Black-Scholes Valuations

Types of Employee Stock Options

There are 2 types of employee stock options:

• Incentive Stock Options (ISOs) otherwise known as qualified or statutory stock options
• Nonqualified Stock Options (NSOs) otherwise known as non-statutory stock options

(See www.irs.gov/taxtopics/tc427.html)

ISOs and NSOs don't differ in the basics of stock-option operation, but they do have different Internal Revenue Code restrictions applied to them.

Some of these differences are:

• Who may receive options? Only employees can receive ISOs. Others (such as directors) can qualify for NSOs.
• ISOs have a 10-year mandatory expiration date.
• ISOs have a strict set of rules that must be stated in the organization’s ISO documents.
• Most importantly, each type of option is taxed differently.

For a more complete description of the differences between ISOs and NSOs (especially the taxes involved), please refer to DLC Course 20: The Basics of Equity Compensation.

Exercising Options

Stock options cannot be exercised until the vesting date. At that point there are three options:

• Do nothing. The timing may not be right to exercise the options. Why? The price may be expected to rise, the employee may not have the money to purchase the option, or the employee may not care to exercise the option because of tax considerations.
• Do a cashless exercise. The employee can contact the broker or plan administrator to purchase the stock at the strike price and then immediately sell the stock on the market. The employee receives the difference.
• Pay for the stock. The employee can request the stock and pay for it. Why? Timing of the sale and/or tax considerations sometimes makes this the best alternative.