What are ISOs?

A stock option grants you the right to purchase a certain number of shares of stock at a pre-established price. An incentive stock option (ISO) is a type of stock option that allows favorable tax treatment to the stock option holder.

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

You Might Also Like:  What is Four Years With a One Year Cliff?

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.

Employees and Consultants,

7 thoughts on “What are ISOs?

  1. ISOs can have some advantages when you exercise them in a private company and there is little or no spread. Otherwise, based on the increase in the stock price, you could get caught with an AMT hit. If it all works out for you in an IPO or acquisition, the full gain over the exercise price, after holding the shares long enough is capital gains. However, I have also seen too many examples of this liquidity event never happening, so beware.

    You might find it useful to look at the ISO section on http://www.myStockOptions.com.

  2. ISOs can have some advantages when you exercise them in a private company and there is little or no spread. Otherwise, based on the increase in the stock price, you could get caught with an AMT hit. If it all works out for you in an IPO or acquisition, the full gain over the exercise price, after holding the shares long enough is capital gains. However, I have also seen too many examples of this liquidity event never happening, so beware.

    You might find it useful to look at the ISO section on http://www.myStockOptions.com.

  3. I was reading about ISOs a question came to my mind regarding some Stock Option in the form of Equity Awards from my former employer (Mcdonald’s Company, IL) .I just found out that I lost them because I am no longer their employee since 2006 and I never receive a note saying something like “use it or loose it. Any ideas how to tackle this matter. I told the phone representative that I was not happy and did not agree with there answer and that I will look for a better response or results. The company handling this awards is Merryl Lynch.

  4. […] Bookkeeping Head count Working in SOMA Convertible debt caps Valuations TechCrunch Karma scores ISOs Powerpoint Business Cards Banks Lawyers Desks 1099s Bug Trackers Agile Processes Advisory Boards […]

  5. […] and hold employment up to the point of exercise (minimum of 1 year). For full requirements see post by Ryan […]

  6. […] Bookkeeping Head count Working in SOMA Convertible debt caps Valuations TechCrunch Karma scores ISOs Powerpoint Business Cards Banks Lawyers Desks 1099s Bug Trackers Agile Processes Advisory Boards […]

  7. […] Bookkeeping Head count Working in SOMA Convertible debt caps Valuations TechCrunch Karma scores ISOs Powerpoint Business Cards Banks Lawyers Desks 1099s Bug Trackers Agile Processes Advisory Boards […]

Leave a Reply

Your email address will not be published. Required fields are marked *