Stock Options: NQOs vs. ISOs

I have written a bunch of different posts over time on the different types of equity incentives a startup or emerging company can offer its workers. Below is a list of some of them.

What Type of Equity Incentive Should I Use?

What’s Better for an Equity Incentive–Restricted Stock or a Stock Option?

Incentive Stock Options vs. Nonqualified Stock Options

Top 6 Reasons to Grant NQOs Rather Than ISOs

LLC Compensatory Equity Awards: Difficult and Complex

ISOs or NQOs?

I still regularly get asked this question: Should I grant NQOs or ISOs?

One thing you have to remember if you are going to grant ISOs is that they are subject to more limitations and restrictions than NQOs, and their tax consequences are more complex and difficult to ascertain than the tax consequences of NQOs. In short, ISOs are more complex than NQOs. Thus, if you want to keep your life simpler, you would just choose to use NQOs so that you don’t have to worry about the varying consequences and limitations of the two different types of worker stock options.

What Are The ISO Tax Benefits?

When Congress put in place Section 422 of the Internal Revenue Code, it was trying to make life easier for workers. The benefits that Congress was trying to put in place were:

  • No ordinary income tax on exercise; and
  • Capital gain on ultimate sale of the stock, if the two holding periods were met.

The problems:

  • The spread on the exercise is an Alternative Minimum Tax Adjustment, that has to be reported to the IRS. The AMT taxes due can be significant. They can in fact be so significant they effectively prohibit exercise because the employee can’t afford the taxes.
  • The employee has to meet two holding periods to qualify for the benefit. They have to hold the option shares for at least one year after exercise and at least two years after option grant. Most employees exercise in connection with a liquidity event and thus don’t meet the holding period requirements. If you don’t meet the holding period requirements the option is taxed as an NQO.

Summary of Differences

  • ISOs can only be granted to employees. You can’t grant ISOs to independent contractors or board members who are not employees. What this means is that–if you decide to grant ISOs to your employees, you are almost certainly going to have to also utilize NQOs. One reason I favor using NQOs for all types of awards is because it is simpler–you only have to figure out and explain the tax consequences of one type of award to your workers–not two.
  • ISOs have two holding periods.  Most employees won’t meet these requirements and thus not benefit from the ISO tax benefits.
  • ISOs have to be priced differently for 10% or greater shareholders.
  • For 10% or greater shareholders, ISOs can only have a 5 year term. NQOs are typically 10 year duration options.
  • ISOs give rise to Alternative Minimum Tax consequences. The AMT can be hard to figure out. This additional complexity makes life more difficult for everyone–the company and the employee.
  • You have to give the employee and the IRS notice of the amount of the spread on the ISO that is subject to AMT, by January 31st of the year following exercise. This creates somewhat of a trap for employees. With an NQO, you have to calculate the tax withholding on exercise. An employee can’t exercise until the company has calculated the withholding tax and made the employee write a check to the company for the employee withholding portion. This avoids a situation where the employee doesn’t understand the tax consequences until the subsequent year. There have been plenty of employees who realized too late they owed too much AMT–and that they couldn’t afford to pay it. This is a result that is usually avoided with NQOs.
  • There is a $100,000 annual limitation on the amount of ISOs that can become exercisable during any calendar year.
  • You can’t grant immediately exercsable ISOs without problems.
  • NQOs give rise to a tax deduction for the company. The spread on an ISO exercise is not deductible by the company. The spread on NQO exercises can add up to very substantial tax savings for companies.

ISOs Still Better for Employees

Having said all of this–ISOs are still more favorable to employees than NQOs. It is still possible for an employee to achieve a better tax result with an ISO than with an NQO. It might be unlikely, but it is possible.

Conclusion

If you really want to give your employees the best they can possibly get–use ISOs. If you want to keep your life simpler, and you understand that for the most part employees are typically not going to benefit from the potential tax benefits of ISOs, use NQOs.

Public Policy Recommendation

Congress ought to repeal the tax on transfers of illiquid stock to workers.

This would allow companies to transfer stock directly to workers without requiring the employee to write a big check to the employer to cover the employee’s share of income and employment tax withholding.

I am not sure of the public policy rationale for making it harder for companies to give workers equity. It doesn’t make sense to me.

 

 

Secret Government Patent Program Buckles Under Public Pressure

USPTO SAWS Program

By Adam L.K. Philipp – Founder – Aeon Law

The US Patent Office has decided to cancel a controversial program that flagged certain types of patent applications for slow-track treatment.

As we previously discussed, since 1994 the USPTO had a program known as the Sensitive Application Warning System (SAWS) to deal with “controversial or inconvenient” patents.

Patents put on the SAWS track included ones dealing with abortion, AIDS vaccines, suicide machines, smart phones, and anything considered “pioneering.”

The details of the SAWS program were kept secret until revealed pursuant to a Freedom of Information Act request by attorneys at a US intellectual property law firm. The attorneys became aware of the program when a patent examiner let slip a reference to it.

The attorneys said that the intent of the program appeared to be to help the Patent Office avoid embarrassment. The revelation of the existence of the program led to considerable discussion in the patent community.

