoming NSOs that are expiring, but it’s ultimately your responsibility to remember when your NSOs expire. It is typical for expiration dates to reach as far as 7 to 10 years into the future. So if you received a grant of NSOs on 1/1/2020, it’s entirely possible that your grant of NSOs may not expire until 1/1/2030. You will want to triple-check to make sure you know the exact date.

NSO Term #7 - Ordinary Income

Sometimes also referred to as Compensation Income, Ordinary Income is income that is taxed at ordinary rates.

This term is important to know because when you exercise an NSO, the spread between the Market Value and Exercise Price will be taxed at ordinary income tax rates.

The U.S. tax system is progressive. This means that as you earn more, each new dollar earned will be taxed at a different rate. For example, if you have a salary of $200k a year, your highest tax bracket would be 32%. However, the entire $200k isn’t taxed at 32%. Your income works its way through each lower tax bracket, getting taxed at different rates. 

In the link above to NerdWallet, there’s an explanation with lots of good examples. 

NSO Term #8 - Capital Gains

A capital gain is the appreciation you’ve seen within an investment you own. For NSOs, a capital gain is the appreciation you’ve experienced since the date you exercised. Here is a link to the capital gains rates.

There are both long-term and short-term versions of capital gains. If you hold an investment for less than a year, it’s considered a short-term capital gain and will be taxable at ordinary rates, if you’ve held for over one year, it’s considered a long-term capital gain and has special tax rates.

Here’s a broad look of when you’ll owe different taxes with NSOs:

NSO Term #9 - Tax Withholding

This is the amount your employer sets aside to cover most/all of the taxes you’ll owe from exercising NSOs. When you exercise the spread, it is treated as taxable income, so your employer will require that you make some sort of plan to cover the taxes you’ll owe.

If you own NSOs and no longer work for the company, you’ll need to set aside taxes on your own or make arrangements with your previous employer to help you with the withholdings. Here’s a graphic showing the common withholdings people exercising NSOs need to consider:

NSO Term #10 - Sell to Cover

Sell to cover is a type of cashless exercise. (If you haven’t figured out how this is helpful yet, just keep reading.) 

When you exercise an NSO you’ll have to pay two things: (1) you’ll have to pay the exercise price, and (2) you’ll have to pay the taxes on the spread (assuming the current market price is higher than the exercise price). 

By using a sell-to-cover strategy, you’ll calculate the total amount you need to pay in exercise costs, and then you’ll add to that the amount you’ll owe in taxes. 

Once you have that number, the brokerage firm holding your options will let you exercise without putting up any cash, provided you sell the total amount of shares that equal the total exercise cost plus your expected taxes.

The shares that remain unsold are the shares that you can then hold for the long-term to sell at a later date.

NSO Term #11 - Same-Day Sale

A same-day sale is another version of a cashless exercise except rather than leaving some shares of the company to grow, you exercise and sell everything immediately.

We covered many more tips and tricks to manage your non-qualified stock options in our NSO Basics article, but being familiar with these 11 terms will help you negotiate your equity compensation more effectively and empower you make wiser decisions financially. 

Fun fact: If you do consulting work for a public company or even a private company, it’s very likely that you can negotiate payment in the form of stock rather than just money. Beyonce did this for Uber and received a grant of $6M RSUs rather than $6M cash. The same can be done with NSOs.

As always, thanks for reading.