Deal Terms
ISO
Last updated
Quick Answer
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.
Related Concepts
Further Reading
Exercise or Wait? A Guide to Startup Stock Option Decisions
Should you exercise your stock options now or wait? The answer depends on taxes, risk tolerance, and your company's trajectory. Here's a framework for making the right call.
Startup Equity Compensation Explained: Stock Options, RSUs, and More
ISOs, NSOs, RSUs, restricted stock — startup equity comes in many flavors. Here's what each type actually means for your compensation, your taxes, and your financial future.
Frequently Asked Questions
What is ISO in venture capital?
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.
Why is ISO important for startups?
Understanding ISO is critical for founders navigating the fundraising process. It directly impacts deal terms, valuation, and the relationship between founders and investors.
What category does ISO fall under in VC?
ISO falls under the deal-terms category in venture capital. This area covers concepts related to the financial and legal terms that define investment agreements.
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