Deal Terms
ISO
Incentive Stock Option — a type of employee stock option with favorable tax treatment if holding period requirements are met, available only to employees of the granting company.
An Incentive Stock Option (ISO) is a form of stock option granted exclusively to employees (not contractors or advisors) that receives preferential tax treatment under the U.S. tax code. The key advantage: if the employee holds the shares for at least one year after exercise and two years after the grant date, any gains are taxed at long-term capital gains rates rather than as ordinary income.
ISOs have an annual grant limit of $100,000 (based on fair market value at the time of grant that can first become exercisable in any calendar year). Grants above this threshold automatically convert to Non-Qualified Stock Options (NSOs). ISOs also trigger Alternative Minimum Tax (AMT) considerations at the time of exercise — the spread between exercise price and fair market value counts as an AMT preference item, even though no regular income tax is owed yet.
ISOs expire if not exercised within 90 days of leaving a company (or 12 months in case of disability or death).
In Practice
An engineer is granted 10,000 ISOs at a $1 strike price. The company's 409A valuation rises to $10 per share. She exercises all options, paying $10,000. She holds the shares for 13 months, then sells at $20/share for $200,000 in proceeds. Her gain of $190,000 is taxed at long-term capital gains rates (typically 15–20%) rather than as ordinary income (up to 37%).
Why It Matters
ISOs are one of the most valuable forms of compensation a startup can offer employees — but only if the employee understands the tax mechanics and plans accordingly. The 90-day exercise window after leaving means employees often face a painful choice: come up with cash to exercise options (and potentially owe AMT) or forfeit years of equity compensation.