What are Non-Qualified Stock Options?

Did you just get a new job and discover that non-qualified stock options are part of your compensation package?

First of all, congratulations on the gig! Second of all…what are non-qualified stock options? How do they work, and when can you actually exercise them? Is there anything you need to be aware of from a taxation or financial planning perspective?

You’ve got questions, we’ve got answers. NSO options can be a fairly complex topic for those who aren’t well-versed in the world of finance. But fortunately, we are – and we’re here to help you make sense of these types of options to make the most of them.

In this complete guide to NSOs, we’ll explain how they work, their benefits & drawbacks, and how they compare to other types of company-sponsored stock options programs. We’ll also break down what you need to know about vesting schedules, taxation, financial planning, and a whole lot more. So – let’s not waste any more time.

What are Non-Qualified Stock Options?

So, what are non-qualified stock options? At the most basic level, these are a form of compensation your company will offer you to get away with paying you less in salary. But below, we’ll offer a much more detailed definition to set the stage for the rest of our conversation.

Non-Qualified Stock Options Defined

Non-qualified stock options (NSOs) are a type of employee stock option that allows employees to purchase company shares at a predetermined price, known as the “strike price.”

Unlike incentive stock options (ISOs), NSOs are not subject to preferential tax treatment and are generally offered to a broader range of employees, including non-executive staff and contractors. NSOs can be an attractive part of an employee’s compensation package, as they provide the potential for significant financial gains if the company’s stock price rises. But how do they work, exactly?

How do NSO Options Work?

NSOs work by granting employees the option to buy company shares at a fixed price (the strike price) within a specified time frame. Once the options vest (become available to exercise), employees can purchase shares at the strike price, regardless of the current market price.

If the market price is higher than the strike price, employees can profit by selling the shares they’ve purchased. However, if the market price falls below the strike price, the options may have little or no value.

That’s the risk you take on with NSO options as part of your compensation package…oftentimes, you’re better off earning more in salary and investing on your own. Let’s progress this conversation by fully unpacking the benefits and drawbacks these options are known for. We’ll start with the benefits of these stock options.

Benefits of NSO Options

• Upside potential: NSOs give employees the opportunity to share in the company’s growth and potentially reap significant financial rewards if the company’s stock price appreciates.
• Flexibility: NSOs can be granted to a wider range of employees, including part-time staff, consultants, and non-executive personnel.
• Customizable vesting schedules: Companies can design vesting schedules to incentivize employee retention and performance.
• Limited downside risk: Employees are not required to exercise their options if the stock price falls below the strike price, which means they won’t lose money in such cases.

Drawbacks of NSO Options

• Taxation: Unlike ISOs, NSOs are not eligible for preferential tax treatment and may result in higher taxes for employees when they exercise their options and sell their shares. We’ll talk more about taxes shortly.
• No guarantee of profit: The value of NSOs depends on the company’s stock price, which can be volatile and unpredictable.
• Dilution: The issuance of stock options can dilute existing shareholders’ ownership, potentially affecting the company’s valuation and stock price. The more coworkers you have, the less value your options have.
• Illiquidity: Employees may have to wait for vesting periods to end and may face restrictions on when they can sell their shares, limiting their ability to access cash quickly. If you want to change jobs or you end up getting laid off before the vesting period is up, you’re out of luck.

Comparing Non-Qualified Stock Options to the Alternatives

You may have noticed that we’ve referenced other types of employee stock options in this article – like incentive stock options (ISOs) or restricted stock units (RSUs). How do NSOs compare to these?

While NSOs have broader eligibility than ISOs, they fall short in terms of tax treatment. And in comparing NSOs to RSUs, you’ll discover that while the former has greater potential for gains, the latter carries lower risk since value exists regardless of how your company’s stock price moves.

If you’re able to choose between the different types of employee stock options, it is certainly worth doing a deeper dive and making sure the compensation you choose is the most beneficial form for your unique needs. With that said, let’s touch on a key topic surrounding non qualified options: vesting periods.

Vesting Schedule & Cliff Vesting

Part of what makes these options so tricky is you don’t have access to them right away. You have to be employed for a certain period of time before you even have the ability to exercise your options – which is known as the vesting period, or vesting schedule.

A common vesting schedule is a four-year period, with a one-year cliff. This means that after one year of employment, 25% of the options become exercisable, and the remaining options vest monthly or quarterly over the next three years.

