Deal Terms
NSO
Non-Qualified Stock Option — a stock option that does not receive the favorable ISO tax treatment, taxed as ordinary income upon exercise. Can be granted to employees, contractors, and advisors.
A Non-Qualified Stock Option (NSO or NQSO) is a stock option that does not qualify for the preferential tax treatment given to Incentive Stock Options (ISOs). Unlike ISOs, NSOs can be granted to anyone — employees, contractors, board members, advisors, and consultants. This flexibility makes them the most common type of option granted to non-employee contributors.
The key tax difference: when an NSO is exercised, the spread between the strike price and the fair market value at exercise is treated as ordinary income and subject to income tax and payroll taxes (Social Security, Medicare) at that moment — whether or not the shares are sold. This can create a significant tax bill at exercise even when the shares are illiquid.
For grants above the $100,000 ISO limit, or for grants to contractors and advisors, NSOs are the default option type.
In Practice
A startup advisor receives 5,000 NSOs at a $2 strike price. The 409A rises to $8 per share. When she exercises, the $6 spread per share ($30,000 total) is treated as ordinary income — she owes income taxes on $30,000 immediately, regardless of whether she can sell the shares. Her basis in the shares is now $8/share.
Why It Matters
NSOs create a tax event at exercise, not just at sale — which can be painful when shares are illiquid. Recipients of NSOs need to plan carefully around when to exercise, especially as 409A valuations rise. Some startups offer early exercise (83(b) election) to allow NSO holders to start the capital gains clock before the spread grows large.