ISOs, NQSOs and RSUs: Which Equity Awards Should You Offer?

September 11, 2020 Aunalisa Arellano

Illustration of three people discussing the different types of equity compensation in a park.

Let’s face it: as a private company, offering equity awards is a value proposition that just makes sense. Equity compensation allows you to attract and retain coveted talent, align your employees’ work efforts to your company’s performance and create a culture of ownership.

But like most finance-related decisions, issuing equity grants is easier said than done. Part of what makes it complicated is that the type of awards you issue will likely shift as your company grows. So how do you determine which equity incentives are right for you?

Incentive stock options

In many ways, incentive stock options (ISOs) are a blessing for startups and early-stage private companies that are facing capital constraints. Unlike the cash cost associated with salaries, ISOs allow you to compensate employees by allowing them to buy shares of company stock at a set price, which is generally lower than actual future market prices. This difference between the exercise price and the fair market value of the stock at the time of exercise, or the “spread”, represents the potential profit your employees might realize when they exercise their options – giving them a solid reason for wanting your share price to rise.

Many early-stage companies opt for ISOs because they tend to offer favorable tax treatment to employees. In essence, once employees exercise their options, the spread is taxed at lower federal long-term capital gain tax rates (rather than ordinary income tax rates) as long as they hold the stock for more than two years from the date of the grant and one year from the date of exercise. As an added benefit, provided they meet the holding period requirements, ISOs are generally taxed when the underlying shares are sold, not when the options are exercised, giving employees control over when they pay taxes.

That said, ISOs aren’t quite as favorable for employers. One reason is that they can only be granted to employees, not to outside directors, consultants or contractors. Additionally, ISOs generally don’t qualify for tax deductions and tend to be difficult to administer. There’s also a $100,000 limit on the aggregate value of grants that can vest each year – a limit that may be hard to adhere to as your company grows. That likely explains why ISOs are typically best-suited for startups and early-stage companies that haven’t yet maximized their earning potential.

Non-qualified stock options

Like ISOs, non-qualified stock options (NQSOs) allow your employees to buy your company’s stock at a predetermined exercise price within a set timeframe. Unlike ISOs, however, NQSOs don’t qualify for special tax treatment under the US Internal Revenue Code. In fact, NQSOs are subject to tax when your employees exercise their options and when they sell their underlying shares.

Despite this potential downside, NQSOs are the most common form of stock option. That’s partly because they can be granted to a wider group of stakeholders – including employees, officers, directors, consultants and other providers of goods and services. NQSOs are also tax-deductible for employers and tend to be easier to administer than ISOs. This makes NQSOs ideal for mid-stage companies that are expanding their workforces, hitting their growth stride and potentially going global.

Restricted stock units

Later-stage, pre-IPO companies often make the move from stock option grants to stock-settled restricted stock units (RSUs) for a variety of reasons.[1] Unlike stock options, RSUs give employees a direct interest in your stock as soon as they vest, without needing to be exercised. Because there’s no purchase or exercise cost associated with RSUs, they tend to be advantageous from an employee perspective.

They also offer benefits to employers, not only because they limit dilution but also because they’re easier to administer. Since the stock isn’t issued until the award is settled, employers don’t need to hold shares in custody or cancel outstanding shares if employees leave the company before their RSUs vest.

Of course, that doesn’t mean RSUs make sense in every case. That’s particularly true if your company plans to remain private. RSUs cannot be sold before they vest – a feature that can frustrate employees who want to cash out. To forestall this frustration, private companies that grant RSUs may want to consider holding a liquidity event, such as a tender offer. You should always consult with your own legal and tax advisors regarding what makes the most sense for your company.

Support at every stage

Although granting any form of equity compensation can be complex, you don’t have to go it alone. To learn more about which types of equity compensation plans make the most sense for your company, Shareworks can help you:

  • Educate your share plan participants about the ins and outs of equity compensation – from reasons to enroll and tax implications to how to trade and complete transactions
  • Increase plan participation by empowering your employees to view the total value of their equity, exercise their shares and track their portfolios through an online portal or mobile app
  • Simplify administration with intuitive record-keeping tools that let you easily track vesting schedules, exercise dates, cap table versions and transaction history
  • Streamline reporting and auditing by maintaining shareholder records, 409A valuation data and stock expensing in one place

To learn more about which types of equity compensation make the best sense for your company’s stage of growth, or discuss how Shareworks can help, get in touch.

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You should always consult with and rely on your own legal and/or tax advisor(s) as Shareworks does not provide legal or tax advice and the information is not tailored to the specific situations of your company or your employees.

Shareworks by Morgan Stanley services are provided by Morgan Stanley Smith Barney LLC, member SIPC, and its affiliates, all wholly owned subsidiaries of Morgan Stanley.

This article addresses RSUs that are settled in stock. RSUs may be settled in stock or cash, depending on the terms of the grant agreement or stock plan and applicable award agreements.

CRC 3191635 (09/2020)