Decoding ISO, NSO, RSU? A Plain English Guide to Your Startup Equity

A survival guide for startup founders and early employees navigating the alphabet soup of equity compensation

You’ve been grinding at your startup for years. You’ve survived the all-nighters, the pivots, the near-death experiences, and now your company is worth something. Maybe there’s an acquisition on the horizon or an IPO is finally within reach.

Now you’re staring at paperwork filled with acronyms and numbers that make your head spin: ISO, NSO, RSU, AMT, 409A, 83(b). It feels like you need a PhD in tax law just to understand what you own.

Here’s the thing: The decisions you make or don’t make could cost you hundreds of thousands of dollars. This guide will walk you through the key facts you need to know, in plain English, so you can make informed decisions about your equity.

The Big Picture: What Are You Actually Getting?

Before we dive into the acronym soup, let’s establish what we’re really talking about. When your startup gives you equity, they’re not just handing you stock certificates. They’re giving you the right to buy or receive shares under certain conditions.

The three main types of equity compensation you’ll encounter are:

• Stock Options (ISOs and NSOs): The right to buy shares at a fixed price.
• Restricted Stock Units (RSUs): A promise to give you actual shares later.
• Direct Stock Grants: Actual shares you own right now (less common but worth mentioning).

Each has different rules about when you can exercise them, how they’re taxed, and what happens during a liquidity event.

Incentive Stock Options (ISO): The Golden Child

ISOs are often the more complex stock option. They come with significant tax advantages, but also some serious strings attached.

How ISOs Work

When you get ISOs, you’re getting the right to buy shares at a specific price called the “strike price” or “exercise price” for a certain period. The strike price is typically set at the fair market value of the stock on the day the options are granted.

Example: You join a startup in 2020 and get 10,000 ISOs with a strike price of $1 per share. If the company goes public in 2025 and the stock is trading at $50 per share, you can exercise your options by paying $10,000 (10,000 shares × $1) to get stock worth $500,000.

The Tax Magic (And Trap)

The big advantage of ISOs is that you don’t pay ordinary income tax when you exercise them. Instead, you might pay capital gains tax when you eventually sell the shares.

Here’s the catch: alternative minimum tax (AMT). When you exercise ISOs, the difference between the strike price and the fair market value becomes an AMT preference item. This can trigger a massive tax bill even if you haven’t sold any shares yet.

Real-world scenario: You exercise ISOs worth $200,000 (fair market value) but only pay $200,000 (strike price). That $180,000 difference could trigger AMT, potentially costing you tens of thousands in taxes on money you haven’t actually received yet.

ISO Rules You Must Know

1. $100K Annual Limit: Only $100,000 worth of ISOs (based on fair market value at grant) can vest in any calendar year.
2. Employment Requirement: You must be an employee. Consultants, board members, contractors, and other non-employees cannot receive ISOs.
3. Exercise Deadline: You typically have 90 days to exercise after leaving the company, or the options convert to NSOs.
4. Holding Period: To get favorable tax treatment, you MUST hold the shares for at least one year after exercise AND at least two years after the grant date.

Non-Qualified Stock Options (NSO): The Flexible Alternative

NSOs are the “regular” stock options that don’t qualify for ISO tax treatment. They’re more flexible but come with different tax implications.

How NSOs Work

Similar to ISOs, NSOs give you the right to buy shares at a fixed price. The key difference is in the tax treatment.

Tax Treatment

When you exercise NSOs, you pay ordinary income tax on the difference between the strike price and the fair market value. This is treated as regular compensation income.

Example: You exercise NSOs with a $1 strike price when the fair market value is $10 per share. You pay ordinary income tax on $9 per share. If you later sell the shares for $15, you pay capital gains tax on the additional $5 per share.

Why Companies Use NSOs

1. No $100K Limit: Companies can grant unlimited amounts.
2. Contractor-Friendly: Can be granted to consultants and board members.
3. Flexible Timing: No strict exercise deadlines after termination.
4. Simpler Administration: Fewer regulatory requirements.

Restricted Stock Units (RSUs): The New Kid on the Block

RSUs are becoming increasingly popular, especially at later-stage startups. They’re simpler to understand but come with their own considerations.

How RSUs Work

With RSUs, you don’t buy anything. Instead, the company promises to give you actual shares when certain conditions are met (usually time-based vesting). You receive the shares automatically when they vest.

Tax Treatment

RSUs are taxed as ordinary income when they vest, based on the fair market value at that time. The company typically withholds taxes automatically. After your RSUs vest, they will fall under capital gains and be taxed as such. If you sell your shares less than one year after the vesting date, gains will be recognized as short-term capital gains.  If you sell your shares after holding more than one year after the vesting date, gains will be recognized as long-term capital gains.

