The main tax benefits of incentive stock options are that the option holder can:

(1) delay his or her personal taxable event until the stock is actually sold by the holder (instead of at the exercise of the option), and
(2) receive long-term capital gains treatment for taxable gain at the stock sale (instead of ordinary income tax rates).

In order to receive the tax benefits of ISOs, the startup and stock option holder must comply with various rules. The main requirements are:

ISO Recipient

Only employees of the startup can receive ISOs.

Continuous Employment

The employee must remain continuously employed with the startup for the period from the date of the ISO grant until 3 months before the date of an ISO stock option exercise.

Stock Option Plan

The ISO must be granted pursuant to a written stock option plan. Additionally, the grant must take place within 10 years from the date the stock plan is either adopted or approved by the startup’s shareholders.

ISO Option Length

An ISO cannot be exercised more than 10 years after its grant. (See “Special Rules” below)

ISO Exercise Price

The exercise price for an ISO must be set at FMV (or higher) of the startup’s stock subject to the ISO grant. (See “Special Rules” below)

Nontransferable ISO

ISOs must be nontransferable and can only be exercised by the employee. However, if the employee dies, the employee’s heirs or beneficiaries can exercise the ISOs.

ISO Holding Period

The ISO holder can not dispose the startup’s shares within (i) 1 year from the ISO exercise, or (ii) 2 years from the ISO grant. Thus, the earliest the ISO shares can be sold (and receive favorable tax treatment) is 2 years from the ISO grant (not 3 years).

Special Rules for Founder ISO Grants (i.e. to large shareholders)

A ISO grant to a shareholder with more than 10% of the startup’s voting stock must (i) be set at an exercise price at least equal to 110% of the FMV of the stock subject to the option, and (ii) the ISO option may not be exercised more than 5 years after its grant.

Please note that the above list is not exhaustive regarding ISO requirements.

Via the written plan, a startup pre-authorizes a certain amount of the company’s common stock which will be issued by the plan’s administrator (usually the startup’s board of directors or a committee selected by the board). For example, if the startup has 5,000,000 shares of common stock outstanding, it may elect to authorize 1,000,000 shares to be issued pursuant to the plan.

A potentially confusing aspect of the option pool is how the option pool’s unissued portion is treated for financings relative to acquisitions. The unissued portion of the option pool is included in the fully-diluted capitalization of the startup, but the same unissued portion is not included in the outstanding share count upon an acquisition (or distribution). In other words, the entire option pool is included in a startup’s total share count at financings, but only the issued portion of the option pool is included in a startup’s total share count at acquisition.

Keep in mind that a startup’s original option pool will likely not be the last option pool the startup creates. The size of the option pool is typically negotiated at each round of financing, since at that time, the startup will likely need additional equity options to attract and motivate future hires.