When a startup issues stock options to someone — a first hire, an advisor, a contractor who helped build the early product — there are two types to choose from: incentive stock options (ISOs) and non-qualified stock options (NSOs, sometimes called NQSOs). Most founders pick the default in their cap table software without knowing what they're choosing. The ISO vs NSO difference matters when someone goes to exercise, and finding out at that point is too late to change it.
What makes an ISO different
ISOs get preferential tax treatment for employees. If the recipient holds the shares long enough after exercising — two years from the grant date and one year from the exercise date — any gain qualifies for long-term capital gains rates rather than ordinary income. For employees in high brackets, the difference between long-term capital gains rates (capped at 20%) and ordinary income rates (up to 37% federal) is meaningful on a large exit.
The restrictions are real though. ISOs can only be granted to W-2 employees — not advisors, not contractors, not board members who aren't employees. They have an aggregate $100,000 limit on the value of options that can vest in any single calendar year, calculated at grant date fair market value. Options above that limit automatically convert to NSOs. And the ISO must be exercised within 90 days of leaving the company, or it converts to an NSO and loses its preferential tax treatment.
What makes an NSO different
NSOs are simpler. They can be issued to anyone — employees, advisors, contractors, board members. There's no $100,000 annual vesting cap. The post-termination exercise window can extend longer than 90 days if you set it that way in the grant agreement.
The tax treatment is less favorable. When someone exercises an NSO, the spread between the strike price and the fair market value at exercise is treated as ordinary income — taxable in the year of exercise, regardless of whether the recipient has sold any shares or received any cash. An employee who exercises NSOs with a $100,000 spread owes income tax on that $100,000 that year, even if the company isn't liquid and the shares can't be sold.
This is the paper-gains-real-taxes problem that has surprised employees at high-valued private companies. It's not unique to NSOs — ISOs have their own version of it — but it catches people off guard when the tax bill arrives before the exit does.
The AMT risk that ISOs carry
ISOs have a version of the same paper-gains problem through the Alternative Minimum Tax. When you exercise ISOs, the spread between strike price and fair market value is a preference item for AMT purposes. If the spread is large enough, it triggers AMT — a parallel tax calculation that some taxpayers owe on top of regular income tax.
Employees who exercised ISOs at high-valuation companies before those companies went public or were acquired sometimes faced significant AMT bills on shares they couldn't sell yet. The tax was real; the liquidity wasn't.
An 83(b) election has to be filed with the IRS within 30 days of exercise. Miss that window and the election is not available. It's one of the few irreversible deadlines in startup equity.
Which type to use and when
The practical answer is straightforward. Issue ISOs to full-time W-2 employees. Issue NSOs to everyone else — advisors, contractors, board members who aren't on payroll.
When an employee's ISO grants exceed the $100,000 annual vesting limit, the excess automatically becomes NSOs. Cap table software handles this calculation. When you want to offer a post-termination exercise window longer than 90 days — some startups offer one to five years as a recruiting advantage — those options automatically convert from ISOs to NSOs at the 91-day mark after departure. Employees should understand this before they sign an offer letter that mentions an extended exercise window.
Some companies issue NSOs to all employees as a matter of policy, typically when they anticipate most employees will exercise early or when the complexity of tracking the $100,000 limit isn't worth the administrative overhead. This is a legitimate choice, though it removes the long-term capital gains benefit for employees who hold long enough to qualify.
The setup that actually protects your people
The ISO vs NSO decision is a downstream consequence of getting the earlier steps right. Before you issue options of either type, you need a current 409A valuation to set a defensible strike price. You need a properly structured cap table that tracks the grant date, grant type, strike price, vesting schedule, and expiration date for every option. You need option agreements signed by the recipient before the options have value.
The vesting schedule matters as much as the option type. An employee who holds ISOs that vest over four years, exercises them early, and files the 83(b) election can end up with a favorable tax outcome at exit. An employee who holds NSOs that cliff-vest at four years and exercises at a high FMV faces the full ordinary income treatment on a large spread. Both scenarios are predictable from the grant terms — the question is whether you've set them up in a way that benefits the people you're trying to retain.
Get the 409A done first. Issue ISOs for employees, NSOs for everyone else. Have every grantee sign their agreement before the grant is effective. Make sure they understand the exercise window and the tax implications before they need to make a decision about exercising — because that's a decision people make without enough information when it gets made at the last minute.
If you're building your first team and working through the option structure, this is part of the early company formation work Alder does with founders before the first hire. Tell us where you are.