by Dan Walter, Performensation
Non-Qualified Stock Options (NQSOs, NQs, NSOs) should really be called Stock Options. Non-qualified (or non-statutory) makes them sound negative. The negative modifier simply refers to the fact that these stock options have no special section dedicated to them in the IRS tax code. Like Incentive Stock Options (ISOs), NQSOs are generally appreciation-only instruments. Unlike like ISOs, if the plan and local rules allow, they can be granted at price less than Fair Market Value (FMV). Although ISOs get most of the press, NQSOs are more commonly granted.
While ISOs are a common start-up tool, NQSOs are often preferred by established companies precisely because of the their lack of special tax treatment. Because all NQSOs granted to US employees will eventually result in ordinary income and the associated tax withholding, finance departments can plan for the future tax event by accounting for a Deferred Tax Asset (DTA). These stock options are easier to administer since there is seldom a need for post-exercise tracking, calculations of maximum limits or adherence to some of the other specific rules governing ISOs. NQSOs are also far less restrictive in their granting rules than ISOs.
Companies can easily grant NQSOs to non-employees including Directors and contractors. Plans must be properly designed to allow this and the provisions are simple to implement. This makes NQSOs very flexible. In fact, every company that grants ISOs must also be able to grant NQSOs by default. ISOs over the $100,000 limit are treated as NQSOs. ISOs that remain outstanding beyond prescribed post-termination grace periods must be treated as NQSOs. Any stock option in the US that isn’t an ISO is a NQSO.
NQSOs can also allow for some tax planning opportunities. Plans can be designed to allow participants to exercise unvested options. This is sometimes called early exercise, or exercise before vest. For NQSOs, ordinary income is realized only after the options are both exercised and no longer “subject to a significant risk of forfeiture.” Early exercises can allow an optionee to exercise when the difference between the exercise price and fair market value of the underlying stock is low (quite often $0.00.) The individual can then file an 83(b) election, effectively moving the date of ordinary income measurement to a period where there may be little or no income to be taxed. This strategy can be dangerous if the spread is significant at exercise and lower on the vesting date. Participants may not be possible to recoup the losses in a reasonable timeframe.
NQSOs should be included in any equity compensation program. They must be used with a full understanding of their strengths and weaknesses. Like any stock option the intent is to focus participants on increasing the company’s stock price. These options may deliver far more compensation than a company has to expense. However, they can also fall underwater and deliver nothing to the participants, while the company cannot reverse the associated expense. When values are high they can be exciting and rewarding. When the participant can’t realize value, NQSOs can be demotivating and create discontent. Companies must calculate and withhold taxes at the time of exercise. This provision means that companies can amortize a DTA for expected exercises. Lastly, like any stock option, their upside can make up for other compensation shortcomings. This, of course, can be a double-edged sword that can inflate pay when the stock price shoots skyward.
NQSOs can be structured to meet fairly short (1-2 years) and very long (25 years is not unheard of) timeframes. Proper plan design, communication and administration are essential to the success of a NQSO program. They are a flexible tool that can allow both companies and participants to take advantage of stock price growth at a fairly low cost.
This is part of a series of posts on equity compensation instruments that will run the first Thursday of every month for the foreseeable future. Please reach out to me directly if you have any questions.
Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay