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ISOs vs. NQOs

I'm doing some work for a friend of mine who is setting up his C-corp and an option plan. I have done many of these at my past and current companies and each time I have had counsel create a plan with ISOs as well as NQOs b/c "everyone" wants to exercise early and start the clock for long-term capital gains treatment. With incredibly few exceptions that has been a bad thing for the employees and the company. The employees tie up money that they lose if the company does not pan out and there is no payback to the option holders. The company has to create a bunch of paper for each early exercise, track it, and deal with employees getting up in arms over every new 409a valuation and every month-end close ("hey, how's my stock doing?"). It just doesn't seem worth it.

So I wanted to ask the other CFOs and practitioners out there whether they think it makes sense to do ISOs or not, and just make NQO options available to employees. Many thanks.

Answers

Konrad Sosnow
Title: Revenue Recognition Guru
Company: Konrad M. Sosnow & Associates
(Revenue Recognition Guru, Konrad M. Sosnow & Associates) |

At start-up time, common stock options are valued at a relatively low price and so not a lot of money is tied up. The ISO tax advantages are significant, but don't forget that tax rates go up next year,

On the other hand, once a company is public the stock option prices are usually such that they represent a significant amount and a thus a significant risk.

Michael Jameson
Title: VP Finance
Company: Undisclosed
(VP Finance, Undisclosed) |

I find ISOs are a dangerous thing for employees. They hear about the "great tax advantages" from someone or the internet and they just dive in and exercise early. Most of the time (just given the statistics) early-stage companies do not have an exit that takes advantage of the early exercise tax benefit (starting the clock sooner on LT cap gains) and thus the employees, who can typically ill afford to gamlbe on stock, find themselves staring at a write-off. I am not a big fan of taking options (no pun intended) off the table for employees, but I would think hard about offering them out.

Of course having tricks up your sleeve can be useful at surprising times, so you might want your counsel to allow ISOs, but simply not use them unless there is a truly compelling reason to do so.

Keith Taylor
Title: CFO
Company: Lyris, Inc.
(CFO, Lyris, Inc.) |

Mark, I don't quite get Conrad's or Michael's comments -- stock options are a necessary / critical offering to employees of startups or private companies expected to be acquired or eventually go public. A MUST-DO.

So, your questions were - 1) ISOs, NQOs, or both? and 2) What to do about employees and early exercises

Question #1: TRENDS ARE AWAY FROM ISOs to NQOs
Radford and Cooley Godward published a report in the past 2 years that indicated that many VC-backed startups were moving away from ISOs to NQOs -- why? 1) Broader adaptability of NQOs(employees and consultants/3rd parties can be issued NQOs vs ISOs); 2) To reflect the reality that companies want to discourage exercise especially if employees terminate, but still hold the shares - the VCs would rather have the shares return to the pool for reissuance to current/future employees. To me, they're cleaner, simpler, and from a practical standpoint keep tracking generally to current employees/consultants.

TAX IMPLICATIONS
To be clear the tax advantages of ISOs are that there is no taxable event to the employee until they are sold. NQOs on the other hand have a taxable event to the employee when they are exercised, which can be very onerous. Regardless, I NEVER encourage employees to exercise their ISOs or NQOs until we're in line of sight to a liquidity event. Even if an IPO is imminent, the holding period for most employees is at least 180 days, if not longer, and so there's no rush for them to exercise and hold for Capital Gains treatment, because with no less than six months to prepare for IPO then the six month holding period, there should be no quetsion that any sale will be treated as Capital Gain. And the exercise price was locked in anyway. The only caveats to this are the $100K limit, the 83b election issue, and encouraging exercise when the FMV (409A validated) and thus the tax (to the employee exercising) would put any taxable gain at a bare minimum.

Keith

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

Keith's comments are right on the mark. ISOs are useful instruments, if only because employees expect them. If, as you mention, folks really do want to early exercise their options, NSOs can be early exercised just the same as ISOs, so ISOs do not offer any additional benefit in an early exercise situation.

Professionally, I prefer (and recommend) NSOs and it generally is just a matter of properly educating the employee base about the differences for them to understand the real differences between ISOs and NSOs. As a CEP, when I am asked the ISO v NSO question, the first big hidden issue that comes to mind are the AMT consequences of ISOs. So many folks got slammed with huge AMT tax liability for exercising their ISOs during the dot com boom and had no money to pay because the stock prices had tanked by the time they found out about the tax liability (sometimes only months later). And even though equity compensation professionals and entrepreneur blogs posted extensively on this, regular employees don't really understand what happened and why and continue exercising their ISOs oblivious to the potential consequences.

