Stock options are the classic "engine" of startup compensation. An Employee Stock Option (ESO) is not actual stock; rather, it is a call option that gives you the right to buy company stock at a specified price (the strike price) for a finite period . This distinction is vital: you don't own the shares yet, you own the opportunity to buy them. If the company's stock price soars to $100 and your strike price is $10, you can "exercise" your options to buy shares at a 90% discount .

The Mechanics of the Strike Price and the "Bargain Element"

The strike price (or exercise price) is typically set at the fair market value of the stock on the day the options are granted . The goal for any employee is for the market price to rise significantly above this strike price. The difference between the market price at the time of exercise and your strike price is known as the "spread" or the "bargain element" .

Example of the Bargain Element:
Imagine you are granted 1,000 options with a strike price of $25. Three years later, the company goes public, and the shares are trading at $75.

Strike Price Cost: $25,000 (1,000 shares x $25)
Market Value: $75,000 (1,000 shares x $75)
Bargain Element (Spread): $50,000

This $50,000 spread is what the IRS views as part of your compensation, and how it is taxed depends entirely on whether your options are ISOs or NSOs .

Incentive Stock Options (ISOs): The Tax-Advantaged Choice

Incentive Stock Options, also known as "statutory" or "qualified" options, are generally reserved for key employees and management . Their primary appeal is their preferential tax treatment. Unlike almost every other form of income, you generally do not pay ordinary income tax when you exercise an ISO . Instead, if you hold the shares long enough, the entire profit is taxed at the lower long-term capital gains rate.

The ISO Holding Period Requirements

To qualify for this "Qualified Disposition" and receive the tax break, you must meet two strict criteria:

You must hold the shares for at least two years from the original grant date .
You must hold the shares for at least one year after the date you exercised the options .

If you sell before meeting these marks, it is a "Disqualifying Disposition," and the bargain element is taxed as ordinary income, just like a standard NSO .

The $100,000 ISO Limit

The IRS limits the amount of ISOs that can vest in a single year. If the fair market value of the shares (measured at the time of grant) that become exercisable for the first time in a calendar year exceeds $100,000, the excess is automatically treated as an NSO . This is a crucial detail for high-level executives receiving large grants.

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

NSOs are the most common type of stock option because they are simpler for companies to administer and can be granted to anyone—employees, board members, or even outside consultants . However, they lack the tax "magic" of ISOs.

When you exercise an NSO, the bargain element is immediately taxed as ordinary income . Your employer is required to withhold taxes (Social Security, Medicare, etc.) on that spread, just as if they had paid you a cash bonus.

NSO Tax Example:
Using the previous example of a $50,000 spread:

Upon exercise, that $50,000 is added to your W-2 income for the year.
If your effective tax rate is 30%, you owe $15,000 in taxes immediately, even if you don't sell the shares.
The $75 market price becomes your new "cost basis." If you sell the shares later for $90, you only pay capital gains tax on the $15 increase ($90 - $75) .

The Hidden Danger: The Alternative Minimum Tax (AMT)

While ISOs avoid ordinary income tax at exercise, they are a "preference item" for the Alternative Minimum Tax (AMT) . The AMT is a parallel tax system designed to ensure high earners pay at least a minimum amount of tax. When you exercise an ISO, the bargain element is included in your AMT calculation .

If you exercise a large number of ISOs and hold the shares to get the long-term capital gains rate, you might find yourself with a massive AMT bill in April, despite not having sold any shares to generate the cash to pay it . This is a common trap that can lead to financial ruin if the stock price plummets after you've already triggered the tax liability.

Time Value vs. Intrinsic Value: When to Exercise?

An option's value is composed of two parts:

Intrinsic Value: The current spread (Market Price - Strike Price) .
Time Value: The potential for the stock to go even higher before the option expires (usually 10 years from grant) .

Exercising early captures the intrinsic value but "forfeits" the time value . Because ESOs have such long terms (10 years), their time value is often significant. Financial experts often suggest that unless there is a specific tax reason (like starting the clock for a qualified ISO disposition), it may be better to wait to exercise until closer to expiration or a liquidity event to avoid "frittering away" that time value .

Comparison Table: ISO vs. NSO Taxation

Event	ISO Tax Treatment	NSO Tax Treatment
Grant	No tax	No tax
Vesting	No tax	No tax
Exercise	No ordinary income tax (but AMT applies)	Ordinary income tax on the spread
Sale (Qualified)	Long-term capital gains on entire profit	Capital gains on growth since exercise
Sale (Disqualified)	Ordinary income tax on spread at exercise	N/A

Frequently Asked Questions: Stock Options

What happens if my options are "underwater"?
If the current market price is lower than your strike price, your options are "out of the money" or underwater. It would be illogical to exercise them because you could buy the stock cheaper on the open market .
Can I lose my options?
Yes. If you leave the company before they vest, you forfeit them. Even if they are vested, you typically only have a 90-day window to exercise them after leaving the company before they expire .
What is a "Cashless Exercise"?
This is when you exercise your options and immediately sell enough shares to cover the purchase price and taxes. It’s convenient because it requires no upfront cash, but for ISOs, it results in a "disqualifying disposition" .