The Patent Office denied that the SAWS program was actually “secret,” although neither patent applicants nor patent attorneys were informed when their applications were assigned to the program.

Concerns about the impact of the program were muted somewhat when the USPTO disclosed that only .04% of all patent applications were routed to the SAWS program.

The public exposure led the USPTO to review the program and it recently posted the following notice on its website, “Upon careful consideration, the USPTO has concluded that the SAWS program has only been marginally utilized and provides minimal benefit.”

Any patent applications previously assigned to the SAWS program will now be put on the regular track.

Patent Commissioner Margaret Focarino said that any future similar “quality-enhancing” initiatives would be “disclosed to the public before implementation.”

We’re glad that the Patent Office made this sensible decision. Secret programs, or even somewhat secret programs, are inconsistent with government transparency and public accountability and are clearly inappropriate when it comes to protecting intellectual property rights.

adam philippAdam L. K. Philipp has been involved in the prosecution of patent applications in the computer science, electrical devices, consumer products and related fields since 1998 and with Internet and technology related law since 1995. He also counsels clients on intellectual property portfolio strategies and infringement matters.

How Do I Value My Company To Grant Stock Options?

Company ValuationGuest Post By Marek Omilian, CFA

Startup companies frequently have to confront this issue.  After the founder stock issuances, the company will want to be able to grant stock options to new hires.  Internal Revenue Code Section 409A requires that stock options be granted at fair market value (FMV) to avoid adverse tax consequences.

How to Determine Fair Market Value

The law does not require that companies hire an independent third party appraiser to value their stock, but it may be very helpful to you if you do.  What the law does require is that the valuation be determined by the “reasonable application of a reasonable valuation method.” The regulations state:

Factors to be considered under a reasonable valuation method include, as applicable,

  • the value of tangible and intangible assets of the corporation,
  • the present value of anticipated future cash-flows of the corporation, (i.e. DCF method)
  • the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, (i.e. Comparable publicly traded companies method)
  • the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction),
  • recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and
  • other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.

One should attempt use all of the above recommendations before making final conclusion. One should also reconcile different indications of value. FMV of common stock does not equal value of preferred stock in the latest round of financing or post-money valuation from the latest round. In fact, FMV of the common stock will always be lower than preferred stock because of liquidation preference given to preferred.

AICPA Practice Aid

“Valuation of Privately-Held Company Equity Securities Issued as Compensation – Accounting and Valuation Guide” commonly referred to as the “Practice Aid,” provides guidance on determining the fair market value of common stock for financial reporting requirements outlined in ASC 718 (old SFAS 123R). The same valuation satisfies the IRC 409a requirement. The Practice Aid is used by all qualified valuation professionals (hint: ask potential service provider if they follow the AICPA Practice Aid to avoid problems down the road when IRS or the auditor reviews the valuation).

In order to come up with fair market value of common equity to establish option strike price the valuation expert has to follow a two-step process:

  1. Determine Business Enterprise Value (BEV) – this is done by using discounted cash flow methodology and/or comparable transaction and/or comparable publicly traded companies approaches. Most of us are somewhat familiar with these approaches as they are the same used for any other business valuation.
  2. Allocate BEV to all of its invested capital: debt, preferred and common equity. This has to be done very carefully, as it needs to reflect all of the preference and priorities given to various classes of preferred stock. This part could be highly technical as, the leading value allocation method between preferred and common is the Option Pricing Method and involves series of option valuations.

One of the new techniques introduced in the revised Practice Aid is the concept of using the latest round of funding to “back-solve” for values of the company and its preferred and common securities. See this post for more info on using the “back-solve” approach.

marek-omilian-150x150Marek Omilian, CFA, Managing Director, Value Prism Consulting – Marek manages the delivery of valuation and decision support analysis.  He has 20+ years of consulting and line management experience working with companies in such areas as: valuations; business case and ROI analysis; decision support analysis; shareholder value enhancement analysis; mergers, acquisitions and divestitures; synergy identification and capture in a post-merger business integration. Office: 206.262.5695 or cell: 404.307.8194. momilian@valueprism.com, www.valueprism.com

Announcement: Moving to Carney Badley

New Startup Law Practice

My good friend and former DLA Piper colleague Mike Schneider and I are pleased to announce that we are bringing our corporate and IP transaction practices together to work on startups and emerging companies at the law firm of Carney Badley.

Carney Badley

You can find information about Carney Badley at www.carneylaw.com.

A New Alternative For Startups & Emerging Companies

We are excited to be working together again, and are looking forward to offering a new option for legal services to startups and emerging tech companies in the Pacific Northwest.  Startups and emerging companies can come to us for help with business formation, angel and venture financings, IP transactions, software licensing, exits and other strategic transactions.

We will also represent angels and institutional investors in their investments in early stage and tech companies.

A New Blog: TheLawofStartups.com

We will be blogging at www.thelawofstartups.com, and we will also plan a podcast discussing startup and legal issues.  Stay tuned for more details.

If you are interested in hearing more about our new platform, please feel free to reach out to either of us directly.

Best regards,

Mike Schneider & Joe Wallin

Learn more and contact Mike here.

Learn more and contact Joe here.