In short, it's important for employees to understand these points about ISOs:
1. Even though there is no payroll tax on the ordinary income that is the gain at the time of ISO exercise (the difference between the purchase price and the current market price on the date of exercise), that same gain can push you into an income bracket that requires a separate calculation of the Alternative Minimum Tax (AMT) AND YOU MAY HAVE TO PAY TAXES ON THE GAIN ANYWAY.
2. The only way to avoid this is by selling the ISOs before the end of the calendar year in which they were purchased. This is called a disqualifying disposition and changes the treatment of the gain to the same as an NSO - the gain will be treated as ordinary income and you will have to pay taxes. The difference is that you will pay the tax at the time you file your income tax return and not at the time of the exercise. The other important difference is that the tax will be calculated in the standard way, not the AMT way, and that's important because when calculating tax liabilty for AMT purposes many normal itemized deductions are not allowed for the purpose of reducing your taxable income.
3. By the time you take all your documents to your tax advisor to prepare your annual return it is too late because you have missed the end of the calendar year and any disqualifying disposition will not affect the ISO status of the exercised stock at the end of the tax year. This is the worst scenario because a large gain on an ISO exercise could, in this situation, have the potential to trigger AMT liability for the preceding year's taxes and then when you have to sell the stock in the following year to pay for the AMT taxes it will be a disqualifying disposition so you then lose the tax benefit of the original ISO exercise and you'll have to pay taxes on the gain at sale as if it were ordinary income instead of short term capital gain.
4. In private companies there is the additional danger that there is no market for selling the shares in order to trigger a disqualifying disposition that might save an employee from AMT tax liability. This is also true of an employee holding ISO stock during an IPO lockup period that spans two tax years (go back and read the nightmare scenaroi in item #4).
5. If you are going to exercise an ISO that has a potentially large gain, consult with your tax advisor first.

So, as you can see, there is a lot of hidden danger in ISOs that, once openly discussed, puts the ISO/NSO debate in a very different light.

Topic Expert
Rex Jackson
Title: EVP and Chief Financial Officer
Company: JDS Uniphase
(EVP and Chief Financial Officer, JDS Uniphase) |

I fully agree with the commentary above, and believe NQOs are the way to go today. Employees generally understand NQOs better, the ISO benefits are (as noted) more often than not unrealized, and the logistical/maintenance burden to the company for ISOs is significant.

Helen Rosen
Title: President
Company: Direct Approach Solutions, LLC.
(President, Direct Approach Solutions, LLC.) |

In reply to Achaessa James that's how the Enron employees lost their money.

But what about restricted stock instead of either ISO's or NQ's?

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

You're right, Helen, that is exactly how Enron employees lost their money. There are many alternatives to options, inclusing restricted stock, stock appreciation rights, restricted stock units, phantom stock, etc. The further one gets from options, the more resources will need to be dedicated to educating the recipients and managing the plan.

For start ups, restricted stock is generally reserved for the founders, who usually receive restricted stock grants at no cost or as if paid for by the money they have invested to start the company, and members of the executive team, who usually receive restricted stock purchase awards that require them to pay something for the stock. Both of these groups usually want to have skin in the game anyway, and they usually have the resources to participate financially at this early stage.

The problem with using restricted stock for regular employees is that if you give them a restricted stock grant that does not require them to purchase the stock, then they have to recognize ordinary income and pay income taxes for the value of the award either at the time the award is made using an 83(b) election, or at the time the award vests for the then-current market value. The former may be a small sum, but the latter could be a significant amount if the stock has gone up in value during the vesting period and that can cause serious problems if the stock vests before there is a public market that would allow the shareholder to sell some shares to cover the tax liability.

Likewise, if the stock is acquired through a restricted stock purchase, there is an initial outlay required to purchase the stock which may eventually have zero value if the company does not succeed. Most regular staff don't have the financial resources to seriously consider this risk. Plus, the IRS doesn't count the stock as owned until it is vested, so unless the employee has received good legal advice and filed an 83(b) election, s/he could be hit with a tax bill on the value of the stock at the time of vesting.

And then there are the questions of the perception of fairness and ownership balance. If you offer your early employees a restricted stock purchase that is affordable at the time the company starts up - the stock is maybe $0.01 per share - and they elect to make the purchase, what will you do when you bring in new employees down the road and the stock now costs them $1.00 per share. The decision to purchase then becomes a major financial decision for the new hires which may choose not to exercise the right to purchase. This can result in a chafing disparity between old staff and new staff because new staff feel hampered from participating. Also, you need to think about the effect of employees leaving with vested stock. An employee with vested options really has to think about shelling out cash to purchase stock on his way out the door, and often they choose not to. But a disgruntled employee leaving after some of his restricted stock has vested then becomes a disgruntled shareholder.

Helen Rosen
Title: President
Company: Direct Approach Solutions, LLC.
(President, Direct Approach Solutions, LLC.) |

Achaessa -

This is most valuable information. You are very learned about this subject matter. I hope others will read this, and maybe use it to help their employees. I say that because I was granted options in one company I took public, exercised, and sold some of it. The amount I had to pay in AMT taxes that year came out to more than I paid for my car! - the differential between what I made selling some of the stock and what I had to pay was so minimal - it really made me wonder about the benefit of stock options altogether for "little" people like me. I'm sure they have a lot more value to the higher uppers.

I hope other people read this and gain from it. Thanks for your insights.

Helen Rosen
President
Direct Approach Solutions
www.directapproachsolutions.com

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