3 Questions about Equity Alphabet Soup — Answered
There are lots and lots of articles and blog posts out there that try to make sense of the alphabet soup you’ll encounter when you grant equity — ISO, NQO, RSA. If you are ready to dive in and slurp it up, we’ve compiled a short list of some of these resources. We’re adding to the pot by directly answering a few questions we’ve heard here at Shoobx about the different types of equity awards startups typically grant.
First, a quick guide to the acronyms for the three most common types of stock grants:
ISO = Incentive Stock Option
NQO = Non-qualified Stock Option
RSA = Restricted Stock Award
Who gets what?
Incentive Stock Option (ISO) grants can only be given to employees, Non-Qualified Stock Option (NQO, also abbreviated NSO and NQSO) grants are usually awarded to advisors, consultants, non-employee board members. The keyword with these two types of equity awards is “Option.” ISOs and NQOs are contracts that give the recipient the option to buy a specific number of shares in the company at a stated exercise price. Unlike ISOs and NQOs, an RSA is actually an award of stock that requires payment by the recipient. RSAs can be granted to employees and non-employees. All three types are typically awarded under a Stock Incentive Plan (approved by the Board and requisite stockholders), and are often subject to vesting.
Why grant an ISO instead of an RSA?
An RSA actually issues stock, giving the recipient equity ownership — making them a stockholder — with all applicable stockholder rights under state law, including (typically) voting powers. The recipient’s capital gains holding period begins at the time of the grant (which matters for taxes). There’s a popular misconception that RSAs are awarded at no cost. This is wrong. The stock must be purchased by the recipient at a price at least equal to the par value of the underlying security, usually common stock (more typically issued at fair market value).
The recipient of an ISO, on the other hand, will not become a stockholder until he or she exercises the right to purchase some or all of the stock. If the company does not permit the early exercise of ISO grants, the recipient will have to wait until some or all of the option has vested to make the purchase. Granting ISOs instead of RSAs can help curtail the number of stockholders in the company.
Why grant an NQO instead of an ISO?
Tax laws prevent a company from granting ISOs to non-employees, and that’s where NQOs come in. To grant options to the company’s advisors, contractors, non-employee board members, and others, the company can award NQOs. But remember, NQOs issued under an option plan are usually only issuable to natural persons — not entities (so be careful when granting to consultants). There are also differences in how ISO and NQO grants are considered for tax purposes.
Stock-Based Compensation — Get a very detailed walkthrough of everything you need to decide about incentivizing employees with options, from Goodwin’s Founders Workbench.
Incentive Stock Options vs. Nonqualified Stock Options — Look for helpful charts and pay close attention to the recap at the bottom of this post by Startup Law Blog. Every blog post should be this useful!
Incentive Stock Option Plans — ISOs vs. NQOs — Taxes! Many blog posts (including ours!) will casually refer to the tax advantages of ISOs over NQOs. Most of them don’t bother to break down exactly what they mean by that, but this post from The Venture Alley tackles it nicely.
Equity Compensation Alphabet Soup — ISO, NSO, RSA, RSU and more — Want to expand your horizon beyond RSAs, ISOs, and NQOs? Learn about RSUs and Performance Units in this helpful post from The Venture Alley.
The Value of Employee Options — This blog post from WilmerHale Launch offers a comprehensive look at how equity incentives are used to recruit, motivate, and retain valuable employees.