Example: You receive 1,000 RSUs that vest over four years. In year one, 250 RSUs vest when the stock is worth $20 per share. You pay ordinary income tax on $5,000 (250 × $20), and the company withholds taxes from the shares or requires you to pay cash. One year after the RSUs vest, you decide to sell 100 shares of the stock when it’s trading at $40 per share. This would result in a long-term capital gain of $20 per share or $2,000.

RSU Advantages

1. No Exercise Price: You don’t pay anything to receive the shares.
2. Automatic Vesting: Shares are delivered automatically when they vest.
3. Simpler Taxes: No AMT complications.
4. Guaranteed Value: Even if the stock price drops, you still get shares.

What Happens During a Liquidity Event?

This is where things get interesting (and potentially lucrative). A liquidity event typically means an acquisition, IPO, or other transaction that allows you to convert your equity into cash.

Acquisition Scenarios

Cash Deal: Your options and RSUs typically convert to cash based on the acquisition price. If you have ISOs or NSOs, you might be forced to exercise them as part of the deal.

Stock Deal: You might receive shares in the acquiring company instead of cash. This can defer taxes but also introduces new risks.

Assumption: The acquiring company might assume your options and convert them to options in the new company.

IPO Scenarios

Going public doesn’t immediately make you rich. There are typically lock-up periods (usually six months) when you can’t sell your shares. However, you can usually exercise options during this period.

Early Exercise: The Power Move

Some companies allow “early exercise” of options before they vest. This can be a powerful tax strategy, but it comes with significant risks.

How Early Exercise Works

You pay the exercise price for unvested options and receive restricted stock instead. You then make an 83(b) election to pay taxes on the current value (hopefully low) rather than the value when the shares eventually vest.

Practical Strategies for Liquidity Events

Before the Event

1. Understand Your Equity: Know exactly what you have, when it vests, and what it’s worth.
2. Model Different Scenarios: Calculate your tax liability under various exit valuations.
3. Consider Early Exercise: If available and the numbers make sense.
4. Build Your Cash Reserves: You might need cash for exercise costs and taxes.

During the Event

1. Get Professional Help: This is not the time to DIY your taxes.
2. Understand the Transaction Structure: Cash vs. stock deals have different implications.
3. Plan Your Exercise Timing: Especially important for ISOs and AMT planning.
4. Consider Tax-Loss Harvesting: Offset gains with losses from other investments.

After the Event

1. Diversify: Don’t let company stock become your entire net worth.
2. Plan for Estimated Taxes: Large equity events can trigger quarterly tax payments.
3. Consider charitable giving: Donating appreciated stock can be tax-efficient.

Red Flags and Common Mistakes

The AMT Trap

This is the big one for ISO holders. Many people exercise ISOs without understanding the AMT implications and get hit with massive tax bills.

How to avoid it: Work with a tax professional to model your AMT liability before exercising ISOs. Consider exercising smaller amounts over multiple years to minimize AMT impact.

The Cashless Exercise Trap

Some brokers offer “cashless exercise,” where you simultaneously exercise options and sell shares to cover the exercise cost. This can have unintended tax consequences, especially with ISOs.

The Concentration Risk

It’s easy to get caught up in your company’s success and hold too much company stock. Remember: Your salary, your equity, and your career are all tied to the same company. Diversification is your friend.

Building Your Equity Game Plan

Step 1: Audit Your Equity

Create a spreadsheet with:

• Type of equity (ISO, NSO, RSU)
• Number of shares/options
• Exercise/strike price
• Vesting schedule
• Grant date
• Current fair market value

Step 2: Understand the Tax Implications

For each type of equity, understand:

• When you pay taxes
• How much you’ll pay (ordinary income vs. capital gains)
• Any special considerations (AMT, holding periods)

Step 3: Model Different Scenarios

Create scenarios for different exit valuations and timelines. Consider:

• Exercise costs
• Tax liabilities
• Net proceeds after taxes
• Timing considerations

Step 4: Make a Decision Framework

Establish criteria for when you’ll exercise options:

• Minimum company valuation
• Maximum AMT impact you’re willing to accept
• Cash reserves needed
• Risk tolerance

The Bottom Line

Startup equity can be life-changing, but only if you understand what you have and make informed decisions. The tax implications alone can swing your net proceeds by hundreds of thousands of dollars.

Don’t wait until the liquidity event to figure this out. Start planning now. Understand your equity, model the tax implications, and build a strategy that aligns with your financial goals and risk tolerance.

Your equity represents years of hard work and risk-taking. Make sure you’re positioned to capture its full value when your moment comes.

The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.