Understanding your vesting schedule is crucial, as it impacts when you can exercise your NSOs and potentially profit from them. And when that time comes, here’s how you can go about it…

How to Actually Exercise Your NSOs

What does it mean to exercise options? It simply means you’re cashing in and in this case, purchasing shares of company stock at a predetermined price (the strike price). Our beginner’s guide to how stock options work is a valuable read if you’re new to this topic – but we’ll explain the important steps in actually exercising your NSOs below:

• Decide when to exercise: Consider factors like the current stock price, your financial situation, and potential tax implications before deciding when to exercise your options. We’ll discuss the tax side of things, later on, to provide more context here. We also have a detailed resource on when to exercise options if you’d like to learn more.
• Notify your employer or plan administrator: Inform your employer or plan administrator of your intention to exercise your options. The process may involve submitting a form or exercising through an online portal, depending on your company’s procedures.
• Choose an exercise method: Determine how you’ll pay the strike price to exercise your options. You have 3 options here – cash exercise (pay the strike price using your own personal funds), cashless exercise (sell a portion of your shares immediately after exercising to cover the cost of the strike price/taxes), or stock swap (exchange previously owned company shares to cover the strike price).
• Complete the transaction: Follow your employer’s or plan administrator’s instructions to complete the exercise transaction. This may involve transferring funds, signing documents, or using an online portal.
• Receive your shares: After exercising your options, you’ll receive the purchased shares. These shares may be deposited into a brokerage account or issued as physical stock certificates, depending on your company’s procedures.
• Decide whether to hold or sell your shares: Consider your financial goals, risk tolerance, and tax implications when deciding whether to hold or sell the shares you’ve acquired. Holding shares may offer potential for future gains while selling can help diversify your investment portfolio and provide liquidity
• Monitor your investment: If you decide to hold your shares, monitor the stock price and stay informed about company news and developments. This will help you make informed decisions about when to sell your shares in the future.

We’ve mentioned taxes a few times already, so let’s get into that – as that’s a key aspect of fully understanding what non-qualified stock options are all about.

What You Need to Know About NSO Taxes

Before you pull the trigger on exercising your NSO options, it’s important to have a full understanding of what this means for you. That’s because you’ll have to be prepared to pay tax on exercised stock options.

But wait…when are stock options taxed, exactly? Taxes are typically due at two points: when you exercise the options and when you sell the stock options.

Upon exercising, the difference between the strike price and the fair market value (FMV) is considered ordinary income and is subject to federal, state, and payroll taxes.

Then, when you sell the shares, any gains beyond your ordinary income are treated as capital gains, which are taxed at either short-term or long-term rates, depending on how long you held the shares.

Our complete guide on trading and taxes can help you gain a better understanding of this complex subject – but frankly, it’s worth hiring a financial/tax professional.

The Impact of Job Changes on NSOs

Job changes can have a significant impact on your NSOs. If you leave the company, you may have a limited time to exercise your vested options (usually 30-90 days). Unvested options, on the other hand, are typically forfeited.

It’s essential to review your stock option agreement and understand how job changes will affect your NSOs, so you can make informed decisions about exercising or potentially negotiating for extended exercise periods. If you only plan on sticking around for a year or two, then having NSOs as part of your compensation plan doesn’t benefit you whatsoever.

How NSOs Figure into the Rest of Your Financial Planning

Incorporating NSOs into your overall financial plan requires careful consideration of factors such as tax planning, retirement goals, and diversification. Here are some strategies:

• Tax planning: Consult with a tax professional to understand and optimize the tax implications of exercising and selling your NSO shares.
• Retirement planning: Consider using the gains from your NSOs to fund your retirement accounts, such as an IRA or 401(k). Learn more in our blog as we discuss the best portfolio allocation in retirement, the best index funds for retirees, and other retirement investment strategies.
• Diversification: Ensure that your investment portfolio remains diversified to minimize risk. Holding too much of your wealth in a single company’s stock can expose you to significant risks if the company’s stock price drops.
• Emergency fund: Use a portion of your NSO gains to establish or bolster an emergency fund, ensuring you have sufficient savings for unexpected expenses.

By integrating your NSOs into your broader financial plan, you can make the most of this unique compensation opportunity and work towards achieving your financial goals.

You may be wondering…do I really need a financial advisor to navigate all this? Not really. In fact, we recently wrote an article discussing why financial advisors aren’t worth it. This is something you can easily manage on your own. After all, who has your best interests at heart more so than yourself?

Our blog has a wide array of articles to help you learn stock options and make sense of how they fit into your compensation package and your overall journey to financial freedom. You can learn about warrants vs stocks, risk management options trading, what happens when stock options expire, picking stock options, and a whole lot more.

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Wrapping Up Our Beginner’s Guide to Non-Qualified Stock Options

So, what are non-qualified stock options? As you now know, these are a type of employee stock option that is commonly offered as part of a compensation package. They have a vesting period before you can actually exercise them. But when that time comes, you’ll be able to purchase company shares hopefully at a lower price than the company stock sits at the present day.

NSO options have an array of pros and cons, and they may or may not be the right choice for you depending on your financial situation. So – be sure to dig deeper and compare NSOs to the alternatives before signing any documentation.

Want to learn more about trading stock options for beginners? As mentioned earlier, you can explore our blog for all the detailed, trusted resources you need to navigate your financial future with complete confidence!