Non-qualified Stock Option (NSO) Basics
Non-qualified stock options (NSOs) give their recipient a way to purchase stock at a set price no matter what the price actually does. They are often abbreviated and referred to as NQs, NSOs, NQSOs, or Nonquals. We might be missing an abbreviation or two, but they all refer to the same thing.
Regardless of what you call them, you’ll want to understand the basics of NSOs so you can make the most of them.
NSO Beginner Basics
We like to compare stock options to buying concert tickets for an artist that might become famous.
When you buy a concert ticket you’re (1) paying real money for something that has some value, (2) there’s probably some taxes you pay at purchase, (3) you’re buying what you think will be a good show/experience, (4) there’s potential you can sell your ticket for a big profit, (5) there’s also potential the show is terrible and you wasted your money.
If you’ve held NSOs or other options, you can related to this.
NSO Key Terms and Example
Here’s an example of what an NSO summary may look like over the span of a few years:
There are a lot of terms in the table above most of which are self-explanatory. Grant Number, Grant Date, and Grant Type are all important but likely don’t need much explaining.
Highlighted in gray is the amount of NSOs you’ve been Granted at various moments in time. Each option you’ve been granted equals one potential share. You have to exercise each option in order for you to officially own stock.
The Grant/Exercise Price is the amount you must pay to your company to receive a share of stock in exchange for the option. When you do this, it’s called an Exercise.
The Current Value is the current market value of your company. This will either be the company price on the stock market or if your company isn’t traded on the stock market, the Current Value will be made known in your company’s latest 409a valuation. (This is a Basics article, so don’t worry too much about this yet.)
The Vested column in this scenario shows how many options you’re able to exercise. Many companies grant options that follow a 4-year vesting schedule. This means that for each year you work at the company after the grant, 25% will become available to exercise.
The Exercised column The Exercised column shows how many options you have exercised (i.e. paid the grant/exercise price to the company).
Exercising a Batch of NSOs
In the table above, you have 1,000 Vested NSOs that can be exercised. For each one of these NSOs, you’ll need to pay the Grant/Exercise Price of $1 Let’s say you do this on 1/1/2020.
To exercise the full 1,000 NSOs you will pay $1,000 to Gryzzl. This is a killer deal because each share is actually worth $20!
You know what a great deal you’re getting by paying $1,000 to receive $20,000 in value, but guess what? The IRS also knows what a great deal this is and will want their share.
That $19 difference between the Current Value and Grant/Exercise Price is known as either the “bargain element” or “spread.” And it will become taxable income upon exercise.
In this scenario, if you had a salary of $70,000 and exercised this batch of 1,000 NSOs, you would have $19,000 added to your income for the year. On your tax return you will not only show $70,000 of income, you will also show the additional $19,000 for a total income of $89,000.
NSO Tax Timing
The following graph illustrates the timing of taxes:
Illustrated above, you can see two things:
That the spread (difference between value at exercise and the exercise price) will be taxable on the exercise date.
If there is a gain after exercising, it will be either be a short term or long term capital gain.
I’ve Exercised My NSOs, Now What do I do?
As described in the example above, if you’ve exercised NSOs, you’re going to have a tax bill so you’ll want to be strategic about how you proceed and be sure to weigh the pros and cons of exercising and potentially selling stock from your NSOs.
There are three common strategies to pay the taxes owed from exercising NSOs and you can do a combination of any of them:
Sell All Exercised NSOs at Exercise
If you’ll owe the full taxes on the difference between the current value of the stock and the exercise price, it’s often recommend that you should sell all of your exercised options since there’s not an immediate tax benefit for holding.
This means that you won’t have any short-term or long-term gain from holding onto the shares since you’re selling immediately, but if you sell everything, it also means that you could miss out on future gains.
Sell Enough to Cover Taxes
If you think there’s a lot of upside in the company and you’re financially able to take the risk, an option you have is to simply sell enough of your exercised NSOs to cover your expected tax bill.
There are lots of risks associated with this strategy, so depending on the stage of the company and how many NSOs you have, it may be worth discussing with a professional.
Exercise All NSOs and Pay Taxes with Cash
This option is the most “risky” because it means that you’re betting even more on the company that you already are. In order to fully fund expected taxes with cash, you usually have to coordinate with your employer since usually employers will withhold some taxes when you exercise.
Final Thoughts on NSO Basics
The biggest takeaway to remember is that NSOs are taxed potentially both at exercise and at the sale. We’ve written another article that dives deep into the taxation of NSOs and will be a great follow-up read.
Because of the two instances where NSOs can be taxed, it’s important to make a plan before you exercise NSOs so that way you don’t find yourself scrambling to pay taxes you weren’t fully expecting.
If you want to review your NSOs and come up with a good exercise strategy, that’s a part of what we do.